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A Better Way to Understand Risks When It Comes To Investing

Crisis is written as 危机 in Mandarin. The two Mandarin characters that are used are literally translated as ‘danger (or risk)’ and ‘opportunity’.

The wisdom in those two characters seems to suggest that only by having danger are there opportunities to be exploited. Currently, some of the risky and dangerous situations that are at the forefront of people’s minds include the tension between Ukraine and Russia; the rising indebtedness prevalent in corporate China; and for a more local bent, the slowdown in the property market in Singapore.

Each carries with it its own set of dangers and problems. But more importantly, each situation carries with it, a different kind of risk from an investors’ vantage point.

Know the ABCs of your risks

Risk can be viewed along a spectrum. On one end, there are risks that are associated strictly with only the company in question. For instance, a company might have poor management that’s over-cavalier with leverage, leading to the company suffering from bankruptcy risks. That’s something that’s specific to only the company in question.

On the other end, there are macroeconomic risks on a regional or even global level that are beyond the control of most companies, such as an economic slowdown due to war between various nations. When we review the risks involved with any investment, risks that are identified can be classified along this spectrum.

Let’s use the land transport outfit SMRT Corporation (SGX: S53) as an example. The company runs train and bus services and each day, there’s a possibility that the company’s train services might be disrupted. This can disrupt the company’s revenue and profit and is a risk investors have to face. But, this is a company specific risk in the sense that it is something SMRT Corporation has a huge degree of control over.

Meanwhile, the fares that the company charges commuters are not within its purview as that’s controlled by the local authorities. This creates the risk of the company being forced to operate with declining profits or even losses if the authorities refuse to allow fares to be adjusted. However, this is a type of regulatory- and policy-related risk that SMRT Corporation has little control over.

As investors, it is important for us to understand the type of risks a company faces and if these are under the control of the company. Risks that the company has control over tends to be more short-term in nature. In fact, when such risks flare up and cause price declines in the market, it might even be an opportunity for investors to start investing into such a company provided they have confidence in the ability of the company’s management to right previous wrongs and handle those risks.

Apart from viewing risks along the spectrum ranging from company-specific risks to macro risks, we should also examine if the risks involved are structural or cyclical in nature.

The main distinction between the two is that cyclical risks tend to pass after a period of time while structural risks are things we as investors want to avoid. A boom and bust in the property market can be considered as a cyclical risk as markets tend to move in cycles. Structural risks, on the other hand, often result in a permanent decline; for instance, the demand for music on compact discs has been permanently stunted following the switch to the online streaming and digital downloading of music. This has caused the compact disc industry to be in a structural decline.

Foolish bottom line

There are many companies listed in Singapore that are facing potential danger at the moment. For instance, Food Empire’s (SGX: F03) main markets for its instant beverage products are Russia and Ukraine, the two main characters in one of the most closely-watched international conflicts today. Meanwhile, residential property developers like City Developments (SGX: C09) and CapitaLand (SGX: C31), both big companies that are part of the Straits Times Index (SGX: ^STI), are exposed to a slowdown in Singapore’s property markets.

Are the risks those companies are facing company-specific or macro in nature? Are they structural or cyclical? If those questions can be answered, investors will then get a much better picture on their investment merits at current prices.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim own shares in Food Empire.