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.
by WWM | Mar 29, 2017 | Risk
Whether managing a business or analyzing a company as a potential investment, nonsystematic risks must be assessed.
An investment in a company may include its stock, bonds, partnerships, or other offerings. A company may also include the mutual, exchange traded, or hedge funds in which you invest. Just because you are planning to invest in Investor Group or Templeton funds does not mean you should ignore nonsystematic risks.
With qualitative analysis, knowledge and experience are key to proper evaluation. Each situation is different and one needs to be mentally nimble to identify the relevant risk factors and how to deal with them.
In two posts, I shall describe typical nonsystematic risks and raise a few of the questions I might ask when assessing a specific risk. The lists and questions will in no way be exhaustive – possibly exhausting for the reader though – but hopefully they will give you an idea of the kind of analysis necessary.
Remember that risk can result in higher than expected returns and not simply losses or lower than expected outcomes. As investors and business people fear negative results, I will concentrate on risk from a negative perspective.
Management Risk
The risk that decisions made by management will negatively impact profitability.
Management of a company may include its Board of Directors, its Officers (senior managers with the legal authority to bind the entity as defined in the corporate statutes), and potentially other managers with lesser authority but key functions in the organization.
Management has a tremendous impact on a company’s actions. Strong management will ensure that prudent decisions are made and that they exert proper stewardship of the company. Weak management will result in the opposite results.
For every company, there is a different management style. Better management improves the probability of success. Poor management increases the risk of loss to an investor.
Note that I do not state that good management brings success and poor management causes loss. Many well-run entities fail and other firms manage to succeed in spite of themselves. There are many other variables that impact a company’s fortunes. Quality of management is just one factor, albeit an important one.
When analyzing a company’s stock or bonds to invest in, management should be a major consideration. This is equally true for investment vehicles such as mutual, exchange traded, or hedge funds you plan to invest in.
For example, ABC investment company has done extremely well over the last 10 years. Their mutual funds consistently outperform their peers. You plan to invest your capital and expect continued high returns. Just before you invest, you read that the primary fund manager resigned to form his own firm and has taken several key analysts from ABC with him.
Is there a possibility that future performance may not reflect that of prior years? If the analysts that discovered the superior investments are no longer with ABC, can ABC continue its success?
What about if Warren Buffet unexpectedly dies? Do you think shares of Berkshire Hathaway will fall upon the news?
Questions to Ask
To address this risk, look at the longevity and performance of the current management team.
Has current management been responsible for past successes or failures?
If the track record of current management is not significant, is there a record for the senior management with their previous companies? Often new management will have been chosen from companies in the same industry. Past performance at a prior firm may indicate success or failure in the new job.
If there is new management, how has the share price moved since the change? If the public sees the change as a positive, the shares should have moved higher. If a negative, the shares may have fallen.
Has there been any recent and/or significant turnover in management? This might indicate a change in corporate philosophy or culture that foreshadows further departures. This could be good (sweeping clean all the dead wood) or bad (all the rats leaving a sinking ship).
For past or planned management changes, has there been a proper succession plan implemented? This helps to ensure that past success will continue with the new management? As Bill Gates stepped back from daily operations at Microsoft, Steve Ballmer assumed greater responsibilities and there were little, if any, continuity issues.
In smaller companies, especially private entities, succession planning is usually a potential red flag issue for investors. Be aware if investing or working in a private or small business.
With mutual funds, I like to see an internal investment culture or philosophy. Not the reliance on one or two gifted managers to produce results.
“Key employee risk” is crucial when I look at any companies or funds. It is something I also strive to minimize in organizations that I have managed.
Operational Risk
Operational and Management Risk are often combined in analysis. They overlap because management decisions directly affect the operations of an organization. But we will keep them separate in this discussion.
Operational risk is the risk associated with operating the specific business.
Specific risks differ for each company due to their unique nature. Even within a single company, changing events may create a wide variety of new operational risk issues.
For example, consider a mining company.
A cave-in occurs underground, injuring several miners. Besides the human factor, there are insurance and legal concerns. Production may be disrupted while the mine is repaired. There may be a negative impact on the company’s reputation. All these ancillary issues that result from the single cave-in may impact profitability (and your share value) over time.
The company has labour contract difficulties and the union votes to strike. Production is shut for six months. This significantly impacts profitability and hurts the share price.
Finally, the mining company decides to hire two employees, Ken Lay and Bernie Madoff, to manage its hedging activities. Within a year, the company is bankrupt and being investigated by the regulators.
