by WWM | Apr 26, 2017 | Risk
The complement of nonsystematic risk is systematic risk.
Systematic risks affect an entire market or a specific segment of that market.
Systematic risk factors are far reaching and impact all companies to some extent. These factors are not unique to the investment under consideration. They will harm a company regardless of how the company operates or manages its risks.
Systematic risk may also be known as nondiversifiable, non-controllable, or market risk.
In this post we will review a few key systematic risks that often affect investors.
Note that it is not an exhaustive list.
Interest Rate Risk
Interest rate risk reflects how changes in interest rates may affect a company or investment.
Individual companies have no control over interest rate fluctuations. Interest rates move based on a variety of high level factors, including: governmental monetary and other policies; Central Bank actions; supply and demand of money and credit; general economic conditions.
A company’s actions do affect their own credit worthiness and the rates that they pay relative to the benchmark (Prime, LIBOR, etc.) but they have no material influence on the benchmarks themselves. That is why interest rate risk is a systematic risk and not a nonsystematic risk.
Why is interest rate risk an issue for companies and investors?
As interest rates rise, the cost of borrowing increases for companies.
For example, last year a $10 million bank loan may have resulted in a 5% variable interest rate. So a company would have paid the bank $500,000 in interest. If general interest rates rise to 8% this year, the company will need to pay the bank $800,000 in interest payments.
That is $300,000 less money available for reinvestment in the business, paying suppliers and other creditors, or being available for interest or dividend payments to investors.
It is also $300,000 less in profits. Earnings are often a key figure used to value companies. With less earnings, the company and its public shares may also be worth less.
Inflation Risk
Inflation risk is the risk that the price of goods and services will rise, thereby reducing the purchasing power of your assets. Inflation risk is usually linked with interest rate risk as interest rates will normally rise as inflation increases. Or rates will rise as governments or central banks attempt to contain inflationary pressures.
Imagine that you need to purchase a specific set of textbooks, materials, and supplies for school in six months time. You can buy them all today for $1000 or you can wait until the school semester begins. You notice that your bank is offering a six month term deposit with a 3% return for the period. You figure that an extra $30 in interest will buy you a few coffees on campus, so you deposit your money with the bank.
Over the next few months you read in the paper about concerns in the Middle East impacting oil prices. The economy is also heating up and the newspapers are using the word “inflation”. A concept that was covered in the economics class you missed with a hangover.
When the semester starts and the term deposit matures, you take your $1030 and head to the local coffee shop with a stop at the bookstore on the way. You collect all the required items and go to the checkout to pay the $1000. You receive a bit of a shock when the bill totals $1050. Not the $1000 that it should have been.
The clerk, by coincidence an economics graduate, explains that during the past six months inflation has rose 5%. As a result, the general cost of living has increased and goods cost correspondingly more money.
That is inflation risk. Unless the return on your assets meets or exceeds the inflation rate, the value of your assets will fall.
As an investor if you invest your cash in fixed income instruments, you need to be aware of expected inflation rates. This is why “real return” is a very important benchmark.
For example, in late 2008 I could recommend an investment that would easily double in 30 days. In fact I would guarantee that return. Sounds good, no?.
But what if I told you that the investment was based in Zimbabwe which was experiencing a monthly inflation rate of 79,600,000,000% (no, not a typo). At that rate, prices double every 24.7 hours.
Even though you would double your Zimbabwe dollars in one month, they would have lost their entire purchasing power in only one day.
While the rest of the world may not be Zimbabwe, on smaller scales this regularly occurs.
Be careful.
Reinvestment Risk
Reinvestment risk arises primarily due to the impact of interest rate changes.
It is the risk that total returns are altered due to a shift in interest rates.
For example, you have $10,000 that you intend to invest for 5 years in a Guaranteed Investment Certificate (GIC) issued by your bank. You can purchase a 5 year GIC that offers a 5% compound interest rate. However, you notice that the 1 year GIC offers a 7% rate. You decide to buy the 1 year GIC now and then purchase another at the end of the year.
At year end you receive $10,700. You reinvest in another GIC, but the best rate you can find is for 1 year at 4%.
That is reinvestment risk. The risk that when you go to reinvest your income you cannot obtain the same rate as you received on the initial amount.
This is a common issue for bond or dividend income.
In much of the world today, this is a real problem for retirees who live on fixed income from investments. As interest and dividend rates fell, income for retirees also decreased. And while inflation in North America has not been a major factor, prices never go down. This has caused financial difficulty for many of the elderly.
Like all risks though, there is potential upside to reinvestment risk, not simply downside.
Perhaps you own a 30 year bond paying 3% annually in cash interest payments. There may be periods during which market interest rates rise and you are able to reinvest at higher levels.
When we look at fixed income investment strategies, we will consider methods to address reinvestment risk. If you cannot wait, google “fixed income ladder” for one simple and effective method.
