What Makes a Stock Risky?

The three most serious risks to a stock investment are: no moat, weak financial strength and too high a stock price; as long as you pick good, strong, cheap stocks you're fine

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Feb 27, 2017
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Someone emailed me this question:

“How do you think about the riskiness of a potential investment?”

My answer isn’t going to be applicable to most people. I am a concentrated investor. I try to limit myself to buying just one new stock each year. I try to own no more than five stocks at a time. A normal position size for me is 20% of my portfolio.

Let’s say a “risky” investment is one with a decent chance of permanently losing half its value. For me, that would mean a risky investment could cost me 10% of my portfolio forever. For that reason, I have to avoid risky investments. I don’t carefully consider the risk/reward of an investment and make the bet on a purely probabilistic basis. Instead, I try to focus on a small number of high probability bets. What do I mean by a high probability event?

No. 1 is obviously lack of competition. Most businesses that fail fail because of competition. The No. 1 requirement for me when looking at a stock is to find a business where competitors are unlikely to put this company out of business. Someone I talk stocks with recently brought up a business called NIC (EGOV). This company runs outsourced portals for the governments of something like 27 of the 50 states in the U.S. Other companies don’t really do that kind of work. They do work for specific federal agencies and state agencies and even municipalities. But, they don’t create a subsidiary in the capital city of a state, staff it with a dozen or two dedicated employees and offer a statewide portal for businesses and citizens to deal with the state government.

There isn’t a contractual “moat” around this business. The contracts are pretty short term. They can be terminated pretty easily by the states. And then the states can basically hand the portal to another private company that can administer the website for them. There’s no barrier to entry that way.

Competition in the industry is obviously more limited than in almost any other market you’ll look at. Most businesses face other companies that are trying to offer essentially the same service they do. Retail is the classic example of where competition is impossibly intense. You need to have a really, really good business model to insulate yourself even the tiniest bit from competitor actions if you’re a retailer.

I rarely invest in retailers. When I have picked retailers they have been companies like Village Super Market (VLGEA, Financial), Tandy Leather (TLF, Financial), and PetSmart (no longer public). I don’t think it’s possible for competitors to build supermarkets of the same size – about 60,000 square feet – as a Village-operated ShopRite supermarket within driving distance of Village’s stores. There is your insulation from competition.

Tandy Leather is much bigger than any of its competitors. There isn’t really market share data for the leathercrafting industry, but a typical competitor of Tandy might be 90% to 99% smaller than Tandy. PetSmart is a category killer in pet supplies. A big source of the company’s profit is premium dog food. In some cases, the suppliers of this pet food – primarily dog food – are willing to sell the product to PetSmart or to a local or regional pet supply store. However, they are – for brand integrity reasons – unwilling to sell their goods to Walmart (WMT, Financial), Kroger (KR, Financial) or even sometimes Amazon (AMZN, Financial).

There have been cases where a pet food producer decided to sell its brand through a more general distribution approach – like through a Walmart – and they ended up regretting that decision. It did harm to the perception of the brand that they couldn’t easily undo. The other restriction on dog food sales is value to weight. It’s not economical to sell anything but the most expensive dog food via the internet. The cost per pound to ship dog food is simply too high relative to gross profit per pound. In fact, my newsletter co-writer and I did some estimates on the business model of one online source of dog food and decided that the company would never make any material gross profit – not net profit, gross profit – off the dog food they sold regardless of scale.

The entire business model of this outlet had to be that it could cross-sell nonfood products (dog beds, toys, collars, maybe one day some medications, etc.) along with the dog food they sold, but there was just no way for them to profitably sell dog food. That isn’t true for everyone. Amazon was in a better position than this company for selling dog food, but even in the case of Amazon, we felt that what dog food sales we could try to model for the company were not meaningful in terms of delivering profit – they were just things Amazon wanted its best customers to use as “Subscribe and Save” type purchases.

Again, the point of the dog food sales still had to be cross-selling. PetSmart’s model was better than selling dog food through supermarkets, discount chains or online. There were still risks of competition, and we spent most of our time looking at those possibilities. But, compared to other retailers, we were more comfortable with the lack of competition in what PetSmart did than we would be with a department store, with most supermarkets, etc. In general, I’m not interested in retailers, and I’m definitely not interested in generalist retailers. But, this is only because of the risk of competition. In a case like Village – where land availability was limited – I was OK with the risk of competition because I actually felt you couldn’t build new supermarkets near the company’s existing supermarkets. New entry was unlikely.