These are examples of operational risks.
Assessing operational risk may not be an easy task.
I recommend when analyzing each company or investment to list every possible operational problem that could arise.
Remember that the operational risk factors in one company may be significantly different from those in another entity. You cannot take a cookie-cutter (i.e. identical) approach when analyzing every company.
For each potential risk, consider what steps have been taken to minimize their impact should they arise.
The worse the potential outcome on the business or share price, the more focussed should be your consideration.
Questions to Ask
In keeping with the mining company example, one might ask what is the safety record?
While no guarantee, a strong history of safety indicates that the company is serious about the issue and that should reduce the probability of future problems. Another company that has been fined for safety violations may have learned their lesson. Or they could continue to be a future risk.
Are labour problems and production disruptions common within the company or industry? If so, you might have to endure periods where the company cannot produce their product which will cause financial difficulty.
Have there been regulatory or other issues arise? In the mining industry, one must be concerned about environmental violations that can result in fines, legal costs, clean-up costs, production shut-downs, etc.
Does the mining company operate in a geographic region that may cause financial problems? Some companies operate in difficult areas, such as mountainous terrain or the far north. The more difficult the mining conditions, usually the greater the cost of extraction. This lowers margins and profitability.
Or the company may be operating in a non-business friendly country. If so, there is the possibility of being harassed by the local government, up to and including nationalization of the company’s assets.
The list of potential operational risk issues is endless.
Focus on those that can have the greatest impact on profitability.
Competitor Risk
Competitor risk is that your competition will do something that negatively impacts your business.
A few years back, the Sony Walkman was the norm for portable music. Then along came something called the iPod and the music world changed.
You used to buy your books from the local bookstore. Today you are much more likely to purchase them from Amazon. Your bookstore is now the place to enjoy a Starbucks’ coffee and do some browsing.
Just because a business model has been successful in the past, does not mean that it will continue to be profitable. When considering investments, bear this in mind.
Questions to Ask
Knowing what competitors are up to may not be a simple task.
Media reports, news releases, and reviewing competitors’ financial statements are good ways to follow their activities.
But you should also look at your own company (or the one you want to invest in).
What is your company doing to ward off the competition?
Are there any barriers to entry for competitors? The greater the barriers, the safer the product or company.
The iPhone is extremely popular, but there is nothing to prevent other companies from developing their own smart phones. In fact, over time there became a variety of alternatives to the iPhone.
Strong barriers to entry include patents on key products or processes, sectors that are expensive to enter, and industries that are heavily regulated and/or where there are monopolies present.
Examples include a pharmaceutical company with a long-term patent on a new cancer drug. Or perhaps you want to challenge the American auto makers. However, the cost of entering the auto industry is extremely high. Or you think you could do a better job than the local water company. Unfortunately, the water authority probably has a monopoly on the market and you cannot legally open a business in competition to them.
That should be more than enough for today.
Next, we will look at a few more examples of nonsystematic risk.
by WWM | Mar 24, 2017 | Risk
When making investment decisions, one must consider the expected returns and involved investment risks. Yes, a few other things too, but baby steps. We will get there in due course.
In assessing potential investments, most investors perform both quantitative and qualitative analysis.
Note that investment decisions include financial instruments such as stocks and bonds. But it also refers to any decisions you make when operating a business. Do I buy or rent my office space or production equipment? Do I develop and market a new product? Do I move into a new geographic region? These are also investment decisions.
Quantitative Analysis
Quantitative analysis is number crunching.
Think of it as quantitative equals quantity.
You take raw data, perform specific calculations, and arrive at a hard number.
Quantitative analysis attempts to be objective and without bias. That is, for a given set of data, different individuals should arrive at the same conclusion.
With investment risk, calculating the standard deviation is an example of quantitative analysis.
Some people fall in love with quantitative analysis. It is reassuring to get objective results that can be directly compared against multiple investment options. Plus it is nice to be able to “blame the numbers” when you make the wrong decisions.
For example, two possible investments both have 10% expected returns. You perform the proper calculations and find that investment A has a standard deviation of 5%, while investment B has one of 8%. You “know” that investment A is the less risky option. That provides comfort when choosing A.
While I agree that quantitative analysis is important, I am leery of relying solely on it.
As we saw, there are limitations to the use of standard deviations. The same is true for most quantitative analysis.
Often, historic data is a key input for quantitative analysis. Yet past results are no guarantee of future performance.