Currency Risk
Each country has a currency with which goods and services are paid.
Some countries share a common currency.
A single currency, the Euro, is shared by 19 of the 29 European Union Member States. The Euro is also the official currency for a few additional smaller countries, states, and territories.
Some countries maintain their own currency but have it “pegged” (i.e. linked) to another country’s currency. The pegging may be a one to one ratio or something completely different.
The Bahamas pegs their currency on an equal basis to the US dollar. In fact, payments can be made in either currency without a problem. And when you get money back, it can be a mix of Bahamian and US dollars. In the Cayman Islands (CI), 1.00 CI dollar is pegged at 1.227 US dollar (1.00 USD = 0.80 KYD). Payments may be made in US dollars at the official exchange rate, but any cash returned will be in CI dollars (there are a few exceptions in certain tourist shops).
Other countries take the pegging concept a step further and actually adopt the currency of another country. For example, Ecuador eliminated its own currency and adopted the US dollar as its official currency.
Finally, some countries let their currency “float”. A specific currency will float like a boat on the ocean. The country’s economic fortunes, as compared to its own expectations and the forecasts of other countries, will rise and fall over time. The country’s currency, by its movements, should reflect these relative changes in prosperity.
Well that is the theory. In reality, individual countries attempt to control the value of their currencies based on premeditated actions taken by the country and/or its central bank.
Currency risk can greatly affect investors in the global marketplace.
Perhaps you are an American investor who buys CAD 10,000 in 5 Year Government of Canada bonds with a 6% coupon interest rate paid annually.
Being an American investing in Canada you must consider both base and local currencies.
The base currency is usually your own domestic currency. The home market in which you operate. The local currency is the currency of the foreign market in which you are investing. In this example, the American’s base currency is the USD. The local currency is the CAD.
Note that for a Spaniard investing in a Moscow real estate project, the base currency is the Euro and the local currency the Russian ruble.
At the time of the investment, CAD 1.00 equals USD 0.80, so you pay USD 8000 for the bonds. Over the 5 years you will receive annual interest payments of CAD 600 and after 5 years, you will receive CAD 10,000. Cumulatively you will have received CAD 13,000; CAD 3000 in interest and CAD 10,000 in repayment of capital.
But what if the CAD has depreciated over the 5 year investment period? At the end of each year the CAD/USD exchange rate is 0.75, 0.68, 0.73, 0.64, 0.58. The interest you receive, assuming you immediately convert it back to USD, will only amount to USD 2028. The maturing bond will be worth USD 5800. This results in a total return of USD 7828.
You actually lost money on this simple fixed income transaction.
Thieving Canadians!
Sociopolitical or Geopolitical Risk
The risk that instability in one or more regions of the world negatively impacts investments. War, terrorism, health scares are examples of this risk.
Wars in Africa continually impact markets in the region and spill over to international companies and consumers who rely on those markets and products.
Consider the global market reaction to the September 11, 2001 terrorist attacks. Regardless of the industry or company, there was a high probability the company’s shares fell that day.
Or how about the Severe Acute Respiratory Syndrome (SARS) scare in 2002. There was a tremendous impact in companies operating in Asia (and certain other areas), not to mention on tourism and export operations.
Individual companies had done nothing different in their operations. But the above risk occurrences may have had significant impact on their business and profitability.
That is an overview of both nonsystematic and systematic risks.
I hope you found it interesting and informative.
Next we shall look at the generic tools available to address risk in business.
After that, consideration of how to address risk as an investor.
Then we shall move on to looking at investment returns and asset classes.
by WWM | Apr 19, 2017 | Risk
Previously we looked at liquidity risk for marketable securities. Stocks, bonds, and the like.
Today we shall review liquidity risk factors for physical assets.
I shall limit this to an overview for two reasons. One, we will consider physical assets in greater detail when we look at the various asset classes. Two, investing in physical assets can be quite complicated. It is an area probably more suited for experienced investors with substantial wealth. Therefore, it is out of scope for this initial investing series.
For purposes of this post, physical assets shall be those “hard” assets that you can physically hold in your hands. These include: real estate, gold, diamonds, fine art, stamps and coins, wine.
We will alter the definition when we look at these assets in more detail. As we shall see then, often one can invest in these assets and never take actual possession. But for now, the term fulfills our needs.
There are also “bankable” assets. Assets held by your bank or brokerage on your behalf. Rarely does one take physical possession, although it is possible (but not usually prudent). These include investment certificates, stocks, bonds, etc.
Physical assets tend to have many problems associated with them as investments. Liquidity being a large one. Here are a few things to consider.
How is the physical asset bought and sold?
Physical assets are significantly more difficult to trade than bankable assets.
