Finding the Next Starbucks - Part 2 - Definition of Risk

Before I delve into some of the specific investment concepts that Michael Moe covers in his book, "Finding the Next Starbucks: How to Identify and Invest in the Hot Stocks of Tomorrow," I want to talk about one of the passages that appears in the first 10 pages that sets the stage for finding a great growth stock. Despite Moe's focus on growth, he does an excellent job balancing that objective with a value-oriented, contrarian approach (which is a big reason why I think the book is worthwhile for a value investor as well). Consider the following excerpt from Chapter 1. I want to drill down on one sentence in particular, but these three paragraphs are very important for any investor, regardless of what types of investments they are looking for.

“Ultimately, in sports, gambling, investing, and life, there is little value in knowing what happened yesterday. The largest rewards come from anticipating what will occur in the future. As Warren Buffett once said, ‘If history books were the key to riches, the Forbes 400 would consist of librarians.”

Fundamental in our pursuit of attractive investment opportunities is my philosophy of risk and reward. I view risk as measuring the potential for permanent capital loss, not short-term quotational loss, and assess the probability of that against what we think the value of the business will be in the future.

“It is with this perspective that I fly right in the face of conventional wisdom, which suggests the bigger the return, the more risk one has to assume. From my point of view, large returns will occur when we find an opportunity where the upside potential is substantial, yet the price we pay for it is not. My goal is to find a stock whose price is below what I think the appraised value should be, not what the quotational value is as indicated by the current market price.”

Much of that may seem logical and obvious to a value investor. However, to a growth investor it may be a bit off-topic. After all, they focus on growth first, with valuation often trailing in importance. By combining the two, as Moe suggests, you can significantly boost your chances of finding the next great growth stock.

I want to expand on one part of that passage:

"Conventional wisdom, which suggests the bigger the return, the more risk one has to assume."

It amazes me that "risk" is almost always defined as how volatile a stock is. If you open a college level finance textbook , risk is almost always defined as how much a stock moves up and down relative to some other benchmark. In most cases, a stock's beta is used to compare an individual stock's "risk" with that of the overall market, the S&P 500 index. So, a tech stock with a beta of 1.50 is much more "risky" than a utility stock with a beta of 0.50.

I strongly disagree with this assertion, and it appears Michael Moe also objects to this conventional wisdom. Should the words "risk" and "volatility" by synonymous? I don't believe so and let me explain why. Consider two stocks you are evaluating for a one year investment horizon. Both stocks currently trade at $50 per share. After doing a careful analysis you determine that:

*Company A has a 70% chance of rising to $60 in one year, and a 30% chance of falling to $40 in the same time frame. The stock's beta is 1.50.

*Company B has a 50% chance of rising to $55 in one year, and a 50% chance of falling to $45 in the same time frame. The stock's beta is 0.75.

Which stock is more risky?

If you consider risk to be volatility, you are going to say Company B is less risky. If you calculate the expected value of Company B stock in a year, you get $50.00 per share, a zero percent gain.

If you consider risk , as I do, to be the odds of permanent capital loss, you will conclude that Company A is less risky. Not only is your expected value in a year higher ($54.00, a gain of 8 percent), but the odds of losing money are only 30 percent, versus 50 percent for Company B.

I would argue that Company A is less risky despite the fact that the betas of each stock imply that Company A will move twice as much, in percentage terms, during the typical trading day. In my view, risk and volatility are different animals. For me, risk is defined as the probability that I lose money during my desired time horizon for a particular investment.

If I'm investing for one year, I want to minimize the odds that after the year is up, I am underwater on the investment. How volatile the share price is during that year is pretty much irrelevant to me because if my analysis is correct, the stock will be worth more than I paid for it after a year's time.

This post is the second in a multi-part series discussing the book Finding the Next Starbucks . You may read Part 1 in the series below and be sure to stay tuned for more posts in the series. Feel free to subscribe to this blog if you want to be notified via email or rss feed when new posts are published.

Finding the Next Starbucks - Part 1


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