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Risk is the probability of losing money. All stocks are risky compared
to government-insured savings accounts; but some stocks are a lot
riskier than others. Yet investors rarely evaluate the inherent risks when
contemplating buying a stock. But it makes sense to do so. For instance,
suppose that you were considering two stocks, and your analysis
showed that both had the possibility of doubling in price over the next
two years, but Company A’s stock was twice as risky as Company B’s.
Knowing that, the choice between Company A and Company B becomes
obvious.
Portfolio Risk
You can reduce your overall risk by diversifying your investments
over a variety of stocks in diverse industries.
The airline and oil industries provide a classic example. Increasing
oil prices translate to high profits for the oil industry, but the result-
ing increases in fuel costs depress airline profits, and hence their stock
prices. Conversely, airlines tend to prosper when fuel prices drop, and
the oil industry is suffering.
Opinions vary on the number of different holdings required for
adequate diversification. Some say that you can achieve adequate diversification
with as few as 12 stocks, while others say as many as 40 or 50
different holdings are required. Diversify as much as possible, and
above all, avoid investing more than 25 percent of your funds in any one
sector, e.g., technology, health, financial, and so forth.
Does Low Valuation Equal Low Risk?
Several academic studies found that portfolios made up of low
valuation stocks, say those with low P/E ratios, outperformed high valuation
portfolios over various time frames. In other words, value-priced
stocks outperform growth stocks. That sounds like news that you can
use, but when you delve into the details, you’ll find that just a few stocks
account for the value portfolio’s outperformance. It turns out that most
stocks making up those portfolios actually lost money.
To illustrate that phenomenon, I made up a portfolio of deep-value
stocks. These were stocks that as of February 2001 had price/book ratios
between 0.1 and 0.5. I call them deep-value stocks because usually
a price/book ratio below 1.0 is enough to qualify a stock as value-priced.
A total of 501 stocks met my deep-value requirements.
I measured the performance of my deep-value portfolio between
February 2001 and February 2002. It returned 3 percent over the 52
weeks. That was a good return considering that the market as measured
by the S&P 500 dropped around 12 percent during the period.
But when I looked at the results in detail, I found that a few outsized
performers skewed the returns. For example, excluding just the top
10 performers would have turned the 3 percent gain into a 6 percent loss.
The same effect worked in reverse. Removing the ten biggest
losers increased the portfolio return to 5.1 percent. Unless you bought
all 501 stocks, you could have made money, or you could have lost money,
depending on the particular stocks you picked.
I’ve done many similar tests in my search for the magic formula
that would routinely turn up a list of market-beating stocks at the push
of a button. Whenever I thought I’d uncovered the Holy Grail, it always
turned out that a few stocks powered the portfolio’s returns.
So What?
Here’s the point! It doesn't matter if value-priced stocks are more
or less risky than growth stocks if you’re only buying 5, 10, or 20 stocks.
Your risk hinges on only three issues:
1. Overall market risk
2. Industry risk
3. Risks specific to your stocks
We’ll examine overall market and industry risks, then move on
to evaluate the risks specific to individual stocks.
Market Risk
Even if you’re a great stock picker, it’s tough making money
holding stocks in a bear, or downtrending, market. On the other hand,
you can make lots of mistakes and still rake in profits in strong markets.
That’s where the market expression: “Don’t mistake a bull market for
brains,” came from. Consequently, overall market risk is an important
factor in the risk equation.
Of course, predicting future stock market direction requires
knowing which way interest rates, inflation, and a host of additional economic
factors are heading. Economists spend their careers trying to discover
the answers to these questions, usually without much success.
Instead of pondering these unanswerable questions, we’ll gauge
market risk by looking at two easily determined factors: is the market
currently undervalued or overvalued and is the market currently moving
up, or moving down?
1. Market Valuation
Several studies show a relationship between market risk and the
difference between the market’s valuation and prevailing interest rates.
It’s an inverse relationship, meaning low prevailing interest rates support
higher market valuations. The S&P 500 Index is usually used as a
proxy for the entire market, and most experts express the market’s valuation
in terms of the S&P 500’s price to earnings (P/E) ratio. This P/E
ratio is simply the market-weighted average P/E of the stocks making up
the index. Market-weighted means the bigger the firm in terms of market-
capitalization, the more weight given to its P/E in the calculation.
One way to determine where we are in terms of valuation is to
invert the market’s P/E to get earnings yield. For instance, the yield is 5
percent if the P/E is 20 (1/20 = 0.05 or 5%). Then compare the market
yield to prevailing interest rates, typically the three-month U.S. Treasury
bill rate.
Usually the market yield is higher than the T-bill rate. What’s
important is the spread (difference) between the two rates. The market
is considered high risk when the spread is low or negative.