Trading markets may be non-existent or extremely inefficient. By inefficient, I mean that any existing market does a poor job of: a) bringing the maximum number of buyers and sellers together; b) readily determining market value for the asset.
When there is no easy way to bring buyers and sellers together, trading suffers.
Perhaps you wish to buy your spouse a ring made with his May birthstone, an emerald. You know exactly the quality and size that you want. If you live in Regina, your buying options may be limited. You can go to the local jewellery stores and pay the prices they offer for whatever inventory they may have on hand.
Meanwhile, Juan’s Jewellery in downtown Bogota, Colombia has exactly the ring you are seeking, but at one-third the price you must pay in Regina. The price difference is due to a variety of factors – labor costs, transportation, import duty, and the fact that Colombia produces fine emeralds itself.
Unfortunately, unless you are in Bogota, it may be difficult to determine that Juan has much better deals than are possible in Regina. This is because there is no formal market bringing buyers and sellers of emerald rings together from around the world. If there was, both you and Juan would benefit.
This tends to be a drawback for physical assets.
Even if a markets exist, the market itself takes a healthy share of the proceeds.
Consider the world of fine art investing.
Art transactions usually occur through dealers or auction houses. While commissions are often negotiable, an auction house may add 20-25% to the buyer’s price as a buyer’s premium. There may also be a commission or fee charged to the seller. This is financially dangerous if you want to trade quickly.
For example, you acquire a painting for $1.5 million. Sotheby’s, a major auction house, charges you $300,000 as a purchasing commission. One month later, you have a major financial crisis and need to sell the painting at auction.
The market is stable and you are able to find another buyer at the $1.5 million you paid. Unfortunately, Sotheby’s charges you a sales fee of $100,000 on the transaction.
While you bought and sold at the exact same price, you lost $400,000 (27%) on your investment. And that $400,000 loss did not factor in other costs associated with art trades, including: shipping, storage, insurance, marketing.
Sadly, in the real world of auction houses, the figures in my example are probably not far off.
As a rule, the fewer options you have to trade, the more you will pay in commissions or fees.
While I used art as an example above, I could easily substitute stamps and coins, collectibles such as porcelain dolls or rare books; pretty much anything that can be bought and sold.
On the positive side, the internet and companies like eBay are improving the efficiency in trading physical assets. But that is a slow process and comes with other risks (for example, dealing with Sotheby’s rather than Joe in Vermont).
How homogeneous is the asset?
Physical assets tend to be heterogeneous. That is, each individual asset is unique from others in its class. Obviously, the amount of uniqueness can vary greatly between assets.
Randomly take 10, 1 carat diamonds to a jeweller and see how homogeneous they are in quality. There are likely significant differences between them that greatly impact their relative value.
Some items like gold, in bullion or coin form, are somewhat easier to evaluate. The keys being the gold content of the item and current price of gold. If a coin, there might also be some consideration given to any numismatic value.
But what about the Mona Lisa painting? There is only one of this asset. How can it be compared to any other piece of art?
The less homogeneity, the more difficult the valuation.
Even for relatively homogeneous assets, each can differ in quality.
You turn 50. Suddenly you need a new 2017 Porsche 911 Turbo S. You go down to the local dealer, but none are available. You are not getting any younger, so you order one directly from the factory in Zuffenhausen, Germany.
Because it is a new vehicle, there is a high probability that every 911 will be almost the same. Still, when it finally arrives, you will want to check it for scratches, etc.
You also want to make certain that Gunter and his auto assemblers were alert the day your car was built. In rare cases, usually timed around German World Cup Football matches, mistakes are made and one or two “Zitronen” are created.
Time can also create differences between homogeneous assets.
In three years, when you attempt to sell the Porsche, potential owners will be more careful in their review than you were with the new vehicle.
Did you have an accident and replace the front end? Did you drive up and down the Autobahn (or rural roads) everyday, putting 300,000 kilometers on the engine? Or did you simply drive it to and from the grocery store once a week and only have 5000 kilometers on it?
Review 100 2017 Porsche 911 Turbo S in three years and you will find a wide range of values for the cars.
What is the quantity of the physical asset?
Like financial instruments, the rarer the physical asset the less likely you can find a seller, although there may be many buyers available. Greater demand than supply will lead to price increases.
Also, with less assets in the market, there will be less trading. This leads to less publicly available information on recent pricing. Less publicly available information leads to less value and pricing transparency.
If Citigroup traded 18 million shares yesterday, that is a lot of shares trading hands. If you own 1000 shares, you should be able to sell them quickly with little impact on prices.
But how often are Monet or Renoir paintings bought and sold? Much less than 18 million times each day (or century). The lack of available buyers, sellers, and recent pricing information makes valuations much harder.
How easy is it to value the physical asset?
The greater the volume of trades, the more information is available to potential traders as to the value of an asset at a given point in time.
