Eddie Lampert on Managing Risk

As investors, risk management is an essential tool.However, the problems of modern portfolio theory and the use of Beta to determine WACC, make us uncomfortable.Beta as a measure of a stock's past volatility does not equate to anything substantial and is a poor indicator of risk.So how does one manage risk? While rereading Lampert's shareholder letter 2006, i came across this interesting paragraph

"Indeed, business is about managing risk. When these risks come in other forms, they are not always accompanied by the same level of detailed disclosure in public filings. Doing business in California will always carry "earthquake risk" and doing apparel business in winter clothing will carry "weather risk." Investors and executives focus on some of these risks and tend to overlook others. If a company’s risk-management process is a robust one, the level of focus will be proportionate to the amount of risk and the probability of the risk occurring, as well as whether or not the risk can be effectively managed. At Sears Holdings, we try to manage risk in an effective way whether it is in our investment decisions, our real estate decisions, or our product line decisions and we are prepared to take risks where we believe the probability of success justifies the investment.We will not always be successful, but if we do a good job of evaluating opportunities and executing on them, we believe that our shareholders will be well rewarded"

Here, Lampert suggests that as investors ,we intend to overlook some risks while focusing on others.So for Lampert, risk management means being prepared for unexpected risks that may appear from nowhere.Another key point is the probability of success needs to be high enough to justify the investment.For Lampert who often buys larges stakes in companies and usually forces management to heavily buyback shares or allocate capital,this means one needs to be conservative with his capital and ensure the probability of success is very high.With the case of Autozone, he forced management to aggressively buy back stock .A share buyback would reward existing shareholders and be an excellent yet conservative way of allocating capital.After all,management is basically increasing the stake of its existing shareholders and not chasing risky acquisitions for growth.Once the stock rebounds, shareholders can then cash out and realise their returns ,provided they had bought it when it was relatively undervalued.What an excellent way to manage risk!

Regards,
Manpreet