The Many Facets of Risk
William is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Risk is a given in the financial world. Anytime you invest or save, there is a risk that the investment will not perform as expected or even lose money. Even with “risk-free” investments such as treasuries or certificates of deposits you can lose money because the yields are generally less than inflation. In stock market investing there is always a high chance for loss of money and there are many different types of risks to weigh: Fundamental Risk, Political Risk, Market Price Risk, and Information Risk. Risks need to be assessed and decisions made accordingly.
Fundamental risk is the risk that the business’s fundamentals are degrading or about to degrade. If you see sales declining or the company is selling an outmoded product, you need to stay away from this company. Increasing debt and an eroding cash position are other danger signs. A good example of a company with increasing debt is Hasbro (NASDAQ: HAS). Its Long-Term Debt to Equity has gone from 69.6% in 2007 to 124.9% in 2011. To me this is a sign of degradation in fundamentals.
Investopedia defines political risk as “The risk that an investment's returns could suffer as a result of political changes or instability in a country.” A number of companies are expanding abroad and deriving significant revenue there as well. Applied Materials (NASDAQ: AMAT) derives 81% of its sales of solar panel and chip making equipment to foreign manufacturers. Specifically 25% of its sales comes from China alone. China has experienced political trouble in the past. It could happen again and they might find this marketplace compromised -- think Tiannemen Square.
Information risk is the risk that a company is withholding information that could be detrimental to your investment. Best Buy's (NYSE: BBY) Chairman Richard Shulz being chastised for not telling the board about former CEO Brian Dunn's inappropriate relationship with a female subordinate comes to mind. Granted it was just a relationship but it makes one wonder what else they are not telling us. Little can be done about this type of risk other than scrutinize a company's SEC documents for implied fraud.
Market Price Risk
Last but certainly not least is the risk that you are paying too much for a share of stock in a company. Take Chipotle Mexican Grill (NYSE: CMG). It has revenue growth and free cash flow growth of 22.26% and 34.60%, respectively, between 2009 and 2011. The free cash flow yield is slightly above the 10-year treasury, which means it is slightly undervalued by that metric. However, I am not paying for a stock that is trading at around $412 per share with a P/E ratio of 56.97, which is more than double the restaurant industry average. An investor can minimize market price risk by waiting for a cheaper price.
Weighing risk is a juggling act. The first risk that I look at is the fundamental risk. If the company is generating plenty of cash flow and doesn’t have too much debt on its balance sheet then I take a look at the other risks. If the market price is too high but the other risks are low, then it becomes a simple matter of waiting for the stock price to come down to a more preferable level. For example, Chipotle Mexican Grill has a great deal of growth in free cash flow, minimal debt and plenty of cash on its balance sheet. It also has minimal exposure to foreign markets. This company would be a much better prospect at a cheaper valuation.
If a company has a high exposure to foreign markets then great care must be taken to ensure a stronger financial position to minimize the fundamental risk you are taking and a lower stock price to minimize market price risk. A stronger cash position and lower debt levels would have to compensate for a possible loss of markets due to political instability. If you want to invest in a company with high exposure to foreign markets where political risks are also high, then take care that it has a strong financial position and low stock price. If a factory is seized during a coup, strong cash position and low debt levels might allow the company to rebuild elsewhere.
Due diligence is required in sniffing out information risk. For example, if there is a possibility of a CEO lying or there has been some information in the past then all risks -- especially fundamental risks -- bear greater scrutiny. A child who lies bears greater scrutiny after the first lie.
So there is always a risk of an investor losing money, but by monitoring the many different types of risks they can manage it better.
stockdissector has no positions in the stocks mentioned above. The Motley Fool owns shares of Best Buy, Chipotle Mexican Grill, and Hasbro. Motley Fool newsletter services recommend Chipotle Mexican Grill and Hasbro. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.