The less trading, the less public information, the more expertise a trader requires to arrive at the proper value.
In trading 18 million shares daily, Citigroup is relatively easy to value at its close of USD 58.99 on April 17, 2017. And with the daily range on April 17 between USD 57.925 and 59.06, I have an strong sense of where Citigroup will open Tuesday (assuming no material news is released overnight that roils the markets or company).
But for smaller public companies, there may be significantly less shares outstanding and lower trading volumes. The volume of the bid and ask prices is as important as the actual prices themselves. Further note how tight the bid-ask spread is for this financial instrument.
If you wish to buy or sell a residential house, it is more difficult. You would examine “comparables” (or “comps”) to the property you are evaluating. While not an exact comparison, knowing the value of homes that have been recently sold that share similar characteristics with the property you are evaluating, greatly assists the valuation process.
Your information will definitely be less than 18 million home sales. But for many cities you can usually arrive at a decent valuation based on comparable properties sold.
Now imagine living in a community where the last house was sold 30 years ago. Finding comparables to assess your property becomes extremely difficult. That is the case with fine art. One study found that the average time to market (from sale to next sale) is about 30 years. In some cases, 100 years is reasonable and some art never re-surfaces on the open market. Makes it very difficult to correctly determine fair market value.
Expert knowledge of the physical asset is crucial.
To (hopefully) prosper in this investing realm requires an expertise in the specific asset.
If you are buying (or selling) a rare coin, you need to know at least as much as the person selling (or buying) it to you. Otherwise, you will be taken to the proverbial cleaners.
Again, the need for market specific expertise is necessary for all physical assets. Unless you have that expertise, I do not recommend directly investing in most physical assets.
That said, there are ways to indirectly invest in physical assets. As we shall see later, this can be beneficial to most investment portfolios. But that is a conversation for a later date.
For the moment, that concludes our look at physical assets.
And it also ends our discussion of liquidity and other nonsystematic risks.
Next, we will look at systematic risk factors.
by WWM | Apr 13, 2017 | Risk
Liquidity is an extremely important consideration when analyzing investments.
For investors, liquidity relates to the ease in buying or selling an asset. By ease, how quickly are you able to trade and how close in price to fair market value.
Time delays, lack of a ready market, lack of volume, and fluctuations in pricing, make it difficult for investors to minimize their purchase costs or maximize their sales prices.
Time and Liquidity
The longer the period in which you may buy or sell, the more patient you can be in waiting for the best price. The less time you have, the greater the probability that you will pay more or receive less than you wanted.
For example, you owe your bookie $7000. Being a generous person, he has given you 90 days to pay your debt. Your only option is to sell your car. Professional appraisals conclude market value is $10,000, so you list the vehicle at $10,000.
Demand for used cars is weak and no one wants to buy your vehicle. You get a call from your bookie telling you that there are only 30 days left. You decide to lower the price to $9000, 10% below market. Still no takers.
As the days continue to pass, fearing for your personal safety, you lower the price even more. Finally, with 2 days left, you sell the car for exactly $7000.
You avoid a visit to the emergency ward and repay your bookie.
While only an example, the relationship between time and price applies to any asset. It also shows that fair market value in theory and in practice can differ.
Note that in options trading, time is a key consideration in the option’s price. The longer the expiration date, the more valuable the option based on that time frame. As you approach expiration, time becomes less a factor and the option will be priced based on its actual value (market price of asset minus strike price).
Price Volatility
Liquidity may also be affected by price volatility.
The greater the price volatility the greater the potential impact on liquidity. At least in the area of being able to buy or sell at the expected price.
Factors that affect volatility include: asset supply and demand; an efficient and effective market to trade the asset; the uniqueness of the asset; the ability to effectively value the asset.
Considerations When Assessing Liquidity Risk
To avoid confusion and undue post length, we shall limit the considerations below to common financial instruments such as stocks and bonds. In a future, separate post I shall briefly highlight some liquidity issues for more exotic investments.
Here are a few questions you should ask when considering the liquidity of any potential investment.
How is the financial instrument bought and sold?
If shares in a company, are the shares listed on a major stock exchange (e.g. New York Stock Exchange), on a minor exchange, “over the counter” (no formal exchange), or are the shares in a private company?
The larger and more formal the marketplace, usually the greater the liquidity.
How homogeneous is the asset?
Stocks or bonds in a company are homogeneous. That is, each unit is identical to all others of the same class.
The more homogeneous the asset, the greater the liquidity of the asset.
100 Class A common shares of IBM is worth 10% the value of 1000 IBM Class A common shares. There is not a similar parallel between IBM Class A and Class B shares. Nor is there a sameness between IBM Class A and Dell Class A. But within an individual company’s specific offering, each unit is identical.
