When buying shares we can get exposure to lots of different markets and industries, and this is one of the great advantages of being our own stock pickers. Managing our own portfolios offers us substantially more upside than buying managed funds or index funds, because we are free from the restraints that institutions are under. For example, if we wanted to, we could focus and concentrate our portfolio entirely on one single industry, or even one single stock (though this is not recommended!).
This article will cover various investing risks and how you can prepare and mitigate them.
The Benefits Of Diversification
To get the benefit of the upside of diversification and also manage our own risk it makes sense to have exposure to a variety of stocks. If we own ten stocks and have 10% of our portfolio in each, then if one stock was to go bankrupt and be a 100% loser it would still only be 10% of our total portfolio. This would not be nice but it would also not be disastrous. Now imagine that one of our stocks went up 300%, the net effect would be a 30% rise in our portfolio, and that does not include any potential upside from any of the other nine stocks in that portfolio. We can also reduce the risk of not having any of our companies going bust dramatically simply by not buying companies that have any debt. A company with no borrowings is not at risk of those borrowings being called in! To make this clear: it is incredibly difficult to not make money investing in several profitable and growing businesses that have large amounts of management ownership and little to no debt. This is the beauty of diversification. It’s a free lunch. We are able to spread our risk but also benefit from the upside of many stocks.
The Benefits Of Concentration
Concentrating capital into a few select stocks can be a highly rewarding strategy for the experienced investor but it has to be earned. Far too often new private investors blow their accounts because they pile the majority of their portfolio into one stock, and are wiped out when that stock tanks. There is plenty of time to become wealthy if we can learn how the stock market works – don’t be that investor who loses all their money taking excessive risk then blames everyone but themselves.
There are many investing risks that one must prepare for and mitigate when building an investment portfolio. Here are several of them and how you can prepare.
- Sector risk
- Illiquidity and size risk
- Political risk
- Currency risk
There are many risks in investing. Our job as investors is to understand our downside. If we can do that, the upside will look after itself.
“Risk comes from not knowing what you’re doing”Warren Buffett
Diversification across different sectors is often a good idea. Investors who were heavily weighted towards stocks operating in the oil industry will have suffered severe underperformance and losses in 2014 when the oil price was on its knees. Being exposed to various sectors mitigates this risk somewhat.
Illiquidity And Size Risk
Smaller companies have the biggest potential for growth but they also have the biggest potential for failure. The smaller the company the harder it is to deal in the shares – this is a risk because if everyone wants to sell at the same time and there are no buyers then the share price will move significantly south. This is liquidity risk. Though it is much harder to deal in smaller companies this is where the biggest rewards can be found, and so it is important not only to understand the reward but the risks as well.
To mitigate this we can have a mix of companies that only trade a few times per day and companies that trade several hundred times a day. Being agile with our positions and getting in and out quickly is one of our biggest advantages against the City and so we should not give up this advantage lightly.
Many of the companies that are listed in the UK do not always operate there. A gold miner in Africa may suddenly have their mining license revoked and their assets seized by the government – and there would not be a single thing shareholders in London could do about it. The Chinese government did not make it illegal for Chinese companies to fraudulently state their financial documents overseas and so a wave of Chinese frauds came to AIM and foreign markets (this is well documented in Netflix’s The China Hustle).
When investing in a company that operates outside of the UK we must be sure that we know what the risks are and that we are comfortable with the potential downside. Sometimes, these companies can be attractively priced as the risk is discounted into the share price, but more often than not these cheap foreign companies are cheap for a reason.
Countries to be careful of include Russia, Israel, India, Azerbaijan, Kazakhstan, the Middle East, most of Africa. Unless you are an expert in these jurisdictions it is highly unlikely you will be fully aware of the risks. A recent example of a cheap company is Urals Energy, an oil producer in Russia, in which a director of the company withdrew money without the rest of the boards’ knowledge and refused to give it back. He then bought an unseaworthy passenger boat for no apparent reason, and a notice from a company of 44.59% of Ural Energy’s stock was then delivered calling for a replacement of all of the company’s directors, apart from the director who authorised the loan. The stock delisted and shareholders lost all of their money.
