In an earlierpost, I wrote about the two types of risks faced by an investor – risks faced by all investors irrespective of the nature of the investment and business risks associated with a particular investment.
Advance warning – this is a long post even if it is not comprehensive and there is no silver bullet or blue/red pill at the end to make investing easier.
Regulatory risk [earning excess returns from favorable regulations]
If a company is able to make above average profits due to a favorable regulation, then it is exposed to this risk. For example, think of a banking license or the right to supply natural gas to a specific geography such as Delhi in the case of indraprastha gas.
There are a lot of examples of this kind of risk. For example, PNGRB – the gas regulator announced in april 2012 that they had the authority to fix gas prices and asked IGL to drop its price by 50%+. The company lost more than 50% of its value after the day of the announcement and since then has recovered most of it, after the supreme court overturned the decision. In spite of the favorable response, an investor in this stock has done worse than the index during the same time period.
The key point is this – If the business model of a company depends on specific regulations, then the company is always exposed to this kind of risk. . The company could be doing well for a long time and then suddenly the regulator or the government can change its mind and put the entire business at risk.
Reputation risk [earning excess returns based on reputation/ brands ]
This is a key risk in those businesses which depend on the reputation of a brand or a company. If the company earns an above average profit due to a favorable image or brand position, then it is very important for the company to safeguard the brand.
Case in point – Maggi from nestle. Irrespective of the merits of the case, the response of the company to the whole lead content issue and subsequent recall was appalling. The issue surfaced in April and the company finally responded in June when the issue blew up in the media. This is a 1.2 Bn dollar brand and the management did not react to the situation till it finally got out of hand. Net result – The company lost close 20% of its market cap in the aftermath.
Management risk [Poor quality management]
This is a risk commonly understood, accepted but least followed by a lot of investors. If you talk to someone who has been investing in the markets for a period of time, they will agree that it is important to invest only with a high quality management.
Capital allocation and distribution – does the management allocate capital at high rate of return in the business and distribute the excess to shareholders via dividends?
The first parameter is quite objective in a nature and can easily be verified by looking at the return on capital of the business over an entire business cycle. It is amazing to find that people end up investing with managements which have consistently destroyed wealth (several airlines come to mind). I understand that at a certain price, even a value destroying business can give good returns, but a majority of the investors end up buying such companies at the peak of a cycle when the profitability seems to be high (but is just a mirage)
Even if we leave aside some of the fuzzy stuff, it is quite easy in a lot of cases to just reject a company if several red flags pop up. In the end, my own experience has been that if you ignore this risk, it eventually catches up. A particular investment with unethical and incompetent management may not go south, but over time the law of averages work and the overall result will be poor.
Customer concentration risk [All eggs in one or few baskets]
This risk arises when a company derives a large percentage of its revenue from a handful of customers. Although this is an easy to understand risk, it not necessarily as easy to evaluate.
There is one crucial factor to consider when thinking of this risk – Customer lock-in. If a customer is locked in with a company and cannot easily switch then it makes sense to devote enough resource to maintain this competitive advantage.
This risk turns up in surprising places. China as a country is the largest consumer of most commodities such as steel. So when this ‘customer’ slowed, the price of the product collapsed and has hurt all suppliers in the product category. It does not matter if as a steel company you don’t supply to the Chinese market. Once the no.1 customer in the steel industry (accounting for 50%+ of global demand) slowed, everyone in the industry was going to get hurt.
Competitive risk
The easiest way to think about this risk is to count the number of companies in an industry and tabulate their market share. If you find just one company and that company has a 100% share, then you have found a monopoly with no competitive risk.
I have generally used a simple thumb rule to evaluate this risk. If the top 3-5 companies account for 60%+ of an industry and most of them earn over 15% return on capital, then the competitive intensity within the industry is low. On the other hand, if I have to spend over a week finding all the companies in an industry and if the top 10 companies account for less than 50% share (assuming I can even get this number), then it is very likely I have stumbled into an industry with high levels of competition and poor profitability.
As an investor, you can manage this risk by first diversifying across industries so that a sudden worsening of the economics in a particular industry will not sink the entire portfolio. The second way to manage this risk is to study each company and its competitive position in detail so that you are atleast aware of the risks and do not get blindsided by it. Finally, as an investor one is paid to understand and manage this risk.
Change or obsolescence risk
This risk is especially relevant in fast moving industries where the underlying technologies are going through a lot of change. Think of telecommunications – this is a fast paced industry which needs a lot of investment, but at the same time the underlying technology keeps changing rapidly (see my post herea long time back on the same topic).
The way to mitigate this risk is to have a very deep understanding of the particular industry, monitor the changes closely and not overpay for the stock. However if you do not have any specialized understanding of such an industry, it is best to stay away – discretion is often the better part of valor in investing
Commodity risk
This is the case where the price of a specific commodity drives the profitability of the business. This is obvious in the case of industries such as steel, metal, oil etc.