If you buy a car, you want to see it before you purchase it. Each car, even those of the same model and year, may be different in some way. With stocks or bonds, you know exactly what you are receiving. You do not require a physical inspection. This is the reason that financial instruments can be widely traded on exchanges.
Also, because there is no difference in assets, valuation is simple. Each share of IBM is exactly the same, so it is valued identically. Try taking 10, 1 carat diamonds and assigning the same value to each. It will not work. In fact, there might be an enormous range between the lowest and highest quality stones.
What is the quantity of the financial instruments?
If you want to buy shares in a company with only 1000 issued shares, it will be much tougher to find a seller from whom to purchase shares than if the company has 10,000,000 shares available.
The greater the number of freely tradable shares, bonds, or other financial instruments, the easier it will be to trade.
Note that there is a difference between “authorized”, “issued” or “outstanding”, and “freely tradable” financial instruments.
Authorized is the maximum amount that the company is legally allowed to create. This can be amended from time to time by shareholder consent.
Issued or outstanding is the number of shares that have actually been created. At most this will be equal to the number of authorized shares. Often it will be less than the authorized level. The issued shares includes both freely tradable shares and any restricted stock that exists.
Freely tradable shares, also known as the “float”, is the key quantity for investors. This is the amount of shares that are available for trading each day. There are no restrictions that prevent trading.
When considering the quantity of shares, focus on the float. Be less concerned with the authorized or outstanding shares.
What is the most recent asset price?
The price of an asset may affect liquidity. The higher the price, the less potential purchasers there might be.
If you wish to sell a new Hyundai Accent, its price would cover every potential new car buyer. However, if you plan to sell a new Bugatti Veyron, you might find significantly less interested customers.
Although this is usually less of an issue with shares, there are still some examples. If you wish to sell 1000 shares of Berkshire Hathaway A shares (valued at about USD 250,000 per share) you might find fewer buyers than if you were selling 1000 common shares of Ford (valued at about USD 11 per share).
Many publicly traded companies “split” their shares when the price reaches a certain psychological price level. For example, when the share price reaches $100, the company may split its share price 10 for 1. That gives every shareholder 10 times the number of shares previously held. The “new” share price should reflect the split and trade at $10 per share.
There are a variety of reasons why companies split their shares. These include: increased liquidity by enhancing the total shares outstanding; commissions and listing issues; improving ease for buying by small buyers; belief that lower priced shares perform better than higher priced ones.
What is the daily trading volume?
The average trading figures tells you how many shares are bought and sold each day.
The greater the average volume, the easier it will be to find buyers or sellers.
Even if the float is relatively large, many shares may be held by a few investors who never plan to sell. This may serve to significantly reduce daily trading and make it more difficult to buy or sell shares.
What is the spread between the bid and the ask prices?
The bid is the highest current amount a buyer is prepared to pay for a share. The ask is the lowest amount that a seller is prepared to accept for a share.
The greater the difference between the two, the less likely a trade will occur.
It is only when the bid and ask prices meet that a trade can be made.
So the narrower the spread, the better the liquidity.
For example, you want to sell your car for $10,000 (ask price). Three people are interested in the vehicle. One offers $8000, another $9000, and the last $9500 (bid prices).
Unless you are prepared to reduce your own asking price to $9500 or a buyer raises his bid to $10,000, the sale will not be consummated.
It is exactly the same with any financial instrument or other asset. Until two parties agree on a price, no transaction can be completed.
With many financial instruments, well established markets exist to bring many buyers and sellers together from around the world. This greatly increases the chances (and speed) of matching a buyer and seller who can agree on a final price.
Also, many investors simply buy or sell their shares “at market”. In our car example, that means you would buy at the ask price of $10,000.
What are the volumes at the highest bid and lowest ask prices?
You want to determine the impact to the overall share price if you engage in a large transaction.
The greater the volumes available at the highest bid and lowest ask prices, the better the liquidity.
For example, you own 1,000,000 shares of ABC that closed the day trading at $10 per share. Your market value is $10,000,000. You decide to sell the shares and buy a villa in Spain with the proceeds.
You call your broker and find the current bid price is $10. You place a “market order” (an order to buy or sell at current market conditions with no restrictions) to sell all your shares, open a bottle of Rioja, and settle in to await your money.
Unfortunately, neither you nor your broker reviewed the bid volumes.
While the highest bid was at $10, it was only for 1,000 shares. The next closest bids were: $9 for 100,000 shares; $8 for 100,000 shares; $6 for 200,000 shares; $3 for 600,000 shares.
At the end of the day, you only net $4.7 million before commissions and taxes. A far cry from your expectations.
When buying or selling “at market” know what the market prices actually are for the volume you are trading. This is usually only a problem if buying or selling an extremely large quantity. Or if the financial instrument is very thinly traded.
