Guard Against These Risks When Selecting Equity Investments
A Closer Look at the Often Forgotten Risks Inherent to Selecting Stocks
When constructing an equity portfolio of individual stocks, smart investors know that risk management should be part and parcel with each and every allocation decision. For every stock, bond, mutual fund or other investment you purchase, there are three distinct risks that are frequently overlooked but that are worth guarding against; business risk, valuation risk, and force of sale risk. In this article, we are going to examine each type and discover ways you can protect yourself from financial disaster that could unfold if you neglect to build adequate defenses against one or more of these potential pitfalls.
Investment Risk #1: Business Risk
Business risk is, perhaps, the most familiar and easily understood of all equity ownership risks. It is the potential for loss of value through competition, mismanagement, and financial insolvency. There are a number of industries that are predisposed to higher levels of business risk, such as so-called commodity-type businesses including airlines and steel mills, as well as others that disproportionately produce surplus wealth for owners.
The biggest defense against business risk is the presence of franchise value. Companies that possess franchise value are able to raise prices to adjust for increased labor, taxes or material costs. The stocks and bonds of the aforementioned commodity-type businesses do not have this luxury and normally decline significantly when the sector, industry, or macroeconomic environment goes off a cliff.
Investment Risk #2: Valuation Risk
Recently, I found a company I absolutely love (said company will remain nameless).
The margins are excellent, growth is stellar, there is little or no debt on the balance sheet and the brand is expanding into a number of new markets. However, the business is trading at a price that is so far in excess of its current and average net earnings, I cannot possibly justify purchasing the stock.
Why? I'm not concerned about business risk. Instead, I am concerned about valuation risk. In order to justify the purchase of the stock at this sky-high price, I have to be absolutely certain that the future growth prospects will increase my earnings yield to a more attractive level than all of the other investments at my disposal.
The danger of investing in companies that appear overvalued is that there is normally little room for error. The business may indeed be wonderful, but if it experiences a significant sales decline in one quarter or does not open new locations as rapidly as it originally projected, the stock will decline significantly or, alternatively, tread water for years as the excess valuation is burned off. This is a throw-back to our basic principle that an investor should never ask "Is company ABC a good investment"; instead, he should ask, "Is company ABC a good investment at this price."
Investment Risk #3: Force of Sale Risk
You've done everything right and found an excellent company that is selling far below what it is really worth, buying a large block of shares. It's January, and you plan on using the stock to pay your April tax bill. Huge mistake.
By putting yourself in this position, you have bet on when your stock is going to appreciate.
This is a financially fatal mistake. In the stock market, you can be relatively certain of what will happen, but not when. You have turned your basic advantage (the luxury of holding permanently and ignoring market quotations), into a disadvantage. You should never have money in the stock market that you might need to access at any time in the next five years. If you do, you are behaving with extreme recklessness.
Consider the following: If you had purchased shares of great companies such as Coca-Cola, Berkshire Hathaway, Gillette and The Washington Post Company at a decent price in 1987 yet had to sell the stock sometime later in the year, you would have been devastated by the crash that occurred in October. Your investment analysis may have been absolutely correct - you held three of the best long-term business opportunities available in the market at the time - but because you didn't have the luxury of holding for the long-term, you opened yourself up to a tremendous amount of risk.
You've transformed good investments into rampant speculations.
Being forced to sell your investments is really something known as liquidity risk, which is important enough I wrote a separate article about it to help you understand why it poses such a threat to your net worth.
The Moral: Periodically Check on All Three Risks and Ask How Exposed Your Equity Investments Are To Them
There is always some degree present in every equity investment you purchase, whether directly through individual stocks or even an equity mutual fund. At the same time, by avoiding or minimizing specific types of risk, you can keep temporary hiccups in the economy or financial markets from destroying your wealth.