MENU

6 Major Categories Of Investment Risks You Should Know: Part 1

I have talked about the importance of looking out for investment risks, and also wrote about how to incorporate a stock’s risks in a properly structured investment thesis.

Through a short series of articles, I would like to list six major types of investment risks, and each major type shall be elaborated on within an article. The six types are: (i) Management; (ii) Industry and Competitive Moat; (iii) Political; (iv) Economic; (v) Social; and (vi) Legal/Regulatory. Let’s now dive into Management risks in this article.

Competent and capable

Has a company’s management team shown itself to be competent and capable? There must be an objective way to determine this: Either through a higher return on equity achieved by the company, or progress in business development efforts undertaken. The risk here is if an investor is “stuck” with a management team which over-promises, but under-delivers.

Alignment with minority shareholders

A management team must show that its actions are aligned with creating value for all shareholders. Management should not take actions which only enrich themselves – an example would be making an acquisition in which they are paid high fees but which ends up being a lemon. Rogue management may also retain too much cash rather than paying it out as dividends, or pay themselves exorbitant salaries without any justification.

Willingness to engage with minority shareholders

A management team should be willing to take time and effort to engage minority shareholders and to explain the company’s plans and strategies to them. A major risk is a management team which remains aloof when challenges arise, such that shareholders are kept in the dark about what’s really going on.

Candour

When things are going well, most management teams do not hesitate to blow their trumpets and shout it out from the rooftops. But when things go downhill, watch out for management teams that sweep problems under the carpet and pretend that things are still going swimmingly. This inability to share problems candidly is more common than one would expect, and we as investors should always prioritize a management team which displays candour.

Good allocator of capital

Finally, we should judge whether a management team has been effective in allocating capital to achieve the highest returns. If capital is allocated poorly, this would erode shareholder value over time and make the company less valuable. A way to observe this is to see if resources and money are being poured into promising areas, or being used to merely restore a non-performing division to its former glory. Throwing good money after bad is a poor strategy, and investors should be wary of such behaviour as it may signal excessive hubris on the part of a company’s management team.

The next article shall look at risks pertaining to the company’s industry and its competitive moat, so stay tuned! [Editor’s note: An article discussing the industry and competitive moat risks has been published. It can be found here.]

Meanwhile, there are 28 surprising and important things we think every Singaporean investor should know—and we’ve laid them all out in The Motley Fool Singapore’s new e-book. Packed with information and insights, we believe this book will help you be a better, smarter investor. You can download the full e-book FREE of charge—simply click here now to claim your copy.

The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.