Investment Bubbles
Even if all the answers above are positive, you still may face liquidity problems.
If the market crashes or an investment bubble bursts, there may be too much selling by investors so that you are unable to get a fair approximation of pre-crash prices.
I will likely write something on investment bubbles as they may become topical in the next year or so.
I hope you can see why liquidity is a key concern for investors.
When investing, please ask yourself these questions when analyzing any financial instrument. It may save you some money on the purchase and help maximize your return upon sale.
by WWM | Apr 7, 2017 | Risk
Liquidity risk refers to the liquidity of the asset or investment that you own. It can refer to two different things.
One, can the company quickly create cash so as to pay its obligations?
Two, how quickly can you buy or sell an asset and is there a trade-off between price and time?
In general, liquidity is the ease in which you can acquire or dispose of an asset. By ease, both the timing and the pricing. The greater an asset’s liquidity, the easier it is to trade in speed and proximity to fair market value.
Today we will look at the first point.
Business Liquidity
For a company, liquidity means how easy it is raise cash to pay its obligations.
The closer an asset is to its cash base, the more liquid. The more difficult an asset is to convert to cash, the less liquid.
If a company has $10 million in assets and only $1 million in short term obligations (i.e., those due in less than one year), the company seems in very good shape. A 10:1 asset to debt ratio is a strong positive for most business. At least in the liquidity context.
However, consider three companies with that exact profile. ABC has its $10 million in assets split equally between cash and its plant and equipment. DEF has $0.5 million in cash, $4.5 million in inventory, and $5 million in plant and equipment. GHI meanwhile has $0.1 million in cash and $9.9 million in a real estate development that will not be completed this year.
All have significantly more assets than debt, but all are in very different liquidity positions.
ABC can easily pay off its debt as it has the cash already on hand. Unless ABC suddenly decides to spend or distribute all its cash, there should be no liquidity problems.
DEF has some cash on hand, but not enough to pay all its current debts. DEF must hope that enough sales are made from inventory prior to its obligations coming due to ensure payment can be made. If sales are slow, DEF may need to lower their prices in order to create stronger customer demand (and sales) so as to be able to pay their liabilities. But given their needs, their liquidity issue is not severe.
Now GHI does have some potential problems. They have very little cash on hand and their assets are tied up in a long term project that will generate no short term positive cash flow. GHI will not have sufficient funds to meet their obligations. To meet their needs, and avoid potential bankruptcy, GHI may need to borrow money from a financial institution or sell part of their real estate project. GHI might also issue debt or equity to the public. However, the time it takes to float either issue might take too long to be a practical alternative.
When analyzing companies for investment purposes, always think a few steps ahead. Do not simply be satisfied with surface results. Always dig deeper.
In this example, all three companies have strong asset to debt ratios. But, in reality, each company is very different with its liquidity situation.
That is a drawback with quantitative analysis. Numbers seldom tell the entire story.
Short Term is Key to Liquidity
Another takeaway from this example is to always be sure and compare apples to apples.
Assets and liabilities may be short, medium, or long term in nature. When looking at short term obligations, you need to compare them to short term assets.
Short term in investing typically refers to assets or liabilities of under one year in duration. For assets, the asset will be converted to cash within a year. For liabilities, the obligation will be paid within a year.
They are also called current assets or current liabilities.
Cash is already cash. Unless there are imposed restrictions, you can do whatever you want with cash. It is fluid like tap water. It is fully liquid.
Other current assets are more like ice cubes. You need time for them to warm up and turn from solid to liquid form.
Accounts receivable, inventory, and prepaid expenses are the usual current assets. Most accounts receivable on sales will be paid within 90 days, so they become cash within the year. Product inventory tends to turnover (i.e., be sold and replaced) within one year and turned into cash, so it is also considered a current asset.
Prepaid expenses differ in that you have already paid out the cash. However, you get the benefit over the coming period. And technically, an asset is anything you own that is expected to bring you an economic benefit in the future.
An example of a prepaid expense would be office rent that you pay one month in advance. At the balance sheet date, you will always have one month’s benefit for the coming period. So while the cash is already gone, the benefit is still there to be consumed. Any prepaid expenses included as current assets will have the future benefit used up within a year.
Short term liabilities are obligations that require cash payment within a year. These might include bank lines of credit and other debt due within one year. It also includes accounts payable to suppliers, taxes payable to governments, etc. Anything where you need to make a cash payment within a year would be a short term, or current, liability.
Balance Sheets Reflect a Point in Time, But Not the Future
When assessing the liquidity of a person or company, remember that any balance sheet analysis reflects only a single point in time.
In our example, ABC appears to be the most liquid company of the three from their financial data. But what if you read that ABC has entered into an agreement to purchase GHI’s interest in the real estate project. Suddenly ABCs excess cash is gone and GHI will be very liquid.