As mentioned above not all of the companies operate in the UK and even report in Sterling. A company may have a growing business, but if the domestic currency dumps 20% in a year then that is a huge problem, as they now have to make even more money just to make the same amount in real terms when they convert to Sterling! Conversely, movements in forex can also benefit companies. If a company operates outside of the UK or in a different currency it is wise for us to check what hedging arrangements the company has in place to manage this risk.
Many of the FTSE 100 companies report in US dollars, and so a weakening of the dollar would weaken their earnings. Always be aware of where the company operates and what potential problems they can face with their currency.
Checklist For Investing
- Does the company have entrepreneurial management?
- Does the company have a moat?
- Is the company able to scale and grow bigger?
- Does the company have steady recurring revenue or is the company at risk of large revenue loss?
- Does the company have good assets or a strong balance sheet?
- Is the company profitable?
Before we invest in a new company, it is wise to have a pre-prepared checklist for us to use so that we can avoid emotional errors and make sure that we stick to our strategy. Humans naturally make decisions based on their emotions; that is how Mother Nature programmed us. This was always useful because when we sensed fear, we would run from the threat. We felt safe when we did what the herd or tribe did. Unfortunately, the stock market goes against every single instinct that we have. Our emotions will cost us money if we can’t control them.
As humans we are programmed to like stories. But investing in a stock that has a good story seldom ends well. We like to buy when everyone else is buying – but when everyone else has bought who is left to buy? We like to hold onto losses because of our natural aversion to loss, but holding onto losing stocks costs us money! Every single investment decision should be made logically and not in the heat of the moment. Remember – you wouldn’t buy a car without kicking the tyres. Here are a few ideas to consider for our stocks to get us started. Not all of these are necessary for a great business, but they certainly don’t damage it.
Does the company have entrepreneurial management?
Some of us will be aware of the principal agent dilemma where one party (the principal) has the discretion to make decisions that impact another party (the agent). The dilemma occurs when the principal is motivated to make those decisions in their own interests at the expense of the agent. This dilemma occurs everywhere where there are decision makers, and it occurs within business at the expense of shareholders. For example, it is generally not in shareholders’ best interests for the management board to increase their salaries by a significant amount.
The first item on our checklist is to look at what percentage of stock management own. Do they all own small amounts relative to their salary? How many directors own stock? If none of the directors own stock, then we can be sure that management is not of an entrepreneurial nature, and we can be safe in our assumption that they do not believe the company to have huge potential. Is this the company then that we would want to buy? Do we want our companies to have management that wish to share in the successes of the company (entrepreneurial management) with their shareholders and are motivated to go the extra mile? Or do we want a company where the management just turn up, go through the motions, and clock off when their time is up – lifestyle directors?
We can find out who the directors are by visiting the company’s website. We can also find out how much stock the management team owns by going through the company’s annual report. This will usually be found on their website and in a section called “Investor Relations”. There will likely be a section for reports and presentations but if you aren’t able to find it you can call the company and they will send it to you. In the annual report we can also see the director’s salaries – this will be under “Director Remuneration”.
Another question that we should consider is where their stock came from. It’s no good management owning large amounts of the company if they issued themselves free shares through options. This dilutes shareholders and awards shares to the management team at no risk on their part. If they do not stump up their own hard earned cash to purchase stock, then I would argue that stock is not worth the cash they didn’t pay for it with.
We should be aiming to invest in companies where boards of directors purchase significant amounts of stock relative to their after tax salaries and where directors have aligned their interests with shareholders. We want directors to make decisions for the benefit of shareholders. We do not want directors who make grandiose acquisitions to further their own ego when the acquisition is clearly a bad fit for the company.
Management owning stock is great, but there is a thing such as too much. If a single person crosses over the 29.9% of equity threshold they are obliged to make a bid for the entire company (by purchasing the other 69.1% of stock) under the City Code on Takeovers and Mergers, which must be at the highest price paid within the last twelve months. If the price we paid was higher than the highest price paid within the last twelve months and the mandatory bid triggered is accepted, this would mean we lose money.