The companies I would consider least risky from a competition perspective would be those with monopolylike type positions and high customer retention. So, I would say that businesses like Fair Isaac (FICO, Financial), Dun & Bradstreet (DNB, Financial), Microsoft (MSFT, Financial) and Facebook (FB, Financial) are less risky than other kinds of companies. Also, businesses that are oligopolistic but where customer retention is high work much the same way.

Omnicom (OMC, Financial) and the other ad agencies, Union Pacific (UNP, Financial) and the other railroads, John Wiley (JW.A) and the other academic journal publishers, etc. There are also companies where new entry is limited for location/size of investment type reasons. So, I mentioned Village Supermarket as being located in a place where it’s hard to put big, new supermarkets. Likewise, Ball (BLL) has big beverage container making plants where it’s very unlikely a competitor would add excess capacity near it. Locally, the beverage container business should always be oligopolistic at worst. U.S. Lime (USLM) controls lime deposits. You don’t ship lime very far. And I don’t expect much development of new sites ever. That’s an industry where locally the situation will always be oligopolistic to more like monopolistic.

ATN International (ATNI) is an interesting example. It sometimes deals with big customers, governments, etc., that potentially have big bargaining power. On the other hand, it is usually competing in duopoly-type situations. I’d say the management of ATN International avoids high competition industries. I’d consider it less risky.

One of the best examples of a company I think is low risk would be BWX Technologies (BWXT). BWX is in what I would classify as a monopoly/monopsony business. It’s a one-seller (BWX Technologies) and one-buyer (the United States Navy) market for nuclear reactors used onboard aircraft carriers and submarines. This is one of the lowest risk investments you can find in the sense that I feel sure the U.S. Navy will still be building nuclear-powered aircraft carriers and submarines in 2047 and I feel pretty sure its only realistic source for the nuclear reactors it needs is BWX Technologies.

What are high-risk businesses? High-risk businesses are anything in a fast-growing industry. New, unsettled industries are particularly tough. So are any industries where it is easy for a competitor to enter the market. Also, industries that are considered attractive because they are big, growing, sexy, etc., are particularly dangerous. ATN International has entered the solar power business in a way that makes sense. It’s a very boring way to enter the business, and Berkshire (BRK.A)(BRK.B) is obviously involved in wind, but I’d generally want to avoid any sort of industry that makes headlines because it’s the future.

One of the attractive things about BWX Technologies is that nuclear is really an abandoned technology. There are a few countries in the world that have bet on nuclear in their nuclear weapons programs, their navies and some civilian power production, but the reason these countries do anything with nuclear usually has roots in the Cold War. It’s not just that it’s difficult to develop new technical expertise in nuclear without having been working on projects for years; it’s that not that many companies are actually interested in starting to work in nuclear if they haven’t done it before.

Actually, the other part of the Babcock & Wilcox (BW) spinoff (B&W Enterprises) is largely involved in coal power plants – and coal is also something people don't want to enter if they haven’t already been in the business. That’s always a plus. Smaller markets like the tiny Caribbean islands where some of ATN International’s businesses are don’t attract competitors the way a big, developing country could. You want to see barriers to entry, but you also want to find industries most companies aren’t going to be interested in even if they could enter it.

What are other kinds of risks? Financial risk is the really, really big one. I’d say that, when I’ve made mistakes that have turned out to be costly, it’s been due to either the company having a lot of financial leverage or operational leverage – or both. When a company has high financial and operating leverage, a small decrease in sales can cause a big decrease in profits. You can look at the Z-Score to check riskiness here. Make sure the Z-Score of a stock you are interested in is always over 3.

Another good rule is that the company’s net debt to EBITDA should be less than 3. Once a company’s net debt is more than 3 times EBITDA it may have difficulty accessing the kind of credit a lot of companies take for granted. There are plenty of companies that can raise a lot of debt at way more than 3 times EBITDA. But, I’m just using that figure as a cutoff between a highly leveraged business and a more normal business. Any business that requires frequent refinancing of its debt is risky.

