Due to the cyclical nature of commodity prices, the cash flows of resources companies were volatile. What rose strongly soon fell suddenly. A good way of analysing the cash flows of cyclical companies, Conlon says, is to view them in the context of a full cycle and not at their peaks. The degrees of financial and operating leverage and their impacts on cash flows should also be monitored. In a battle cry for fundamental analysis, Conlon says investors should inspect the four “building blocks” of companies – operating and financial leverage, valuation and stock liquidity – before deciding how much they should rely on volatility measures.

“Most people look in the rearview mirror and torture stock price information to make it confess. This is easy to do because managers have got access – that’s why they use it, not because it’s right. “Risk is fundamental, not statistical. Investors should demand more fundamental risk data from funds managers.” Laubsch of RiskMetrics is not so polemical. He argues that risk management is comprised of equal parts “art, science and culture”, meaning a combination of fundamental and quantitative analysis, and a proactive way of dealing with risk.

Both he and Conlon consider the idea that crises arrive unexpectedly is a “myth”. (The carnage on equity markets is “something that a hedge fund manager would call a multi-standard deviation event,” Conlon says. “What a load of rubbish.”) For Laubsch, both quantitative and qualitative risk analysis can uncover warnings of menacing outlier events. “Everyone talks about black swans,” Laubsch says. “The subprime bubble was not one – it was a white swan. People predicted it, but most people don’t want to hear that the world is going to end when there is easy money to be made.

“Risk is always underpriced at the latest stage of the party.” Investors who rely on VaR as their only guide to market volatility are “foolish”, and those who ignore it are “equally foolish”. Some of the historical VaR simulations used by banks in the runup to the credit crisis did not identify market volatility because they were backward-looking. Responsive volatility measures would have been more useful, Laubsch says.

“If you have a regime shift, which is what happened in late 2006 to 2007, using historical simulation is quite useless.” Forensic accounting also uncovers weaknesses in companies. Analysis of New Century Financial, the first subprime lender to fail, found the business had not replenished its capital reserves against loan losses, which had been tapped as subprime defaults accelerated. The company hid this shortfall by combining its reserves against both real estate and loan losses as one sum. New Century stock traded north of US$30 in November 2006. In March, the company collapsed.

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