2. Market Direction
Sizing up the current market direction gives you a heads-up as to
whether it makes sense to invest new money or stay on the sidelines. A
strong uptrend gives you a green light to add to positions, while a strong
downtrend advises caution.
Since many investors rely on the S&P 500 to represent the market,
the easiest way to gauge market direction is to compare the index to
its 200-day moving average (MA). If the S&P is above
its 200-day MA, it’s probably in an uptrend, and vice versa. The distance
between the index and its moving average reflects the trend strength.
The trend is strong if the index is far above or below its moving average.
It indicates a trendless or consolidating market if the index is hovering
near, or crisscrossing, its moving average.
The S&P 500 Index reflects the action of large-cap stocks in a
wide variety of industries. Other indexes may provide better indications
depending on the particular market sector that you’re considering. For
instance, the Nasdaq reflects the action of tech stocks, and the Russell
2000 index better shows how small-caps are faring.
There are a variety of other indexes available to show the action
of mid-caps, value or growth stocks, or of individual industries. SectorUpdates.
com (www.sectorupdates.com) is a good place to find these
indexes. Click on Sector Charts to see the complete list.
It’s best to avoid buying stocks in a downtrending market unless
it belongs to an industry sector showing strength despite the weak overall
market.
3. Spotting Strong Industries in a Weak Market
No matter how weak the market, stocks in some industries will
do fine. You can still make money if you spot those strong industries.
BigCharts (www.bigcharts.com) displays lists showing the
10 best and 10 worst performing industries for periods ranging from one
week to five years. The default is three months, and that’s a good starting
point. But things change quickly, so check the one-month listings to
make sure that a hot industry on the three-month chart isn’t fading. Once
you’ve spotted an industry of interest, you can click on the industry
name to see a list of the 10 best and 10 worst performing stocks within
that industry for the selected period.
You take on additional risks when you buy stocks in underperforming
industries, even in strong overall markets. So it pays to see how
your candidate’s industry is faring anytime that you’re considering a
purchase.
Company-Specific Risks:
Company-specific risks relate to a firm’s business plan, stock
valuation, profitability, accounting practices, growth strategy, and other
factors particular to the company, rather than to the overall market.
Some of the risks listed in the following pages are serious enough to
disqualify a candidate from further consideration and are identified as such in
the description. Others are less severe and by themselves would not disqualify
the stock. However, in the end you’ll do best by picking the candidates with
the fewest risk factors.
1. Products on Allocation
Companies selling products into markets where demand exceeds
supply can only fill a proportion of each customer’s order until the firm
is able to ramp up its production. Customers soon figure out that they
must order two or three times what they really need to get sufficient
product. They often stockpile inventory to make sure that they don’t run
short. The resulting exaggerated order rate causes analysts, investors,
and company officials to overestimate demand.
Eventually production catches up with demand and customers
begin receiving full, instead of partial orders. Since they overordered,
they find themselves overstocked, and start canceling orders. This scenario
invariably plays out faster than everyone expects. Trex Company’s
experience illustrates the phenomenon.
Trex makes fake wood decking material. It pioneered and dominates
the fast-growing field. In early 2000, Trex couldn’t keep up with
demand and had to put its customers on allocation even though it had
ramped up production by more than 70 percent. Trex continued to add
production lines and in August told customers that shipments would
soon catch up with orders. Customers adjusted quickly by reducing orders
down to the levels they really needed. As a result, instead of the expected
increase, Trex’s September quarter sales dropped to $25 million,
compared to June’s $36 million.
2. Litigation
Large corporations are almost always being sued– sometimes
by disgruntled employees or customers, sometimes by other corporations
over patents or other issues, or sometimes by shareholders upset
because they lost money on the stock. These lawsuits are part of the
costs of doing business and usually would not affect your analysis.
However sometimes a company is involved in a lawsuit that could
materially affect its business prospects, or even threaten its survival.
Companies such as MP3.com and Napster were almost driven
out of business by lawsuits brought by music publishers and recording
companies in 2001, contending that MP3 and Napster were distributing
copyrighted songs without paying. Asbestos-related litigation has
driven several large firms into bankruptcy. Just the threat of a large
lawsuit can weigh heavily on a company’s stock price.
Corporations must disclose all significant lawsuits in their
quarterly and annual reports. Management, of course, routinely says
that all such claims are without merit. Nobody, certainly not company
management or stock analysts, can predict the outcome of a lawsuit.
Avoid all stocks facing litigation with a potentially costly outcome.
3. Restates Earnings
A company usually restates earnings when its auditor or the Securities
and Exchange Commission (SEC) finds that its earlier reported
earnings were too high. Any significant downward earnings restatement
is a red flag signaling that the company had been practicing creative accounting
to enhance its reported earnings. Circumstances vary, but just
because it was caught once doesn’t mean management has changed its
ways. Avoid firms that significantly restated earnings downward unless
new management is now in charge.
