🧑🏫 Main risks
Course: How to Analyze Stocks
Great investors focus on risk management.
It’s just as important as trying to maximize your returns.
In this article, I’ll teach you how to look at the main risks a company faces.
"The greatest risks are the ones you didn’t think were risks." - Nassim Taleb
🧑🏫 Course: How to Analyze a Stock
This is the ninth article in the series How to Analyze a Stock.
In this course you’ll learn:
How to find attractive stocks
Where to find information about these companies
How to determine whether a company is an attractive investment
In case you missed it:
What is risk?
In academics, risk is measured as volatility.
Let’s give an example to make this clear.
Company A:
Yearly stock price fluctuation: 30%
Average yearly return: 12%
Company B:
Yearly stock price fluctuation: 15%
Average yearly return: 8%
Academics would say that Company A is way riskier than Company B because it fluctuates by 30% per year versus 15% for Company B.
They measure risk by beta.
The higher the beta, the more risk.
Beta is a metric that measures the volatility of a certain stock compared to the market as a whole.
A beta lower than 1 indicates that the company fluctuates less than the index and a beta higher than 1 indicates that the company fluctuates more than the index.
But if you know that Company A would return 12% per year while Company B would return only 8% per year, wouldn’t you prefer Company A?
Let’s give another real-life example.
Beta S&P Global: 1.17x
Beta PepsiCo: 0.57x
Based on the numbers above, S&P Global looks riskier than Pepsi.
But which company would you have wanted to own over the past 10 years?
CAGR S&P Global (including dividends): 20.1%
CAGR PepsiCo (including dividends): 10.4%
S&P Global performed twice as well as PepsiCo.
That’s why a lot of great investors like Warren Buffett, Charlie Munger (God Bless You), and Howard Marks state that looking at risk via academic metrics such as beta is complete nonsense.
But how should you look at risk instead?
Risk is equal to the permanent loss of capital.
Everyone knows this famous saying from Warren Buffett:
“The first rule of an investment is don't lose money. And the second rule of an investment is don't forget the first rule.”
In 1979, Daniel Kahneman discovered that people feel the pain of losing (money) twice as much as the pleasure of gaining it.
It’s also very hard to recover from investment losses.
Here’s a question for you: if your investment loses 40%, how much do you need to make to recover from this loss?
When your investment decreases by 40%, you need to make 67% to recover from this loss.
You don’t see the math?
Let’s say that you have an investment portfolio of $100,000 and that your Portfolio decreases by 40%. As a result, you now have $60,000.
When you want to get back to $100,000 you need to make $40,000 on a total portfolio value of $60,000.
Making $40,000 on $60,000 is equal to 66.67% ($40,000/$60,000).
Two kinds of risks
For investors, there are two different kinds of risks:
Market risk: risk inherently linked to being invested in the stock market
Example: when the entire market crashes by 30%, your stocks are likely to decline as well
Company risk: Specific risks related to a certain company
Example: when you invest in Mastercard and its payment network would be down for two weeks, you’ll suffer from this as an investor
Total portfolio risk
When you don’t diversify, your total portfolio risk is very high.
Just imagine that you only own 3 companies and that one of them goes bankrupt. This is something you want to avoid at all costs.
That’s exactly why you want to diversify.
The consensus states that you should own around 20 stocks to reduce this risk.
Company risk
Now you know how to think about risk in general, let’s switch our attention to company risk.
What’s the chance an investment will result in a permanent loss of capital? The lower this risk, the higher your margin of safety.
You want to invest in companies where the risks are limited and where there aren’t a lot of Black Swans.
Here are some questions you can ask yourself:
Does the company depend on certain commodity prices?
What’s the risk of disruption and technological changes in the industry?
Can regulation changes harm the business?
Does the company depend on general economic conditions?
How competitive is the market, and what is the company's competitive position?
Does the company face a lot of supply chain risks?
Is the company in good financial shape?
….
The mapping of the different kinds of risks a company faces helps you to make up your mind.
You also get to know which potential Black Swans a company might face.
What risks does Mastercard face?
Here’s an overview of the main risks of Mastercard: