Thursday, May 27, 2010

What Is Risk?

The mainstream finance industry defines a company's riskiness by its stock price's volatility. For value investors, there is no such short cut; a company's riskiness is defined by a slew of factors that can affect the business. Previously, we have considered some items that can affect risk on the cost side. Today's post will discuss some items relevant to risk on the revenue side.

First of all, a company's revenue can have varying degrees of cyclicality. What this means is, during recessions, certain industries are hurt more than others. Conversely, these industries tend to do better when the economy is strong. Nevertheless, there is higher risk involved in a cyclical business, since poor conditions can persist and cause companies to be unable to meet their obligations. For a more detailed discussion of this topic, see this article.

Secondly, risk is lower when a company has a "moat" (as coined by Buffett) that essentially protects it from competition. In these instances, revenues are more stable, thereby reducing downside risk. Of course, companies with strong moats are hard to come by.

Revenue risk is also reduced when a company is not depedent on one product, as having multiple lines serve to diversify a company's risk should a competitor make inroads or should a product become obsolete. Having a diverse array of customers also helps, since that way a company's fortunes are not tied to the health of companies outside of its control. (This was an important factor when we answered a reader's question on auto parts suppliers a few months ago.)

Finally, it's important to understand how persistent current revenues are. Does the company need to keep innovating just to hold revenues steady, or has it already done most of the work? As an example, contrast Walmart with Apple. Apple's earnings are only as good as its latest products, and it must make sure to keep producing products that customers value, which won't be easy over the long-term. On the other hand, Walmart already has a presence where it can sell the products customers value, without having to innovate anew!

While it's impossible to predict the future, investors can better protect themselves from unforeseen events by choosing companies which are less susceptible to revenue declines. By considering the factors discussed above, downside risks can be reduced.

1 comment:

segemran said...

very nice article Saj.

i also like introduce the price in the "risk equation"

the possible threats that can cause a permanent loss of capital get reduced when the price is elowr and lower.