The same goes for any party or director who owns a large amount of stock yet has not been required to make a bid (there are certain exceptions from the Code). If they own a large enough amount they then become incentivised to buy the rest of the company, take it private, save on the listing fees and costs, and keep the company for themselves. This would be bad for us because in an unlisted company we are unable to sell our shares in a stock market and are locked in – hence whenever a company announces that it is delisting it is not uncommon for the stock value to more than halve.
This happened with London Capital Group – an online broker where management owned over 90% of the stock. The company was clearly turning itself around, and eventually management decided that they would rather not pay any listing fees and remove the irritation of being answerable to shareholders by doing away with them. Shareholders were stung with a 50% drop in share price, and those who are still holding stock are unable to sell.
To conclude, we want entrepreneurial management with enough skin in the game to align themselves with shareholders, but not management with too much equity so that they are incentivised to snatch the business and delist from the stock exchange.
Rule #1: Check for management ownership and where it came from.
You can do this by checking the annual report, which can be downloaded from the company’s corporate website.
Does the company have a moat?
An economic moat, as coined by Warren Buffet, is what offers a competitive advantage in business from its competitors. Imagine a castle as the business, and the moat protects the castle. For example, The Coca-Cola Company’s moat is their flagship brand Coca-Cola and its entrenchment into almost every society and social culture. Apple’s economic moat is their innovation and their ability to continuously see what the consumer will want and create it before they know it, and their ecosystem which hooks people in with its ease. They did it with the iPhone. They did it with the iPod. The chances are, they’ll do it again!
High margin businesses often attract competitors due to their potential to make plenty of money. A company with a high margin business and no economic moat will see those high margins deteriorate and eventually be eroded by competition.
Economic moats are important because without one there is nothing to stop competitors coming in to steal market share. This happened to Safestyle UK, who were involved in the manufacture, sale, and installation of plastic windows throughout the UK. They were highly profitable and made a lot of money, until a competitor realised that they could do the same too! Safestyle’s share price plummeted because they did not have an edge over the competition. If we invest in a company that does not have this moat we leave ourselves wide open to attack.
Rule #2: Check for a business moat and a competitive advantage over other businesses.
A good way of doing this is asking yourself if you had a lot of money, could you do much to hurt the business? Anyone wanting to disrupt Coca-Cola will need more than just money.
Is the company able to scale and grow bigger?
This point is often overlooked by private investors yet it is of paramount importance. If a company cannot scale and grow bigger then where are those future growing profits going to come from? A company can increase its profits by cutting costs, but that is limited. There is no limitation on how big a company can grow.
We can look at a company’s potential growth by looking at how much market share they have, how big the potential market is, how big the potential market can grow. We can look at overseas markets and look at if the company could grow there.
Another way to look at a company is operational gearing. This is where a company benefits from fixed costs regardless of revenue. This could be a pub chain that has to pay the rent on the leases regardless of custom coming through the door. It could be a technology company, which has a fixed cost platform irrespective of how many users are signing up. Whilst operational gearing is fantastic when plenty of punters are coming in through the doors and users are signing up to a fixed cost platform en masse, we must be careful because operational gearing is a double edged sword and works both ways. If the pub chain is struggling and revenue is in decline it must still pay the rent on the lease. Likewise, the tech company still needs to support its platform otherwise it will lose all revenue!
Companies that benefit from operational gearing can also see margin improvement too. We calculate margins by taking the profit (revenue minus costs) and dividing this by the revenue. A company turning over £1,500,000 on a fixed cost base of £1,000,000 is making £500,000 on a margin of 33.3%. If that company was to grow their revenue to £2,000,000, an increase of 33.3%, they would actually increase their operational profit by 100% going from £500,000 to £1,000,000! Furthermore, their margins would also increase from 33.3% to 50%.
A company that can scale and that can grow bigger can continue its growth for many years and see dramatic appreciations in their share price.
