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Three Categories of Risk to Keep in Mind When Investing

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Jun 05, 2013
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Warren Buffett said there are just two rules of investing:

  • No. 1: Don't lose money.
  • No. 2: Don't forget rule No. 1.
That's a tongue-in-cheek, oft-used phrase, but worth remembering at all times. But it raises the question: How exactly do you "not lose money?"

One thing to do is create a checklist. This is something that I heard Mohnish Pabrai discuss a couple years ago and I've recently implemented, which seems to make the decision-making process more efficient, allowing me to discard ideas quicker. Sometime in the next week or so I'll post the checklist I use currently. It's nothing special just basic common sense factors, but it does help.

3 Areas of Risk

My checklist is guided by three general categories of risk
. I think many other value investors use these basic categories, and I think I first read them in something that James Montier wrote, but I'm not sure. But in any event, I've always found it helpful to remember that risk comes from these three areas. Many things can cause businesses to deteriorate or stock prices to fall leading to permanent loss of capital, but they all stem from at least one of these three categories:

  1. Valuation Risk
  2. Leverage Risk
  3. Business Risk
Valuation Risk

Valuation risk is usually the easiest to quickly identify. You might have the opportunity to invest in a great business that produce high returns on capital with extremely attractive prospects for future growth. This business might produce these returns while employing modest debt, or maybe even little to no debt. But in this case, you might have to pay 30 or 40 times current earnings to buy the business.

Coke was this type of situation in 1998. Microsoft was this type of business in 2000. There are countless other examples. Investors who bought shares at that time saw their business continue to produce high returns on invested capital. Their businesses continued to grow sales and generate free cash flow, and increased earnings and shareholder net worth year after year. But the stock price went nowhere or even went down.

Amazon is one such example currently. There are even some value investors ( Tom Gayner ) who have purchased shares. These guys are smarter than I am, and I'm smart enough to know that Amazon is a great business, but I can't get comfortable with paying 100 times free cash flow for the opportunity to own what might turn out to be much more cash flow later. A lot of things have to go right for that investment to work out in the long term.

To eliminate valuation risk, just simply buy stocks with low multiples to earnings or assets, and make sure the earnings are normalized.

Leverage Risk

Leverage risk can come in a variety of different areas, but a couple simple things can be done to ensure you are not taking on leverage risk with the investment you are about to make. This comes right from Ben Graham and Walter Schloss. Check the debt-to-equity ratio. Try to find companies that "own more than they owe" as Graham said. In most industries, I try to look for debt-to-equity ratios under .50.

The other thing to quickly check is the current ratio. This is the ratio of current assets to current liabilities. It provides a quick measure of the liquidity that the business has. Look for current ratios above 1, preferably higher than that. This means that a company's current assets (cash, inventory, receivables, etc...) are sufficient to cover all short term liabilities including debt that is currently due. Note that some established businesses like WMT can operate with a current ratio less than one for reasons we'll discuss another time, but understand these businesses are the exceptions, and not the rule.

Schloss said: "Debt causes problems." The easiest way to prevent leverage risk is to look for companies with little to no debt. If they have debt, make sure they have assets to support that debt and cash flow to pay the interest payments.

Business Risk

While it's fairly easy to determine if you're taking on valuation or leverage risk, business risk is much more difficult to figure out. This category includes all of the risks that come from the general business, and it includes macro factors that could impact the business. In 2007, you were taking on leverage risk by investing in financials. You were taking on business risk by investing in housing stocks. These stocks were decimated because of macro factors that caused sales to plummet and losses to occur.

The ability to prevent (or limit) business risk has to do with your ability to understand the business. This is why Buffett is so good: He can quickly identify business risk and avoid all situations where he's not comfortable with the long-term economics of the business. This style of investing provides a huge margin of safety for him because he can concentrate his investments in businesses within his circle of competence that carry very little business risk.

To find out if you're taking on business risk, go to GuruFocus and look up the 10-year financial history of the stock. I like to look at sales growth first. If sales are declining steadily, you might have a "melting ice cube" that is operating in a dying industry. It doesn't mean you should eliminate the opportunity, but it is a sign you might be taking on business risk. You can also look for things like returns on capital and margins (are they deteriorating? inconsistent?). If margins and returns are stable, it's a great sign. If not, there might be business risk involved.

One of my favorite things to look at is book value per share. Just like an individual person, if a company is growing its net worth over time, they are doing something right. If not, they might be doing something wrong. Every company that went bankrupt because of something other than leverage had book value deterioration at some point.

You can also check things like F Scores and Z Scores, but I prefer simply to glance at the 10-year financials.

To Sum It Up

All risk factors in investing can be traced to three main categories: valuation risk, leverage risk and business risk. It's fairly easy to figure out the first two. The third one takes more analysis and subjectivity. But if you eliminate the first two, and stay adequately diversified, you'll dramatically increase your overall portfolio margin of safety and company-specific risk will not hurt you. This is the philosophy of Graham, Schloss and Greenblatt's magic formula. It's the philosophy of the insurance underwriting business.

If you have exceptional investment skills, you can concentrate your portfolio and go for higher returns. There are many ways to approach investing, but it helps to keep these three risk factors in mind at all times.

Keep in mind this post is simply an overview of some simple things to check to determine if you might be taking on risk. If you are concentrating your portfolio, much deeper analysis is required. But these three things provide a great foundation to build a checklist on if that is something that would help your investing.

I'll post my checklist soon. If you have comments, I'd love to hear them.

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