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Charting a path through uncertainty - How Blue Whale views and manages risk.
by Stephen Yiu

01 Dec 2020


When Odysseus, a hero of the Trojan War, sailed home through the Strait of Messina, he was warned to do so with great caution, for on both sides of the strait lay danger – a six-headed man-eating monster on one and a giant whirlpool on the other. Odysseus navigated the passage cautiously through the middle and delivered the ship and crew closer to home and safety.

We find this to be an apt metaphor for managing a portfolio of 25-35 holdings in the stormy seas of global equity markets. There are many risks and dangers that lurk around a surging market rally. Therefore, to deliver consistent significant outperformance successfully, we must navigate the choppy waters with hard work and discipline.


What is risk?

Volatility is not risk

Many professional investors take volatility as an indicator of risk; our view is quite different.

Firstly, share price volatility is hardly ever an indicator of company quality. As owners of Adobe and PayPal, if we had managed risk by simply looking at volatility then we would have established only small positions in these high quality businesses or sold out of them long ago – to the detriment of our investors.

Secondly, volatility can be a good thing, providing opportunities to buy high quality companies during short-term depressions in price.

Lastly, in the pursuit of limiting volatility via diversification, one often ends up with returns no better than a passive index fund.


How Blue Whale views risk

Quite simply, we define risk as a permanent loss of capital.

A permanent loss of capital can occur at the company level (bankruptcies, fraud, mismanagement etc.), industry level (technological/creative disruption) and at the market and macro levels through critical changes in economic output and political interference.

By viewing risk as the danger to outperformance from an irreversible loss of capital, we can better focus on how to manage and mitigate it.


How Blue Whale manages risk

We start by accepting, like in the Serenity Prayer, that there are things we cannot change.

Throughout the history of markets, there have always been testing periods when share prices went sideways or down. We accept that we cannot predict or control these years of lean market performance. If an investor sold their holdings during these times, they could well recognise a permanent loss of capital.

However, as long term investors, we believe that staying invested is the best way to ride out any storm. Although we cannot guarantee positive performance forever, we have developed a risk management framework to help us through turbulent times.

The North Star of our framework is our understanding of risks and their likelihoods. For risks where outcomes are clearer, we manage our exposure through our in-house fundamental research and our strict valuation discipline:

By investing in only high-quality businesses, many company-level risks are simply eliminated through our in-house research process: we do not invest in companies and industries that are getting disrupted (conversely we like the companies doing the “disrupting”) or experiencing weakening competitive position; we do not invest in companies with high debt or potential cash flow problems; nor do we invest in companies that are weak on corporate governance and where there is little or no alignment between management and shareholders. This means that high quality companies, even if they have highly volatile share prices, are actually less risky.

For macro-level risks, we are not in the business of second-guessing the Bank of England or the US Fed so we focus on what is within our control, namely: stress testing our companies’ balance sheets and cash flows through recessions and adverse scenarios; speaking with company representatives to ascertain the impact of geopolitical events. In short, we develop a thorough understanding of the impact of macro risks on our portfolio holdings and we act accordingly.

For market-level risks, we exercise a strict valuation discipline. We do so by assiduously monitoring industry and market developments with the aim of ensuring that market prices do not run significantly ahead of company fundamentals. When we see a company’s valuation getting frothy, we will reduce the holding and channel capital into other, less expensive, high quality businesses. If the market itself becomes frothy, we are not averse to increasing our cash holding.

For risks where there is more uncertainty, we can choose to either eliminate, accept or reduce our exposure. For example:

  • We decided to eliminate our COVID risk exposure through IHG because the return to revenue and cashflow growth in the business was highly uncertain.
  • On the other hand, in the case of Mastercard and Visa, we decided to accept the COVID risk coming from reduced cross-border travel spend as this would be partly mitigated by an acceleration in online and digital card payments.
  • We decided to reduce our exposure to market risk in the case of Amazon, which had rallied significantly on the back of strong eCommerce revenues during the pandemic. We exercised our strict valuation discipline and took the company out of our top 10 holdings in Q3 2020.

Our risk management framework, like our research process, is straightforward but not easy. It is, however, absolutely necessary if we are to continue charting a course to delivering consistent significant outperformance for our investors.


Dealing with Uncertainty through 2021 and beyond

The classical scholars out there will be quick to point out that Odysseus didn’t get past the dangers completely unscathed – he’d lost six of his crew to the six-headed monster perching on one side of the cliffs in the Strait of Messina. However, therein lies the lesson in risk management: the rest of his four-dozen men and the entire ship sailed through, achieving Odysseus’s primary objective.

Though young, many in our team have experienced multiple market cycles, and we therefore accept that not all our holdings will be perennial outperformers. We are aware of the risks and uncertainties out there. However, we prefer to be decisive in the face of uncertainty rather than be paralysed by it. We accept the risks, and we take action to manage, monitor and mitigate them with all the tools we have available to us. That’s what active investing is all about.

2020 has certainly been a year full of risks and dangers but we are glad to report on successfully delivering outperformance for our investors. In 2021 we will take the example of Odysseus with us – cautiously navigating the route ahead of us, remaining vigilant and with the aim of continuing to deliver consistent significant outperformance for our investors.



This is a continuing part of our ongoing series on How We Invest at Blue Whale. In part 1 we talk about the companies we avoid, in part 2 we talk about what we look for in a company, in part 3 we talk about our tech exposure, part 4 is about valuation, and part 5 is about country exposure.


Please note that the information provided in this article is not to be construed as advice and any views we express on holdings do not constitute investment recommendations and must not be viewed as such. If you are unsure as to the suitability of an investment for your circumstances, please seek independent financial advice. Investments can go down in value as well as up so you may get back less than you invested. Your capital is at risk. Past performance is not a guide to future performance.