A Useful Way for You to Manage Investing Risk

In investing, a common definition of risk is how volatile a financial asset’s price is – in other words, the measurement’s done on how much the asset’s price has moved up or down historically.

But, a more useful definition would be the odds of suffering a permanent loss on your capital.

If you’re an investor in stocks – like we are at The Motley Fool Singapore – then a way to minimise the odds of losing money permanently will have to deal with factors involving the strength of the underlying business as well as the price you pay in relation to the business’s intrinsic value.

With this in mind, there are questions we can ask ourselves to assess the level of risk that’s inherent in a stock. But before I get into the types of questions that are useful here, a few disclaimers are needed:

  • Investing risk is often something which cannot be boiled down to a precise number if we’re considering anything other than volatility. But that does not discount its usefulness in any way.
  • Thinking about risk in this manner means that it’s going to be a fluid concept. A company with a robust low-risk business may end up becoming really risky if management decides to one day pursue a different business strategy.
  • The list of questions you’re going to see is not exhaustive and each individual may have their own unique list depending on their personal experiences and circles of knowledge.

Now that the important caveats are out of the way, let’s dig into some of these questions.

1. Is there any form of concentration in the company’s business model?

Concentration can come in many forms such as customer concentration, supplier concentration, and geographic concentration. It may not always be a bad thing, but having concentration does increase the level of risk that a company has to face.

Say for instance that your company depends on one customer for 50% of your revenue. If this customer were to go bust or to stop ordering from you for one reason or another, your business’s going to take a massive hit.

That’s exactly what happened to U.S.-based sapphire glass manufacturer GT Advanced Technologies. The company went bankrupt last October after it failed to meet certain product specifications of its largest customer, iPhone maker Apple.

On the other hand, a company like food & beverage retail outlet operator Breadtalk Group Limited (SGX: 5DA) has a much better concentration-profile.

In 2014, 50% of its revenue came from Singapore, 32% from China, and the rest from other areas around the globe (mainly Asia and the Middle East). With 922 outlets in total (as of 31 March 2015) spread across the aforementioned territories, it’s likely that tens of thousands, if not hundreds of thousands of customers visit Breadtalk’s various establishments daily.

2. Is the company’s balance sheet weak?

Wobbly balance sheets are often ones that are bloated with debt.

This presents a danger because the presence of high amounts of borrowings can cause a company to go bankrupt (GT Advanced Technologies went belly-up partly due to its high levels of borrowings too). In less extreme scenarios, it can also gut a company’s business by forcing the sale of assets to meet its creditors’ demands.

Walter Schloss, an investor with a phenomenal multi-decade track record, sums up the issue with a simple statement:

“I like to look at the balance sheet and I don’t like debt because it can really get a company into trouble.”

Some examples of local companies with rock-solid balance sheets include Kingsmen Creatives Ltd (SGX: 5MZ) and Raffles Medical Group Ltd (SGX: R01). Meanwhile, firms like Swiber Holdings Limited (SGX: AK3) and Ezra Holdings Limited (SGX: 5DN) are at the opposite end of the spectrum.

Kingsmen Creatives, Raffles Medical, Swiber, and Ezra's balance sheet details (1)

Source: S&P Capital IQ

The table above shows how the quartet’s cash holdings stack up against their borrowings. The former pair have minimal debt in relation to their levels of cash while the opposite is true for the latter pair; the amount of borrowings they have far outweighs the level of liquid readies they have on hand.

3. Is the company’s valuation high?

Investing can be a risky affair if we purchase a company’s shares at a price that’s higher than its intrinsic value. While the use of the price-to-earnings (PE) ratio is far from perfect for measuring the intrinsic value of a firm, it can still provide a useful framework for thinking about the dangers that can come from paying a high price.

Companies with high PE ratios are generally expected to be able to produce high earnings growth in the future. If supra-normal growth fails to happen, then those shares can get whacked hard with the market awarding a low PE ratio to the company’s shares eventually.

Hypothetical Company's PE ratio

You can see how this dynamic can play out in the hypothetical table above.

A Fool’s take

Thinking about risk in the manner I’ve presented above can help you better manage your investing risks. What other questions might you have that you think are important in teasing out the level of risk an investor might be facing with a company? I’d love to hear from you – drop a comment in the comments section below!

Meanwhile, if you'd like more investing analyses, insights, and important updates about Singapore's stock market, you can sign up for The Motley Fool Singapore's free weekly investing newsletter, Take Stock Singapore. Written by David Kuo, it can help you grow your wealth in the years ahead.

Like us on Facebook to follow our latest hot articles.

The Motley Fool's purpose is to help the world invest, better.

The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing owns shares in Apple, Kingsmen Creatives, and Raffles Medical Group.