These companies became the darling of the markets in the 2010-2012 period when the price of gold was going through the roof. A lot of these companies got a double boost from rising demand (due to rising gold prices) and from an increase in the value of their inventory.
A similar story has played out in the agri space for seed companies (where the price of commodities have dropped) or mining firms.
Capital structure risk
A company having a high debt equity ratio is generally a riskier company. What is ignored sometimes when evaluating this risk are the hidden liabilities which are the equivalent of debt, even though they do not appear as such on the balance sheet.
The deadly combination is when some other form of business risk hits a highly indebted company. In such cases, the end result is often bankruptcy (atleast for the minority shareholders in india, promoters have no such risks)
Valuation risk/ growth risk
This not a risk of the business risk. If you pay for the growth and it does not happen, then you are in trouble. An example which comes to mind is Hawkins cooker. A lot of investors continued to give high valuations to the company even when the growth slowed.
There are several other companies (Which I will not name) which seem to be in a similar place – low growth, but high valuations. If we are lucky the drop in the multiple would be slow and gradual unless the growth picks up and justifies the valuations.
How to think about risks
Are you still reading? congrats !! you are true fan of this blog and also like to read boring stuff on investing J
Let me give an example – I used to hold Noida toll bridge company earlier in my portfolio . As I started thinking of the risks associated with the company, there were two key ones I was able to identify
– Reinvestment risk: The company had been generating a good level of free cash flow, but had no opportunity to re-invest it. A company which cannot re-invest its cash flows is equivalent to a long dated bond and will get valued as such. Hence in this case, once the company reached its steady state cash flow, the future returns were likely to follow the growth in cash flow which was expected to be in the range of 6-8%.
– Regulatory risk: The Noida toll bridge is a BOT project with an assured 20% return during the operation period (around 30 years). On top of that if the company did not make these returns in any year, the company could just carry forward the shortfall to the subsequent years. This meant that by 2011-12 the company had close 2000 Crs+ of shortfall on its books. The ground reality was that the Noida authority had refused to raise the tolls even by the level of inflation and every time they did, there were protests and dharnas. So the chance of realizing this shortfall was low.
The key point in the above idea was that the upside was limited and there was a regulatory risk which if it materialized, could completely destroy the investment thesis. So in a stroke of brilliance, after having held the stock for 2+ years and with a minimal gain, I decided to wise up and exited the company.
No mathematical precision
You would have noticed that I have not used any greek letters or volatility measures till now to measure the business risk. It should be quite obvious that these academic measures do not represent the risks for a company.
The best one can do is to be aware and analyze these risks on an ongoing basis. If you are being compensated to bear this risk (in the form of expected returns), then you continue to hold the stock. If the returns are inadequate or if you think the downside from the risk will be too severe, then the best option is to sell and move on
– I have a checklist of all the above risks and use it to evaluate which of these risks are relevant for the company I am analyzing.
– I try to dig deeper into the critical risks for the company and understand what are the key drivers and how it could hurt the company and its valuation
– My job as an investor is to evaluate the upside from the bull case of the company versus the downside from all the risks facing the company. If the downside risk seems too high, I will just move on to the next idea.
Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.
Great post Rohit, one worth reading multiple times over the new year.I think my new year resolution will be to think about the framework you talked about and evaluate my current investments based on the risks faced by each of them. I completely agree that this is an area which will give an edge to the hardworking investor and hopefully protect the a permanent loss of capital.For upside and downside analysis, do you do it in a quantitative fashion assigning probabilities and calculating payouts. Or is it more qualitative and gut feel based?
Good article on risks to be reconsidered
Great Post Rohit!! Thanks for sharing!
Brilliant one. Thank you
Thank you for such an insightful article.
Hi Rohit, Good post. Patanjali could be a major risk to the present incumbent FMCG companies. I see their products a lot more nowadays and they have become aggressive with their advertising. There is widespread feeling that the product quality is better, cost is lower than the competitors and with the proud feeling of consumers of having bought a “swadeshi” product, this could be a game changer ..
Superb post Rohit sir,Thanks a ton for sharing.
Well written
Hello Rohit , Would it be possible to put 2-3 names of companies with each risk you have mentioned ?I see you have put in just 1 or 2 name (Noida toll bridge , Indraprastha Gas)Thanks
What a amazing post, very well written.Thanks for sharing, truly loved it 🙂
Another major risk to evaluate is whether the company's performance has been driven by a single person for its growth and what if he quits or becomes incapacitated and there is no next in line competent person or in a family owned businesses no heir or the heir may just be a carefree p…boy like Yash B or Gautam S who will run down the business in no time.