Any business that is borrowing short adds risk to your portfolio. If two companies each have debt equal to 3 times EBITDA, but Company A has 90% of its debts coming due in the next three years while company B has 90% of its debts coming due sometime beyond the next 10 years, company B is definitely a lot less risky. The riskiness here for a shareholder is bad timing. A business that has high financial and/or operational leverage could hit a bad sales patch at the same time debts come due. That could cause the company to enter bankruptcy, issue shares at a low price, or refinance its debt at a high interest rate.

For example, Weight Watchers (WTW) issued shares to Oprah Winfrey at a very, very low price. This dilutes shareholders. The business ran into trouble. That would have happened regardless of how it was financed, but because Weight Watchers was financed with a lot of debt and especially with a lot of relatively short-term debt, the company was in a situation where it needed more money, a new spokeswoman, etc., at exactly the same time its stock price was very, very cheap. In general, you want to avoid investing in any company that issues shares to do just about anything.

Even Warren Buffett (Trades, Portfolio) has made mistakes issuing stock in Berkshire. In his most recent letter to shareholders, he says that issuing some stock to do the Burlington Northern acquisition was a good deal. However, the stock he issued to buy both Dexter Shoe and General Re was a big mistake. I’d strongly encourage investors to focus on businesses that reduce their share count year after year (historically, this has included companies like Omnicom, American Express [AXP] and IBM [IBM]) and certainly to avoid any company that increases its share count year after year. Any business that isn’t 100% self-financing is riskier than a company that self-finances all of its growth.

Other risks include things like customer concentration. Dependency of any kind is always a problem. Looking at my own portfolio – it’s Frost (CFR), George Risk (RSKIA), BWX Technologies, Weight Watchers, B&W Enterprises and Natoco (TSE:4627) – the riskiest stock in that group is clearly Weight Watchers. That stock has high financial and operational leverage. It also isn’t especially cheap on an unleveraged basis. B&W Enterprises is also somewhat risky. The company is project driven and has major pension obligations. It is tied to coal and to the financing of projects outside the U.S.

Natoco and George Risk have strong balance sheets, but the businesses aren’t especially low risk. For example, George Risk is dependent on a key distributor of its products. I’d say that Frost and BWX Technologies are the lowest risk stocks in my portfolio. BWX Technologies is now quite expensive. There’s significant price risk with that one. The stock price could drop by a big amount without making BWX cheap.

Frost is still cheap. As I write this, the stock price is near $90. In normal times – let’s say 2022 when the Fed Funds Rate is 3% or higher – Frost should certainly be worth more than $120 a share. Obviously, Frost is extraordinarily highly leveraged – it’s a bank. But, the company finances something close to 90% of its balance sheet with customer deposits. It probably retains something like 90% of those deposits from year to year. And then it keeps more of its balance sheet in bonds than some other banks do (because it keeps less in loans). I’d say that although Frost is highly leveraged, it’s more like the way Berkshire is highly leveraged with float. The company isn’t dependent on anyone other than customers to provide it with financing. For that reason, I’d say Frost is now the least risky stock in my portfolio, BWX Technologies is probably the second least risky stock, and then George Risk would be the third least risky.

The other stocks – especially Weight Watchers – are pretty high risk. It’s worth mentioning that about 85% of my portfolio is in Frost, BWX Technologies and George Risk. I’d say that, as a basket, they are low risk. I wouldn’t prefer the Standard & Poor's 500 over a basket of those three in terms of riskiness from year to year. The portfolio is low risk.

Having said that, different investors would look at it differently. For example, BWX Technologies is not in any sense a value stock, and George Risk is illiquid, family controlled and dependent on one product category and largely one distributor for much of its profits. Finally, Frost is a bank. Some people would see all three as being risky in some way. Value investors wouldn’t like BWX. Most investors don’t trust family controlled, illiquid, micro-caps like George Risk. And a lot of people don’t – especially since the 2008 financial crisis – trust banks at all. You’ll never get agreement about risk.

Those thee stocks – which are well over 80% of my portfolio – are a low risk basket. But, some people would say they are high risk. And a lot of people would say they’re a mixed bag that isn’t especially safe or unsafe relative to other stocks. You have to judge riskiness for yourself. Moat, financial strength and price are the three big ones. You don’t want to be invested in a stock with no moat, with questionable financial strength, or where the price is now clearly above intrinsic value. Those are the three risks to watch out for.

Disclosure: Long Frost, George Risk, BWX Technologies, Weight Watchers, Babcock & Wilcox, and Natoco.

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