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Are You Holding Risky Stocks?

With the wild August that the Straits Times Index (SGX: ^STI) has been through, it’s perhaps a good time to talk about investing risks.

So, let’s first understand what risk is.

The sharp fall that the Straits Times Index had experienced in August – it declined by more than 12% from peak-to-trough during the month – may lead many to form the mistaken notion that stocks are risky.

But, what the market benchmark has done is to prove merely that stocks are volatile. It’s important that we do not confuse volatility with real investing risks.

“Using volatility as a measure of risk is nuts,” investing maestro Charlie Munger once said. He went on to propose a better system for understanding risk:

“Risk to us is (1) the risk of permanent loss of capital, or (2) the risk of inadequate return.”

If we’re to follow Munger’s prescription, how then can we assess risk?

Preventing a permanent loss of capital

There are many ways in which we can permanently lose our investing capital. But let’s focus on two in particular here: Overpaying for stocks and companies that run into financial trouble.

When we invest, we first have to have a rough grasp of how valuable a business is. If we overpay for a stock by buying it at a price that’s substantially higher than its intrinsic worth as suggested by the economics of its business, we then run the very high risk of never seeing the bulk of our investing capital again.

Timbre-flooring specialist Jason Holdings Limited (SGX: 5I3) is a good example of the risks associated with overpaying. On 26 May this year, I had written an article about the company and pointed out that it was valued at 330 times its trailing earnings and 9.4 times its book value at its trading price of S$0.64 then.

Those are extremely high numbers. That’s especially so when we compare them to the price-to-earnings (PE) ratio of 14 and price-to-book (PB) ratio of 1.3 that’s carried by the SDPR STI ETF (SGX: ES3) – an exchange-traded fund tracking the fundamentals of the Straits Times Index – at that time.

It wasn’t just the high valuations that were a problem. In my earlier article, I also highlighted the lack of any strong historical growth in Jason Holdings’ business.

Jason Holdings is today trading at S$0.12, more than 80% lower compared to where it was on 26 May 2015.

Meanwhile, companies can get into financial trouble if their balance sheets are too bloated with debt. Among Singapore’s blue chips (the 30 companies that make up the Straits Times Index), stocks like Noble Group Limited (SGX: N21) and Golden Agri-Resources Ltd (SGX: E5H) can be considered to have debt-heavy balance sheets. You can see this in the table below.

Noble and Golden-Agri's balance sheets

Source: S&P Capital IQ

This isn’t meant to say that Noble Group and Golden Agri-Resources are necessarily in trouble. But, the presence of high levels of debt itself is a risk that investors have to note.

Ensuring adequate returns

Moving on, how should we handle the risk of earning inadequate returns? It can also be partly reduced by not overpaying for a company’s stock.

Long-time investors in software giant Microsoft can probably attest to that. From 2000 to today, Microsoft has seen its revenue quadruple and operating cash flow nearly triple. How has its shares done? After adjusting for reinvested dividends, Microsoft’s shares are today sitting at where it was back at the start of 2000. This is what happens when a stock starts out trading at 80 times earnings.

A Fool’s take

Your stocks may have zipped up and down violently in August (mine certainly have!) along with the broader market. But that doesn’t mean you’re holding onto risky stocks – it just means your stocks are volatile.

What’s more important here is that your stocks are not carrying high valuations and are not financially weak. There’s certainly more to it when it comes to assessing investing risks, but these two can still go a long way in helping you steer clear from the truly risky stuff.

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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 writer Chong Ser Jing doesn't own shares in any company mentioned.