When modelling future results, variable inputs (e.g. inflation, growth rates, etc.) must be determined. These require forecasts and projections of the future. Even the best of estimates may not be wholly accurate.
While quantitative analysis is very useful, it should never be used as the only means of decision-making. You also need to deal with qualitative aspects to get the whole picture.
Qualitative Analysis
Qualitative analysis is more “touchy-feely” than quantitative analysis.
Whereas quantitative analysis tries to be objective, qualitative analysis is subjective.
Think of it as qualitative equals qualities of the investment.
There are no hard numbers that you can calculate in order to arrive at your decisions. The information is there, one just needs to know how to find it. Usually experience and intuition are key factors in arriving at the correct results.
What one person may discern may be completely different than another might find. Obviously this is an area where competent investment professionals can add value. The more experienced, knowledgeable, technically proficient an asset manager is, the better they should be to assess an investment’s “soft” characteristics.
Now do they get it right often? And/or at a cost to investors that is reasonable? Those are the concerns in the active management versus passive debate.
In the realm of qualitative analysis are the two major components of investment risk. Although they are called a variety of names, we will use the terms nonsystematic and systematic risk.
Each investment decision has components of both nonsystematic and systematic risk. If you can learn to identify the key subsets of these two risk components, you will have an advantage over others when making decisions.
Today we will briefly describe both components. In subsequent posts, I shall identify some of the more common subsets of each class and ways to deal with them.
Nonsystematic Risk
Nonsystematic risks are unique to a specific company, industry, asset, or investment.
Note that when I use the term “company”, for ease in writing, I shall also include sole proprietorships, partnerships, joint ventures, etc. under this heading. If there are any differences worth noting, I shall split them out at that point in time.
Nonsystematic risks may also be called specific, non-market, security-related, idiosyncratic, residual, unique, unsystematic, or diversifiable risk.
The oil company you invested in drills a dry hole. A key employee in your company quits. Your home’s hot water tank explodes, flooding your house. All specific risks.
Systematic Risk
Systematic risk is derived from risks that effect the entire market or a specific segment of the market. Systematic risk factors are far reaching and impact all companies or other investments to some extent.
These factors are not unique to the investment under consideration. They will impact a company regardless of how the company operated or manages its risks.
Systematic risk may also be called non-diversifiable, non-controllable, or market risk.
A global glut of oil drives crude prices down, which in turn lowers the value of your oil company stock. A hurricane hits your home on the Gulf Coast causing significant damage. These are more systematic and non-controllable risks.
Dealing With Nonsystematic and Systematic Risk
For passive investors (i.e., investors of financial instruments), minimizing nonsystematic risk factors is not difficult. By adequately diversifying your investment portfolio, you can effectively manage nonsystematic risks.
Some academics believe that by holding between 12 and 18 stocks (or bonds), one can achieve adequate diversification to eliminate nonsystematic risk. Yes, but they need to be the perfect mix of assets. When we discuss portfolio creation later on, I will review how to properly diversify an investment portfolio.
I think that for most readers living in the real world and not academia, you will need a few more investments to minimize nonsystematic risk. For example, perhaps 40 or more stocks with the right mix. If you only have investable capital of $100,000 you will own 40 companies each with $2500 in stock. The transaction costs, rebalancing expenses, and time to monitor 40 companies can add up.
However, if you invest in a single well diversified exchange traded or mutual fund, you can easily exceed 40 companies in one investment. Usually at very reasonable expense ratios.
Consider Vanguard’s Total World Stock ETF (VT). In this one ETF, you can invest in nearly 8000 companies, located in 47 developed and developing markets around the world. According to Vanguard’s fact sheet, that covers “more than 98% of the global investable market capitalization.” And the annual expense ratio on this fund is only 0.14%. Talk about inexpensive, global diversification (and minimization of nonsystematic or stock specific risk).
That is one of the main reasons that funds should form the core of most investors’ portfolios. You can get great diversification at low cost. Something that is very hard the less capital you have to invest.
For those managing a business, it is impossible to diversify one company. However, by being able to identify the nonsystematic risks, you can take steps to reduce their potential impact. We will look at the specific risks and how to deal with them in my next post.
As some of the alternate names suggest, systematic risk is more difficult to manage. Although sometimes called non- diversifiable or non-controllable risk, you can actual take measures to reduce this risk. Diversification, insurance, and hedging are examples of ways to address systematic risk. When we look at portfolio construction, I will make suggestions on dealing with systematic risk issues.
Next up, a deeper examination of nonsystematic risk.