Balance Return + Risk

Building your investments can look like a straightforward process. Your investment portfolio consists of stocks, bonds, or any other array of investment devices and these will supposedly grow. The gains, dividends, or interest income you receive will compound and the initial investment grows to the point where you can retire or support the lifestyle that suits you. But there is another aspect to investments that is usually overlooked and misunderstood: risks.

There are risks involved in ANY investment. Even the safest of invests, U.S. treasuries which are backed by the U.S. government, have the risk of inflation reducing the returns. Stocks run the risks of going to zero if the underlying business fails. Bonds have default risk.

How investments do correlates directly with the investor’s ability to handle both risk AND return. Returns must be maximized and risks must be minimized. Applying this is where the financial industry and professionals tend to lead individuals astray. They preach that there is an exact correlation between them. To increase return, you must increase risk. To reduce risk, you must reduce return. To understand this better, I’ll explain the dynamics between price and value as it relates to the stock market.

Investing in stocks is investing in businesses. A stock, or a share, is a piece of a business. If you buy 1 stock of Walmart, you own a piece of the company, albeit a very small piece. If you were to purchase all of the shares, you would own the whole company. If you look at a historical graph of the Walmart stock price, you can see that it goes up and to the right, indicating an increase in value. If you read through their historical financials, you can also see that the revenues and number of stores increased in tandem during that time period. As the value of the company grew, so did the stock price.

Even though the stock price and the fundamental of the business is correlated, it is not exact. Sometimes, the price and business become disconnected. This usually occurs because of a dramatic event, or the business is misunderstood. Consider Amazon. During the Dot.com crash in the 2000s, the stock price fell nearly 99% and, at the same time, the sales were increasing. The same thing happened to many companies during the great financial crisis and during Covid. These events can also be caused on a smaller level as well that only affect a select company.

By understanding that a stock is a business, we can then analyze that if the company does well, the stock will correlate to this reality eventually. Investing is just buying something for less than what it is worth. Maybe the business is temporarily going through an issue and will recover. This is value investing. Maybe the company will have massive growth opportunities in the future the rest of the market misunderstands. This is growth investing. Both of these insights are used by Iron Bay Research, and preferably at the same time. The stocks we pitch like to be companies that are selling at a discount and have growth opportunities.

So how does this relate to returns and risk? Buying a great company - that will provide a return. Buying that company at a fair or undervalued price - that will protect against risk. The latter concept is usually where the confusion lies. By only purchasing stocks in great businesses and ensuring we don’t overpay on price, we ensure that in the future there is a reduced chance that the price will be higher than what we paid for it. We concentrate our research on understanding that the company we invest in has a durable moat, has great management, potential to grow in the future, and selling at an intrinsically fair or better than fair price.

An easy example is buying a home:

Let’s say a house is worth $400,000. It is well built, updated, and in a great neighborhood. Paying $400,000 for a home worth $400,000 is fair. Paying $300,000 for that same house because you bought it at an uncertain time in the housing market is even better. Buying that same house for $300,000 while the areas around it are growing, leading to that house being worth $500,000 in the future - a very sound investment.

This same concept applies to businesses, and we apply it to every business we recommend.