It’s possible that one of the most easily misunderstood things in investing is risk. Many use the movement of a stock’s price – its volatility – as way to measure risk. But, that’s faulty thinking. Don’t just take my word for it. “Using volatility as a measure of risk is nuts,” Charlie Munger once said. Munger, for those unaware, had a top-notch investing career as a hedge-fund manager in the 1960s and 1970s before eventually becoming billionaire investor Warren Buffett’s long-time sidekick at the helm of the massive U.S.-based conglomerate, Berkshire Hathaway. Munger went on to propose that a…
It’s possible that one of the most easily misunderstood things in investing is risk. Many use the movement of a stock’s price – its volatility – as way to measure risk. But, that’s faulty thinking.
Don’t just take my word for it. “Using volatility as a measure of risk is nuts,” Charlie Munger once said. Munger, for those unaware, had a top-notch investing career as a hedge-fund manager in the 1960s and 1970s before eventually becoming billionaire investor Warren Buffett’s long-time sidekick at the helm of the massive U.S.-based conglomerate, Berkshire Hathaway.
Munger went on to propose that a better way to think about risk is “(1) the risk of permanent loss of capital, or (2) the risk of inadequate return.” In other words, risk is the possibility of suffering a loss on one’s investment capital or the possibility of earning only meagre returns.
For stock market investors, the thing that can cause a permanent loss (or low returns) to happen would mainly be a lousy (or lousier than expected) performance from a stock’s underlying business over the long-term. And, that’s because a stock’s business is often the main driver of its price in the long run.
With these in mind, just how risky is oil rigs and vessels builder Sembcorp Marine Ltd (SGX: S51) as an investment? Investors in Sembcorp Industries Limited (SGX: U96) may also be interested in the question given that Sembcorp Marine was responsible for over half of Sembcorp Industries’ revenue in 2015.
There are certainly more ways to measure Sembcorp Marine’s riskiness, but the following two are important things to look at nonetheless:
1. Balance sheet risk
Excessive debt can create lots of headache for shareholders of a company. In tough times, if a company finds it hard to service or repay its loans, then shareholders may have to face terrible consequences such as a dilution of their stakes in the company, involuntary asset sales by the firm, a complete elimination of dividends, or in the worst-case-scenario, the company’s bankruptcy.
On the other hand, a strong balance sheet – one that is flush with cash and with little debt – gives a company higher odds of tiding over rough times. Moreover, a solid balance sheet can even allow a firm to go on the offensive in a weak business climate and gain competitive advantages over financially weaker competitors.
For Sembcorp Marine, it’d appear that its balance sheet is not in good shape.
As of 31 December 2015, the company had S$3.38 billion in total borrowings but just S$629 million in cash. And as the chart above shows, Sembcorp Marine’s net-debt to equity ratio is now at 103% – that’s not only high, it’s the highest the ratio has been for the company over the past decade.
Given the tough conditions in the oil & gas industry at the moment with the drastic fall in the price of oil since 2014 (from over US$100 per barrel in mid-2014 to less than US$40 today), I think there’s more reason for pause on the state of Sembcorp Marine’s balance sheet.
2. Customer concentration risk
When a company depends on just a handful of customers for business, it can be hurt really badly if its customers collapse or simply walk away. The U.S.-based GT Advanced Technologies, a maker of sapphire glass products, is a cautionary tale. The company became bankrupt back in late 2014 after its product failed to meet certain specifications of its customer, the iPhone maker Apple Inc. At that time, Apple was likely the majority-source of GT Advanced Technologies’ revenue.
For Sembcorp Marine’s case, I’d argue that the company also has high customer concentration. In the company’s recent earnings briefing for its 2015 fourth-quarter results, management stated that one single customer had accounted for roughly S$3.2 billion of orders in an order book that was S$10.4 billion in size at end-2015. In other words, one single customer is currently responsible for 30% of Sembcorp Marine’s order book (which represents future revenue).
Potentially exacerbating the situation is the fact that the customer in question is the Brazilian oil & gas company Sete Brazil, which is facing the possibility of bankruptcy at the moment.
A Foolish conclusion
As you can see, Sembcorp Marine has high balance sheet as well as customer concentration risks. But, it should be noted that none of the above is meant to say that Sembcorp Marine will necessarily be a bad investment going forward. This look at Sembcorp Marine’s riskiness is merely to point out issues investors may want to think about when considering the company as an investment.
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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 Berkshire Hathaway and Apple.