Investing is an activity where investors take on risks to earn a monetary reward. Thing is, how should one think about risks in the stock market?
For academics – and even a large swathe of investment professionals – the preferred tool is something known as beta, which essentially measures a stock’s volatility relative to the market’s volatility. But that may not be useful at all.
“Using volatility as a measure of risk is nuts,” investing maestro Charlie Munger once said. He then offered a better alternative: “Risk to us is 1) the risk of permanent loss of capital, or 2) the risk of inadequate return.” But this begets the question: How should such risks be measured?
We can do so by looking at a stock’s business. Over the long-term, it’s the business’s performance which drives a stock’s price. If the business does poorly, the stock will too. From that, it stands to reason that when measuring a stock’s risk (keeping in mind that risk can’t be boiled down to a precise number if we’re considering anything other than beta), we should be looking at risk factors that concerns the business.
The following’s not an exhaustive list, but here are a couple of questions we can use to think about how risky a business is.
1. Is the company heavily-leveraged?
Debt is not always a bad thing, but it can prove to be a danger when it’s present in excessive amounts. When a heavily-leveraged company experiences a downturn, either in its specific business environment or the broader economy, it can get crushed from the burden of having to repay its creditors.
Warren Buffett, Munger’s long-time business partner and a legend in the investing business himself, once wrote the following on the topic:
“Leverage, of course, can be lethal to businesses as well. Companies with large debts often assume that these obligations can be refinanced as they mature. That assumption is usually valid. Occasionally though, either because of company-specific problems or a worldwide shortage of credit, maturities must actually be met by payment. For that, only cash will do the job.
Borrowers then learn that credit is like oxygen. When either is abundant, its presence goes unnoticed. When either is missing, that’s all that is noticed Even a short absence of credit can bring a company to its knees. In September 2008, in fact, its overnight disappearance in many sectors of the economy came dangerously close to bringing our entire country to its knees.”
A company like SBS Transit Ltd (SGX: S61) is an example of a company that’s neck-deep in debt. As of 30 June 2015, it had S$4.5 million in cash and equivalents and a massive S$511 million in total borrowings. Its total-debt-to-equity ratio is 153%. Contrast this with a firm like tourism asset owner Straco Corporation Ltd (SGX: S85). For the same period, it had S$109 million in cash and equivalents with just S$80 million in total debt; its total-debt-to-equity ratio is at a very manageable 39.5%.
2. Is the company’s business located in an area that’s geopolitically unstable?
Singapore’s stock market is home to many companies that pursue their businesses predominantly outside Singapore. Instant coffee maker Food Empire Holdings Limited (SGX: F03) is one such firm – it counts Russia and Ukraine as two of its key markets (the countries accounted for roughly 55% and 11%, respectively, of the company’s total revenue in 2014).
Russia, while a big nation with a population of more than 140 million, has been plagued by uncertainty for a long time. In 1998, it defaulted on its debt and over the years, it has had frequent clashes with the Western world. The most recent scuffle with the West (involving economic sanctions against Russia) had occurred because of Russia’s annexation of parts of Ukraine in early 2014.
The Russian-Ukraine conflict’s currently unresolved and it has badly damaged Food Empire’s business. In 2014, Food Empire had logged a loss of US$13.6 million compared with a profit of US$11.3 million in 2013 largely due to the depreciation of both the Russian ruble and Ukrainian hryvnia against the US dollar (the company reports in the US dollar). In the second-quarter of 2015, Food Empire commented in its earnings release that “the political conflict between Russia and Ukraine has not been resolved and continues to dampen growth prospects for the Group.”
Geopolitical instability in a company’s important markets can be a really formidable headwind to overcome (if it’s even possible at all). That’s a business risk investors have to think about when looking at a stock.
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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 owns shares in Straco Corporation.