Or perhaps the balance sheet is as of December 31. All looks fine. Then on January 20, ABC declares a special dividend to shareholders and seriously erodes cash on hand.
What has already happened is very useful for investors and creditors.
But what really is important is what a company will do in the future.
If you plan to lend money or provide supplies on credit, you want to know if the company will have the ability to repay when the amounts are due. Not if they have the means in the past.
Learn how to read and understand financial statements of companies you intend to deal with, either as an investor or business counterpart. That shows how they have operated in the past and gives clues as to how they run a business.
Often, the best way to study financial statements is to start with the notes and work back to the actual statements. Much more useful investing information is usually contained within the notes. Yet most amateur investors ignore this key area.
But also follow news releases, management reports, prospectus information, competitor and industry trends, etc. to see where the company is going. What is safe today from a liquidity issue, may be fraught with peril in six months time.
Do not be the investor with the worthless bonds or the supplier who will never be paid.
Liquidity Safeguards
When investing in corporate debt, we will look at investment protection in some detail. For now, let me briefly point out some common measures to protect yourself when dealing with companies who owe you money.
The effectiveness of each measure is directly linked to how desperate the company is and the amount of leverage you possess. Conduct as much research as possible before investing, lending, or supplying to a company or individual.
Debt may be secured against general or specific assets. When you assume a home mortgage from the bank, the bank holds a lien on the house until the mortgage is repaid. That means that the bank gets the house if you do not pay them.
Debt may be prioritized. For example, senior debt is safer than junior debt. Senior debt will have priority of payout over subordinate issues in the event of bankruptcy. Senior debt moves you to the head of the creditor line should the company fail to pay its debts. The more subordinate, the less likelihood of a full payout.
With dividends, preferred shareholders will receive dividends before common shareholders.
There are a variety of other measures to improve the likelihood of being paid. We will consider them down the road.
Next we shall review liquidity risk for investors in companies.
A very important consideration if you ever want to buy and sell financial instruments.
by WWM | Apr 3, 2017 | Risk
Nonsystematic risks are risks that are unique to a specific company, industry, asset, or investment.
In Nonsystematic Risk – Part 1, we reviewed management, operational, and competitor risks.
Today we will look at a few more nonsystematic risks, including: key customer; key supplier; credit (default); legal.
Key Customer Risk
Are there any customers that make up a significant portion of the company’s revenues? If so, there is a financial risk to the company if their business is lost.
For many businesses, heavy reliance on one or two customers is a common occurrence. The greater the concentration of one’s revenues, the greater the risk to the business.
For example, Dynacorp, a (fictional) small publicly traded company, obtained a 5 year government contract to provide specialized parts for the armed forces. This contract makes up 90% of Dynacorp’s revenues. As the government is quite generous, the parts have an excellent margin and Dynacorp is extremely profitable.
At the end of the 5 years, the government puts the contract out to tender. Dynacorp loses out to another vendor. Their revenue stream falls to almost zero and Dynacorp must quickly find new sources of revenue or face insolvency.
The same issue, in a slightly different context, also applies to mutual funds.
If there is too much exposure to one investment by the fund, adverse changes in the price of that investment could negatively impact the fund’s overall performance.
There is an old saying, “Don’t put all your eggs in one basket.” If that one basket slips, every egg will break.
To the extent possible, never put all your company’s revenues in the hands of one customer. Be leery of investing in a company which relies on very few key customers. Nor put too much of your investment capital in any one asset.
Questions to Ask
The notes accompanying a company’s financial statements may provide information on key contracts or clients. I suggest you always give them a read when analyzing investment options. In fact, starting with the notes and then working your way back to the actual statements is usually a good policy.
For companies with a few key clients, try to determine what would happen if those customers leave. Can the lost revenues be easily replaced? Often, this is difficult in the short term.
In our Dynacorp example, the company sells specialized army parts. The probability that Dynacorp can quickly find another buyer is small. In all likelihood Dynacorp will need to redesign their parts to meet the needs of other potential users and/or attempt to secure new contracts with other armed forces. This will take time and possibly capital to redesign their product offering.
Is there any reason that the key customers cannot leave?
Perhaps there is a long-term purchase contract in place. Maybe the company provides a vital product to the customer that cannot be acquired elsewhere. Or possibly there is a special relationship (e.g. partnerships, cross-ownership, family ties, etc.) between the customer and company that increases the probability of the customer remaining loyal.
If any of these are present, there may be reduced concern over losing the key client. However, if the customer goes bankrupt, then relationships, contracts, etc., may not mean anything.
Key Supplier Risk
Another thing to look for is the reliance on any key suppliers. As with key customers, review the financial statements for relevant contracts or even large amounts payable to specific companies.
If a company relies on one supplier, it has little leverage against price increases. If these increases cannot be passed on to its own customers, that will negatively impact profitability.
