Value Investing And Enterprise Risk Management: Two Sides .

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Value Investing and Enterprise Risk Management:Two Sides of the Same CoinSponsored bySociety of Actuaries’Committee on Knowledge Extension ResearchPrepared ByMax J. RudolphRudolph Financial Consulting, LLCJanuary 2013 2013 Society of Actuaries, All Rights ReservedThe opinions expressed and conclusions reached by the author are his own and do not represent any official position or opinionof the Society of Actuaries or its members. The Society of Actuaries makes no representation or warranty to the accuracy of theinformation.

ContentsExecutive Summary . 5Risk and Return – A Balancing Act . 5Unique Solutions . 5Background . 7Researcher . 7Introduction . 8Fundamental Analysis . 8Mosaic Theory/Scuttlebutt . 9Buffett’s Search . 10Structure . 121- Introduction . 13ERM . 13Value Investing . 15Comparison - Introduction . 162-Governance and an Enterprise Risk Management Framework . 16ERM . 16Value Investing . 19Comparison – Governance and an Enterprise Risk Management Framework . 213-Risk Management Policy . 22ERM . 22Value Investing . 24Comparison – Risk Management Policy . 284-Risk Tolerance Statement . 29ERM . 29 2013 Society of Actuaries, All Rights ReservedRudolph Financial Consulting LLCPage 2

Value Investing . 29Comparison – Risk Tolerance Statement . 355-Risk Responsiveness and Feedback Loop . 37ERM . 37Value Investing . 38Comparison – Risk Responsiveness and Feedback Loop . 406-Own Risk and Solvency Assessment (ORSA) . 42ERM . 42Value Investing . 43Comparison – Own Risk and Solvency Assessment (ORSA) . 457-Economic and Supervisory Capital. 47ERM . 47Value Investing . 49Comparison – Economic and Supervisory Capital. 498-Continuity Analysis . 50ERM . 50Value Investing . 51Comparison – Continuity Analysis . 529-Role of Supervision in Risk Management . 53ERM . 53Value Investing . 53Comparison – Role of Supervision in Risk Management . 54Conclusion . 54Appendix I - Howard Marks . 56Appendix II - Phil Fisher: The 15 points to look for in a common stock . 60Appendix III - John Train’s winning investment strategies . 61 2013 Society of Actuaries, All Rights ReservedRudolph Financial Consulting LLCPage 3

Appendix IV - An Investing Principles Checklist . 62Appendix V - Tenets of the Warren Buffett Way. 64Appendix VI - Investing for Insurers . 65Appendix VII - How Warren Buffett is Different from Most Investors . 66 2013 Society of Actuaries, All Rights ReservedRudolph Financial Consulting LLCPage 4

Executive Summary“Investing is simple, but not easy.” Warren Buffett“Everything that can be counted does not necessarily count; everything that counts cannotnecessarily be counted.” Albert EinsteinRisk and Return – A Balancing ActThe goal of this paper is to examine similarities between value investing and enterprise riskmanagement (ERM) methods. For some, especially portfolio managers, this may be obvious.These investors come to the table with experience using risk as a constraint while trying tooptimize returns. Years of experience have taught this group that risk balances return, and thatreturn balances risk. Value is added by creating favorable imbalances. The investor with highreturns and average risk has succeeded, as has the investor reporting average returns and lowrisk.Many concepts are shared between ERM and value investing. When defining risk, which isgenerally unique to the individual, an analyst considers uncertainty, downside risk, andoptimization. Value investors look at concepts like conservative assumptions, margin of safety,and asset allocation. These concepts are comparable, and this paper uses the InternationalActuarial Association’s Note on enterprise risk management (ERM) for capital and solvencypurposes in the insurance industry to take the reader through general ERM topics. This isfollowed by a comparable value investing discussion and a comparison of the two practiceareas. 1In some firms, a risk manager is placed in a position with little authority, limiting the benefits ofERM. A process driven ERM function can identify risks and risk owners, create a commonlanguage, and send useful reports to the Board. A stronger risk officer adds value by usingtransparency to understand risk interactions, scanning for emerging risks and generally keeping afocus on how an entity’s risk profile is evolving.Unique SolutionsEvery situation is unique. Risks and circumstances are specific and rarely duplicated. This meansthat solutions need to be unique as well. Looking at risk prospectively differs from looking atwhat has happened in the past. This is true for investing as much as it is for risk management.Things change. Stuff happens. The past does not always predict the future. Creating a flexible,1International Actuarial Association, Note on enterprise risk management (ERM) for capital andsolvency purposes in the insurance industryhttp://www.actuaries.org/CTTEES FINRISKS/Documents/Note on ERM.pdf (March 31, 2009). 2013 Society of Actuaries, All Rights ReservedRudolph Financial Consulting LLCPage 5

ethical, environment that uses common sense to guide decision making will create a culture thatadds value for the investor and risk manager.Quantitative models are important to both investors and risk managers because they lead togreater understanding of a risk profile. But there is also a downside to models. They work untilthey don’t. Projected assumptions fail to be reproduced in reality. Sometimes the results aremisleading, as can be the case when cash flows and income statements are used interchangeably.Value investing uses the same quantitative valuation techniques as other asset classes, like bondsand real estate. Calculating the present value of contingent cash flows is the same for a riskmanager and investor.Not all models are computer-based. Qualitative models based on experience often do anexcellent job, and also provide oversight for quantitative models. Investors are more likely to usethese types of methods, as they generally don’t have access to the detailed information availableto an internal risk manager. A multidisciplinary method is sometimes referred to as a latticeworkapproach to investing. This method takes the best each model has to offer and focuses onunderstanding how these models interact. It starts to take on the methods of a detective solving amystery. This is similar to mosaic investing theory. Mosaic theory proponents collect pieces ofinformation and put them together into a coherent story.A successful analyst often uses time arbitrage. This allows those with a longer time horizon tomake better decisions than those with a shorter time horizon. When the herd all moves in thesame direction, reacting to each new piece of information, the intelligent contrarian looks atfundamental analysis. Has anything really changed, or is the current zig likely to be followed bya zag and remain true to the intrinsic value? It could be a competitive advantage for those willingand emotionally able to wait out the market’s gyrations. The signal is the intrinsic value. Thenoise is opportunity, sometimes described by the parable about Mr. Market who gives you aprice at which he will buy/sell every day and allows you to choose when to take advantage ofthis opportunity.Both risk managers and value investors look at integrated risk analysis, seeking to understandaggregate risk across the entire entity. Knowing how the exposures might interact in the futuredrives scenario analysis and improves the odds of both survival and success. An investor’scapital allocation process is comparable to a risk manager’s capital management process, andmany of the tools are compatible.Those who are good at either risk management or investing have shown the skill set to succeedin the other. The actuarial skill set seems particularly advantageous to move seamlessly betweeninvesting and enterprise risk management projects. In the future, analysts will continue tocalculate intrinsic values based on discounting contingent events. This can be applied to eitherinvesting or evaluating risks. 2013 Society of Actuaries, All Rights ReservedRudolph Financial Consulting LLCPage 6

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Value investing uses the same quantitative valuation techniques as other asset classes, like bonds and real estate. Calculating the present value of contingent cash flows is the same for a risk manager and investor. Not all models are computer-based. Qualitative models based on experience often do an