4. Sector Outlook Diminishes
Earnings disappointments or reduced guidance from one company
in a market sector warns that all companies in the same market face
similar problems.
The contract manufacturing industry affords a good illustration.
On September 13, 2000, SCI Systems, one of the industry’s major players,
said that it wasn’t going to meet its September quarter forecasts. The
company blamed the shortfall on slower than expected sales and on
component shortages. You’d think that those same issues would apply
to all players, but analysts didn’t see the connection. According to one
analyst, SCI’s woes were a “temporary problem” caused by a “design
flaw in one of its customer’s products.”
SCI’s competitors Solectron, Jabil Circuits, and Flextronics took
the news in stride, taking just small hits to their share prices at the time.
However investors in those stocks would have been well advised to heed
SCI’s warning. A month later all three began death slides that eventually
led them to lose more than 60 percent of their value. Avoid stocks in industries
where competitors have recently reduced earnings guidance, or
have reported negative surprises.
5. Interest Rate Risk
Interest rate changes, or even the prospect of changes in rates,
usually move the market. Rising interest rates are perceived as bad for
stocks in general and pressure the entire market. Interest sensitive industries
such as homebuilders, utilities, and all companies carrying high
debt can be especially hard-hit when rates rise. Banks and others in the
financial sector suffer when the spread between short- and long-term interest
rates narrows.
Conversely, energy, healthcare, and technology stocks often outperform
the market in rising interest rate environments.
Interest rate changes, actual or prospective, in the direction that
works against a particular company’s industry sector add risk but not
necessary a disqualifying factor per se.
Company-Specific Risks:
1. Financial Health
Company failure is the most disastrous stock ownership risk that
you face. Shareholders typically lose their entire investment when a
company files bankruptcy. Don’t even think about buying a stock without
first checking its financial health to make sure that it’s not a bankruptcy
candidate.
2. Business Plan/Growth by Acquisition
Some companies are better investment prospects than others because
they have superior business plans. They may address markets with
little competition, produce products seen as superior by consumers,
have better distribution methods, and so on.
You can’t assume that a firm has a viable business plan just because
it’s publicly traded and analysts are recommending buying its
stock. The dot-com bust illustrated that given the right circumstances,
firms with little chance of success can raise billions of dollars from gullible
investors, both amateur and professional.
An especially important factor of a company’s business plan is
its growth strategy. Most firms grow by developing new products, opening
new stores, and so forth. However some resort to an acquisition
strategy to maintain growth after they’ve saturated their original markets.
Early successes implementing this strategy lead to overconfidence.
Eventually the company makes a bad acquisition, its results fall short of
expectations, and the shortfall sinks its share price. Since it was issuing
shares to pay for the acquisitions, the lower stock price devalues its acquisition
currency, further slowing growth which puts more pressure on
the share price.
Possible scores range
from –11 to +11. Candidates with negative scores are riskier than those
scoring positive, but a negative score is not by itself a disqualifying factor.
3. Valuation
The market often bids up profitable companies with intriguing
business plans to unrealistic valuations, making them risky investments,
despite their strong prospects. Eventually most firms trade at prices reflecting
their long-term growth prospects.
Few firms grow earnings as much as 40
percent annually for sustained periods, and most don’t achieve anywhere
near that rate. Consider stocks with implied earnings growth of
30 percent or higher as risky bets, but high valuation by itself is not necessarily
a disqualifying factor.
4. Faltering Growth/Creative Accounting
Young companies exploiting emerging market opportunities often
experience explosive growth in their early years. The market expects
that growth to continue indefinitely and prices the firm’s shares accordingly.
Those early growth rates are unsustainable, and company management
sometimes resorts to accounting shenanigans to maintain the
illusion of growth when real growth slows. Eventually the house of
cards collapses, earnings fall short of expectations, and the stock price
crumples.
5. High Expectations
Unmet expectations lead to disappointment, and the market reacts
by hammering the offending company’s stock price. The higher the
expectations, the more chance of disappointment. Consequently, high
expectations equate to high risk.
Sentiment Index values of 9 or higher indicate risk, but high Sentiment
Index scores alone are not a disqualifying factor.
Summary
Professionals always evaluate the risks intrinsic to a prospective
stock purchase, and you should too. Be wary of investing in overvalued
markets or in downtrending markets or sectors. There are thousands to
choose from, so disqualify stocks with product allocation, litigation,
earnings restatement, sector outlook, financial health, or creative accounting
risks. The existence of any of the less serious risk factors
makes a stock less desirable, so in terms of risk, “less is more.” | 
Disclaimer