What happens if the supplier falls into business difficulty and is no longer able to provide the needed products? If a company cannot get needed supplies, they will have difficulty serving their own customer base. That will mean lost revenues and unhappy clients.
For example, your business operates a fishing lodge in northern Canada. Two airlines service your lodge. ClearSky is your preferred carrier due to better prices and flight times. Whereas JunkJet has a poor reputation and service level. Everything goes well for your lodge. ClearSky is an excellent business partner and your customers are always happy with the service.
Unfortunately, ClearSky changes its business model and no longer serves your lodge airport. You are forced to use JunkJet. As the “only game in town”, JunkJet raises their prices 100% for flights to the lodge. To be competitive with other fishing lodge options in the north, you cannot pass on all the increase to your clients. As a result, your profit margins fall.
Then, due to poor flight quality, overall customer satisfaction in your lodge falls and complaints on TripAdvisor increase. Business begins to suffer even though the lodge itself continues to provide first class service. Unless you can find a new air carrier, there is a good chance that you will be out of business in a year.
When considering investing in companies with key suppliers, be aware that this scenario can easily occur.
And if you are managing a business, always try to avoid having to rely on one or two key suppliers.
Questions to Ask
When reviewing businesses, look for any reliance on key suppliers and the steps taken to ensure a continuous supply at previously agreed upon prices.
This might be indicated by the supplier having a special relationship with the company. Or perhaps there are fixed contracts in place that assure price and volume.
Also, consider the business health of the supplier by looking at their financial statements and available public information.
Credit (Default) Risk
Companies, like individuals, enter into contractual arrangements that often impose financial obligations. This may be buying inventory on credit, paying accounts payable within 30 days of invoice receipt, or owing taxes to the government.
To raise capital, companies often issue debt or equity instruments to investors. The debt and certain types of equity (typically preferred shares) require the company to pay interest or dividends to the investors for a period of time. At the end of the specified period, the company will pay back an agreed upon amount to the investor. In the case of preferred shares, there may be no expiration date.
The decisions that an individual company makes and the consequences of resulting actions impact that company’s profitability and cash flow. There are macro-economic factors that play a part, but the company’s own actions are the key to its cash flow.
For a supplier, government, or investor, credit risk is the probability that the company will not generate the cash flow to make good on its financial obligations. Investors may not receive their interest or dividend payments and may not receive all of their capital at the end of the agreed term.
Questions to Ask
The only question you need to answer is whether the company has the cash, and the desire, to pay its financial obligations. A review of the financial statements will give you clues.
Focus on cash balances and current assets. Are there adequate liquid assets to pay the company’s short term obligations?
Does the company have any significant financial obligations? Have they entered into any new arrangements that may place additional strain on the company? For example, has the company entered into any agreements to acquire buildings or equipment? Do they have any unfunded pension plans that require a cash infusion?
Has the company (or government) reneged on any previous obligations? This may address the desire to pay their debts.
If you are a creditor (say a bond investor) and assets have been pledged against the debt, is the market value of the assets in excess of amounts owing? What is the liquidity of the asset? Can you receive market value if selling the asset in a distressed sale to pay the debt? Are there other debt holders ahead of you if there are claims to the pledged assets?
Legal Risk
The risk that actions taken by the company will result in loss due to legal actions.
Product liability issues may result in warranty, recall, or losses from lawsuits.
For example, let us say Dell’s new laptop has a tendency to overheat. Numerous customers return their laptops under warranty for repair or replacement. This costs the company money.
Because the problem seems to be structural, Dell decides to recall all of the affected model. They will provide cash refunds or replace the computers with upgraded models. Another cost to the company.
Finally, a group of customers who suffered burns from the computers band together and file a class action lawsuit against Dell. The customers claim that Dell knew, or should have known, that the computers would injure its customers. The suit requests punitive damages against Dell of $10 Billion. If the case goes forward, there will be significant legal fees, adverse publicity for Dell, and the possibility of a judgement that costs them a lot of money.
Legal risk may also result from corporate negligence.
After the Gulf Coast oil spill, British Petroleum (BP) faced many lawsuits relating to corporate negligence and related matters. Even if the suits are unsuccessful, they will still cost BP substantially in time, money, and reputation.
Questions to Ask
Does the company engage in activities that increase the possibility of legal action against it? The greater the number of activities that could result in legal issues, the greater the chance that something will occur.
Has the company been involved in legal action against it previously? If so, what were the results?
Okay, that is enough for today.
I expect that this investing thing is a little more work, and a little less exciting, than you thought it would be.
Risk and return are the building blocks for all things investment related. So we will spend a little bit of time with them in detail. I think the effort up front will make our later discussions easier to digest.
We will look at one more example of nonsystematic risk in our next post and then move on to something new.