Rule #3: Check for operational gearing potential, how the business can grow, and how big it can grow.
Look at the fixed costs, but also look what can happen if topline revenue growth slows. Gearing is a double edged sword.
Does the company have steady recurring revenue or is the company at risk of large revenue loss?
When investigating a company we should always look at the company’s revenue source and potential pitfalls. A company that has recurring revenue has the revenue streams already onboard, which can be projected into the future. The revenue that is recurring will only leave should the company no longer provide an adequate service for their price or compared to competitors.
Companies that rely on certain clients for a large percentage of their revenue are at risk should that client terminate or decide not to renew that contract. The client can even go bust and leave the company with a liability, as they have done the work but not collected the cash.
It is not necessary to have a recurring revenue business model. Companies can do very well providing a repeated service to customers over several years, for example support services companies. However, it is necessary for us to be aware of the risks of large clients for the company. We can check detailed descriptions of the revenue breakdown in the Annual Report.
Rule #4: Check for recurring revenue or repeated business, and check for large client risk.
Revenue breakdown can be checked in the annual report, downloaded from the company’s corporate website.
Does the company have good assets or a strong balance sheet?
Companies that have weak balance sheets or poor assets leave investors at risk of being out of pocket. Balance sheets are covered in Chapter Seven. Weak balance sheets can mean not having enough cash in order to cover working capital, which means the company has an unexpected cash call where they are not able to function in their day-to-day operations. It can also mean they are laden with debt that they might struggle to pay off if they were to lose a client from the business. Remember, if the owners of the debt want to recall their borrowings, and the company cannot renegotiate elsewhere, the company can go bust!
Poor assets can mean that capital expenditure is required in order to improve them. For example, a restaurant chain’s units may be outdated and deteriorating badly. If the chain does not deploy capital in order to freshen up and improve their units, customers may end up going elsewhere! In the same manner, a software company that has not invested in their platform may have an asset that is now far behind the competition, and will soon no longer provide an edge and become useless.
We should always check that a company has enough cash or cash equivalents to sustain their operations, and always make sure that the company has good assets.
Rule #5: Check the company’s balance sheet and look for debt and their cash position. Check the company’s assets to make sure there are no hidden surprises.
You can find the company’s balance sheet on SharePad and in the financial statements in Regulatory News Service or annual report. If you don’t know how to read a balance sheet then this post will help, as well as my free book available by subscribing.
Is the company profitable?
If a company is not making profit then it cannot deliver any dividends for shareholders. It is also unlikely to grow sustainably into the future and may be at risk of issuing further equity and diluting shareholders.
Some companies like to make it harder for us to see if they are profitable or not. For example, a company with a £9 million loss may then dispose of an asset for £10 million. This would mean the company would report a profit of £1 million despite the fact that the asset sale has nothing to do with their core business. If this asset sale was a one-off sale and therefore exceptional, the company’s real bottom line was a £9 million loss!
It’s not enough for us to just look at the bottom line (profit). We need to look higher and see how that figure was reached. Companies that capitalise costs (put costs onto the balance sheet rather than through the income statement), and companies that make non-recurring asset sales for cash, can all report a profit and give a false picture of the true state of the business.
Rule #6: Check how the company reported the bottom line because it may not be what it seems.
The net income or net profit can be checked on the income statement which is part of the financial statements. This can be found on SharePad and in the financial statements. If you don’t know how to read an income statement then this post will help, as well as my free book available by subscribing.
Creating your own checklist
No single investment strategy is the same. Everyone has different aims and goals, and so a person who is investing for income may not be looking at the same companies as a growth investor. However, these six rules are a good start. There are other risks of course, and we should try to understand these as much as we can before buying! Investing is all about understanding the risks and finding the stocks where the rewards significantly outweigh those risks and is in our favour.
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 The reason being they’re mostly absolute junk.
 If management are not paid similarly to other companies in their sector they can jump ship and chase the higher package. If the remuneration package stays under the competition it can lead to a revolving door of exits at the management level.