The Emperor and the Dog

January 29, 2006. On that day, it will be the new Chinese New Year. The Year of the Dog.

Hence, I thought it would appropriate if i bring up this delightful investment piece from the book, Sun Tzu on Investing.

There’s an old Chinese story about an Emperor and his pet dog.

The Emperor awoke one day when he heard a loud noise. From his bedroom window he could see a large ox-drawn cart had run into a wooden flagpole used to raise the Emperor’s family crest high above the castle. The flagpole was ever so slightly tilted, but the damage appeared minimal and no repair work was initiated. Later that day, the Emperor was walking his dog past the flagpole and the dog stopped to, well, to do what dog’s do to flagpoles. Suddenly, with a loud snap the pole crashed down onto the poor dog before he could even lower his raised hind leg, killing him instantly.

What the Emperor and his attendants couldn’t see was damage hidden below the surface. The flagpole had leaned ever so slightly, but it was enough to cause a critical break in the structure just below ground level. Obviously, the dog got the raw end of this whole deal. But let us pose a simple question: If you were trying to assess blame for unnecessary risks in this situation, where would you place it?

You could blame the workers employed by the Emperor to erect a flagpole for choosing a pole with a weak spot and concealing it below the ground. Or you could blame the Emperor, although it may cost you your life, for his vanity in demanding such a tall flagpole to fly his family crest above the castle. Maybe the fault was with the deliveryman who carelessly backed his ox cart into the pole causing the imminent damage. We could also blame the dog for marking too wide a territory! The story illustrates how difficult it can be to assess where risk originates. To the dog it mattered not how or why it happened, or even to who the blame should be assessed--just the fact that it happened.

When it comes to equity investing, you are the dog. If there are risks being taken by companies you hold, you are the one who will suffer the most direct damage. That’s the cold, hard truth. The thing is, those who are taking the risks may not recognize them as such, or may be purposefully concealing them from you. All the more reason for you to be extremely careful in selecting the companies you choose to invest in, and the integrity of the managers.

Enron Corp, a leading Houston, Texas-based global energy giant employing over 6,000 people was dramatically exposed during 2002 as its executives and its professional consultants had been going to great lengths to hide some of the risks that the company was assuming from its shareholders. But even without their efforts to cover their trail of secret off-balance-sheet high-risk investments, one would guess that 99% of the people who bought Enron stock never attempted to sort through Enron’s financial footnotes searching for risks. Had they done so, they would probably not have identified the key risks, as even some of the smartest accounting minds in the world have disclosed that Enron had been a black box--i.e. a complete mystery to them. But the point is that millions of intelligent shareholders (including a good number of global professional fund managers) accepted the blue-chip status of this massive business without performing any due diligence tests, they accepted broker advice and analyst buy recommendations, when the sad reality was (despite audited financial reports to the contrary) that the company was literally on the verge of financial collapse.

We are never going to have all of the information necessary to assess all the risks inherent in equity investments. Despite moves to improve corporate transparency, companies are under no obligation to reveal their internal operations to outside investors. To do so would require making some sensitive information public when good business acumen dictates keeping it as a secret to preserve competitive advantages. However, we are each obligated to at least consider potential risks and ask the right questions. If not, like the Emperor’s dog, we are sure to eventually be crushed under the weight of our own ignorance.

Investing is all about risk. The more risk you take, the higher your potential returns. And this is all correct, except for the fact that it is exactly wrong. Investing is all about perceived risk. Where you as an investor have an advantage is only in situations where you can correctly assess that the market has overestimated (or underestimated) future risks or returns. That requires foreknowledge. Remember Sun Tzu’s words, Foreknowledge cannot be gotten from ghosts and spirits, cannot be had by analogy, cannot be found out by calculation. It must be obtained from people, people who know the conditions of the enemy.

Foreknowledge only comes from asking the right questions of the right people. Occasionally, we all miss a key piece of information and suffer an unexpected loss on an investment. These situations can be minimized by investors who refuse to accept broker and analyst opinions at face value, insist on asking their own questions of management, analyze a company’s financial footnotes on their own, and purposefully list every possible downside risk involved in a business--even a business they have already invested in and consider a favorite holding. The most difficult risk to assess is the risk of a negative unexpected event affecting one of your favorite stocks, the very stock you have been buying and recommending to all your friends.

A truly excellent piece.

What is most interesting about the write-up is the very last statement.

The most difficult risk to assess is the risk of a negative unexpected event affecting one of your favorite stocks, the very stock you have been buying and recommending to all your friends.

How?

Your Favorite stock, the very one that you have been banking on, the one that you recommend to all your friends, has a serious flaw stemming from a negative unexpected event.

How?

What are you going do about it?

Are you going to accept that your investment is very likely to go bad, accept the defeat and move on?

Or are you going to continue digging in the hole that you found yourself in?