Wednesday, December 15, 2010

How value investors think about risk

Quite a number of people will tell you that investing in stocks is very risky, and that you can lose a lot of money by buying stocks. A significant number of these people think stocks are risky simply because they can drop in price.
While it is true that there are a number of risks in investing in stocks, short-term market fluctuations is definitely not one of them (This assumes that you know what you’re doing, invest for the long-term, and apply sound investing principles. And if you don’t have these things in your approach to investing, you shouldn’t be buying stocks anyway.)

When you invest in stocks, you are investing in small pieces of companies. And because of that, a lot of the risks you face are generally related to whether or not those stocks or companies you have invested in will remain financially stable and continue to be profitable and grow profits at a healthy rate. Some of the other risks that investors face are paying too much, dilution of their holdings, and etc. In this article, I will be talking about some of the risks that value investors look at when investing in stocks.

Side note: Investors should avoid picking individual stocks if he or she doesn’t know how to value them. This doesn’t mean that investors who can’t value stocks can’t get invested in stocks. You can still get exposure to stocks through dollar cost averaging into a low-cost index fund or a good mutual fund.    

Financial strength

The better the financial position of a company, the less likely it will go bankrupt, restructure, or do things that will destroy significant shareholder value, and the lower the risk of you losing a huge part or even all of the money you invested in that company (when I talk about losing money, I don’t mean paper losses, but permanent impairment to the profitability of the company). True, just because a company is financially stable doesn’t mean you won’t lose money investing in it. But if you don’t get the basics right, you will always be exposed to significant risk, and a strong financial position is the foundation of a company that’s unlikely to wipe out their shareholders anytime soon. 

Here are some of the things I look at when deciding whether or not a company is financially stable:

The company’s operating cash flow need to be able to comfortably fund its interest payments and capital expenditures.

The company shouldn’t have too much debt, and should have enough cash on its balance sheet to keep operations running (even in severe downturns) without taking on significant debt, diluting existing shareholders and issuing new shares, restructuring, or etc.  

Growth

In his “Conservative Investors Sleep Well” writing, Philip A. Fisher wrote, “It has already been pointed out that in this rapidly changing world companies cannot stand still. They must either get better or worse, improve or go downhill. The true investment objective of growth is not just to make gains but to avoid loss.”

The main reason investors put their money into stocks is to beat inflation and end up with more money (in real terms) in the future. If the earnings and revenue of the stocks you invest in don’t grow or grow at a very slow pace, you will face the risk of inflation eroding the value of your investments. To reduce this risk of losing our money slowly to inflation (or even quickly if inflation really spikes), we have to invest in stocks that we believe will consistently grow both profits and revenue at a faster pace than inflation.

It is ironic that some, if not most, of the same people that avoid stocks because they think that stocks are too risky expose themselves to a much higher risk of losing money in real terms to inflation by having too much of their assets in cash or even very low yield bonds (cash are incredibly lousy long-term investments, and I don’t think you will do very well lending money to IBM at 1%).       

Competitive advantage

Investors can reduce their risk by investing in companies that have a competitive advantage over their competitors, as these companies’ competitive advantages will, to a certain extent (this depends on the significance of the competitive advantage), protect their current profitability and give them the opportunity to grow healthily and profitably.   

There are quite a few different types of competitive advantages. Here are a few of them: Having a strong brand, being the low-cost producer, having a near monopoly over a certain market, and etc.

Management

One of the main purposes of a company’s management team is to minimize the risk of shareholders losing money (as I said earlier, when I say losing money, I don’t mean losing money in terms of paper losses, but losing money in terms of impairment of the long-term profitability of the company) and create good value for shareholders by making sure the company stays financially stable, grows profits and revenues at a healthy rate, constantly increases its competitive advantage, reinvest its profits at a good rate of return or pay out dividends if it can’t, and etc. Needless to say, bad management equals high risk of losing money. That’s why we need to invest in companies headed by good management teams if we want to reduce our risk.

I wrote this article here about some of the things we should look at when evaluating the quality of management. It’s a good sign if management does what it says, is honest with shareholders, own, in relation to their annual compensation, a significant amount of shares in the company, and consistently achieve a good return on equity for shareholders.  

Price

It’s always important to utilize Benjamin Graham’s margin of safety concept when investing,and generally only buy a stock when it is trading at a significant discount to your estimation of intrinsic value. The lower the price you pay for the stock in relation to its intrinsic value, the larger your margin of safety and the lower your risk.

Just think about it this way:

If you pay too much for a company’s stock, the company has to keep producing fantastic results for maybe even a long time (I think most companies will eventually disappoint), and if it doesn’t, reality will catch up to the stock and its price will plummet.

But if you buy a company’s stock for cheap, the company can perform poorly and you still might get away with your principal intact. This is the case as the price you paid for the stock might reflect that of a company that’s of a much lesser value than what the company’s current intrinsic value is. So, even if the intrinsic value of the company significantly declines, the company’s declined intrinsic value per share might still be somewhere around the price you paid for each share of the company’s stock.

Circle of competence

Risk comes from not knowing what you're doing. –Quote from Warren Buffett

How you value a company should also be affected by the industry the company is in. Example: same-store-sales are important for retailers, while cost of funds and a strong deposit base is important for banks.

It can be very dangerous to invest in companies from an industry that you do not understand, as you might buy a stock that you think is cheap and has great fundamentals, only to find out later that because you didn’t take into account something significant during your evaluation of the stock, you actually overpaid for the stock and/or the fundamentals are actually quite lousy.

It really isn’t important to have a large circle of competence, as you can make a lot of money by simply having a very good understanding of a few or maybe even one industry, and investing in good companies (when they trade at attractive prices, of course)  in those industries or industry. As long as you invest in companies you understand, the risk of losing money is significantly reduced.

This circle of competence concept also applies to investing. If you don’t know how to value companies, you should regularly invest your money in a low-cost index fund or a good mutual fund instead of picking individual stocks.


If you have any questions, or have anything that you would like to share, please feel free to comment. Thank you for reading, and may you always sustain good returns on your portfolio. Take care.