Key Risk Factors
Management Risk
There are three areas that can eliminate companies from further consideration based on the way a company is managed:
- Transparency – If product line data or other key information is not available in the SED filings, then the company will not be considered.
- Options – If options are causing significant dilution or the combination of option issues and stock buybacks consume a significant percentage of income, danger is lurking.
- Compensation – If the Chairman is also the CEO, earns about as much as Barry Bonds, and has achieved near rock star status, then he or she probably does not have the proper focus on the shareholders.
- Board of Directors – If the board is comprised many of people from the same family, then is it really a public company?
- Super Liabilities – Some pension and retirement medical liabilities become so large that no management can possibly overcome them.
Political Risk
Even excellent management cannot overcome the acts of an unfriendly government. Therefore I will only invest in countries that score well or have shown solid improvement in the Index of Economic Freedom published by the Heritage Foundation. For this reason I will not invest in China or Russia. In the United States some sectors of the economy are very exposed to negative actions by the government. For this reason I will not invest in pharmaceutical companies.
Litigation Risk
Some industries are very exposed to class action law suits that can potentially bankrupt them. For this reason I have avoided companies with large exposure to asbestos mitigation and other forms of large environmental cleanup.
Karmic Risk
Some investments do not bode well for one’s well being in this life or any other. I could not sleep well at night if I was invested in a tobacco company. Even though I believe in a strong defense for the United State, I have also not been able to invest in a defense company so far.
Risk
Analysis
The ultimate goal is to build a financial model of the company based on financial statements filed with the SEC using conservative projections of future earnings. Before the model is built an assessment of the total level of business risk is done. Financial theory states that investors who assume higher risk should have higher expected returns. Thus the higher the risk, the higher the discount rate used to assess future earnings. However, studies have shown that there is no correlation between actual returns and a stock’s market risk as measured by its beta. I believe that the same is true for business risk. While the risks associated with any single business can be reduced through diversification, I believe that a company with low business risk is every bit as likely to produce satisfactory returns as a company with high business risk. Assessing business risk is a highly subjective, but necessary, process for the value investor.
I used to go through a fairly complex assessment of risk and create a risk scorecard for a company. Companies that received a very high score were then eliminated from consideration. However, over time I found that there were only a few factors that really mattered. It occurred to me that if a company has good management, that management should be able to address most forms of risk in the normal course of business. What really matters is the risk associated with management, itself, and a few factors that can overwhelm even the best management.
Searching for Value
When searching for value stocks either a top-down or a bottom-up approach can be used to narrow the universe of all stocks down to a smaller group for further analysis. In a top-down approach the search begins by looking for sectors, industries, or countries were the market may be underestimating future earnings or overestimating business risks. In a bottom-up approach a group of stocks is selected based on set of metrics such as price/sales, price/earnings, price/book, price/cash flow, dividend yield, earnings growth, analyst ratings, or return on equity. Over the years I have found that a top-down approach works best for me. Even when I find stocks that look good based on their metrics, I will only invest in areas that appear to offer exceptional opportunities for future growth.
Once a stock is selected for further analysis based on its inclusion in one or more of my defined areas for future growth, the first step is to try to understand the reasons for undervaluation. These reasons will fall into areas such as lack of growth, inability to control costs, inconsistency of results, excessive debt loads, competitive issues, and large, undefined future liabilities. SEC Edgar filings and other Internet sources are studied to see if a change in the reasons for the undervaluation may have occurred. These changes could include things such as a change in management, resolution of a major lawsuit or regulatory action, acceleration in the repayment of debt, layoffs and other cost reducing efforts, or most importantly a change in products or markets that make faster earnings growth a real possibility. When looking at these potential factors leading to undervaluation it can be seen that value investing does not require a consistency of good performance as is usually the case is with growth investing. However, companies with consistently good performance can be undervalued.
Value
Defined
Modern portfolio investment theory is based on the premise of efficient markets. It purports that efficient markets will be effective in collectively processing all available information on a stock to arrive at an appropriate price. The available information includes a variety of business risk factors in addition to financial statement data. These risk factors are related to all components of the business including management, organization structure, products, markets, legal issues, production capabilities, employee relations, and foreign exposure. The value investor will seek to use financial statement data to arrive at a fair market value based on his or her assessment of future earnings and a risk adjusted discount factor. The value investor seeks to make a case that the market price may be to low due to underestimation of future earnings or overestimation of the business risk factors. If the analysis is correct, then the stock price should adjust to a higher price over time as markets digest the prospect of higher earnings or lowered risk.
Mike Shinn for www.fizone.com
December 2007
Value
Selections