In the investing world, it’s common to see risk being defined as a how volatile the price of a financial asset is. In other words, the assessment of risk is done based on how much the asset’s price has moved up or down, historically.
But as billionaire investor Warren Buffett once wrote, “Volatility is far from synonymous with risk.” A more useful definition for risk would thus be the odds of suffering a permanent loss on your capital.
If you’re an investor in individual stocks – like The Motley Fool Singapore is at our premium newsletter service Stock Advisor Singapore – a way to minimise the odds of losing money permanently will have to deal with factors involving the strength of a stock’s underlying business as well as the price you pay in relation to the business’s intrinsic value.
With these in mind, here are three simple questions we can ask ourselves to assess the level of risk in a stock. But before I get to the questions, a few important points are worth keeping in mind:
- Risk is not something which can be boiled down to a precise number if we’re considering anything other than a financial asset’s price volatility. But, the lack of a precise number does not take away anything at all from the usefulness of considering the strength and value of a business when assessing risk.
- Thinking about risk in this manner means that it’s going to be a fluid concept. A company with a low-risk business may become really risky one day due to a bad break or poor moves by management.
- The three questions I’m going to cover are not exhaustive, so feel free to add to my list based on your personal experience and knowledge base.
Now that the important caveats are out of the way, let’s get going with our questions.
The first question: Is there any form of concentration in the company’s business model?
Concentration can appear in a number of different forms, such as customer concentration (where a few customers account for a large chunk of revenue), supplier concentration (where a company depends on only a few suppliers for most of its inputs), and geographic concentration (where a company sources its revenue from only a few countries).
It may not always be a bad thing, but having concentration does increase the level of risk that a company’s business is facing.
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 whatever reason – your business is going to take a massive hit. That’s exactly what happened to the US-based sapphire glass manufacturer GT Advanced Technologies. The company filed for bankruptcy in October 2014 after its products failed to meet certain specifications of its largest customer, the iPhone maker, Apple Inc.
A company in Singapore’s stock market with high customer concentration would be the oil rig builder Sembcorp Marine Ltd (SGX: S51). In 2015, two customers collectively accounted for 26% of the company’s total revenue of S$4.97 billion.
The second question: Is the company’s valuation high?
Investing can become very risky if we overpay for a company’s stock. The use of simple valuation metrics such as the price-to-earnings (PE) ratio is far from perfect, but it can still provide a useful framework for thinking about the dangers that can come from overpaying.
Companies with high PE ratios are generally expected to be able to produce high earnings growth in the future. If the growth fails to materialise, then the stock prices of those companies can fall hard as a result of the market awarding a low PE ratio to the companies’ shares eventually.
You can see how this dynamic can play out in the hypothetical table below:
The last question: Is the company’s balance sheet weak?
The late Walter Schloss, an investor with a fantastic long-term track record, once said this about a company’s balance sheet:
“I like to look at the balance sheet and I don’t like debt because it can really get a company into trouble.”
Schloss’s statement is simple, but it packs a tonne of truth. Weak balance sheets are ones that are bloated with debt. Although debt can help produce even more returns for investors when a company uses it wisely, it can also be a source of danger.
The presence of high borrowings can cause a company to go bankrupt (GT Advanced Technologies failed partly because of its high debt load too). In less extreme scenarios, the presence of high amounts of debt can gut a company’s business by forcing it to sell assets to meet financial demands from creditors. Existing shareholders run the risk of dilution as well if a company with a weak balance sheet has to sell new shares to raise capital and restore the health of its finances.
Oil and gas company Swiber Holdings Limited (SGX: BGK) shuttered its doors late last year as a result of it having borrowed too heavily. Right now, two related oil and gas companies, namely, Ezra Holdings Limited (SGX: 5DN) and EMAS Offshore Ltd (SGX: UQ4), are both teetering on the edge of bankruptcy because they have borrowed too heavily as well over the past few years.
In an article I published over two years ago on 13 January 2015 titled Why You Should Proceed With Caution with the Cheapest Oil Stocks, I had pointed out that Swiber, Ezra, and EMAS Offshore had really weak balance sheets given their net-debt to equity ratios of 131%, 100%, and 85%.
For examples of companies with strong balance sheets right now, we can look at Riverstone Holdings Limited (SGX: AP4) and Vicom Limited (SGX: V01). As of 31 December 2016, both companies have zero debt and significant cash positions (RM 103.2 million for Riverstone and S$105.7 million for Vicom).
A Foolish Conclusion
Thinking about risk from a business-perspective cannot yield us any precision on how risky a company is exactly. But, it can still help you better manage your investing risks.
Meanwhile, if you'd like to receive more investing insights, 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.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. The Motley Fool Singapore has recommended shares in Apple and Riverstone Holdings. Motley Fool Singapore writer Chong Ser Jing owns shares in Apple and Vicom.