Investment risk is a near and dear concept to all investors.
In the world of finance, risk is represented by a number that is calculated based upon the price volatility of the underlying security..
However, we like to think of risk as the likelihood that an investment incurs losses instead of delivering its expected return.
As it stands, risk is ubiquitous and comes in many forms for different types of investments.
With equities, there is a risk of falling share prices, reduced dividends and/or share buybacks.
With bonds, there is a risk of the borrower defaulting on its obligations.
With real estate, there is vacancy and replacement cost risk.
Here are three salient risks that investors should be aware of in 2023:
1. Interest rate risk
It is no secret that the Federal Reserve has hiked interest rates aggressively to rein in inflation.
The current benchmark rate stands at between 4.25% to 4.5%, representing a rise of four percentage points since March 2022.
Investors should also be aware of the Fed’s “dot plot”, a survey of officials on where they think indicators such as interest rates, inflation, and unemployment will be in future.
At present, the dot plot reflects expectations of interest rates hovering at about five percentage points through most of 2023 and possibly 2024.
The higher rates not only impact US companies, but also companies in relatively open economies, such as Singapore and Hong Kong.
Rate hikes affect various businesses differently.
Companies that are dependent on debt face higher interest rate risks, with the impact being the greatest for those with a large proportion of loan facilities pegged to floating interest rates.
Due to the high probability of interest rates increasing further this year, such companies are in line to incur higher interest costs.
Paying higher interest charges to lenders means lower profitability and cash flow generation.
There are a few ways to determine if a company is sensitive to higher interest rates.
First, examine a company’s capital structure to determine the level of debt it holds
Second, look at the breakdown of borrowings to glean insights about its debt maturity profile.
Third, review if the company relies heavily on capital injection.
Are such injections required to sustain operations, fuel growth, or simply for working capital needs?
Each of these observations can point to a different conclusion about the reliance of a company on debt.
These metrics provide a better picture on which stocks to weed out from your investment portfolio.
2. Supply chain risk
The supply chains of businesses have been disrupted as globalisation shows signs of reversing.
Businesses that invest heavily in production outside of their home country are bringing these processes back home, in-sourcing various parts of their supply chain.
There are several reasons to explain this phenomenon.
One such factor is geopolitics where countries impose tariffs on one another, institute export and capital controls, and reshore operations and jobs.
Besides the US-China tensions, the Ukraine conflict demonstrates how reliant countries are on one another for trade.
Another factor is COVID-19.
Around the world, critical production and distribution sites have been severely disrupted, upsetting the supply and demand of goods and services.
The most notable consequence of supply chain disruptions is inflation.
In past decades, globalisation put a lid on inflation by facilitating easier access to many ingredients that feed into the final product.
Now, the limited supply of raw ingredients results in inflationary pressures for both consumers and businesses alike.
Higher raw material costs, wages, and surging overheads increase expenses and compress margins.
Agile businesses with more diversified exposure are likely to emerge as winners.
Robust supply chains involve the maintenance of vast networks and strong relationships with reliable suppliers upstream and distributors downstream.
Companies which are able to source for substitutes can rely more on alternative inputs to tide them through choppy waters.
For example, The Coca Cola Company (NYSE: KO) has over 50 suppliers for just sugar cane and beet alone, thereby minimising concentration risk.
By having more than 200 brands with some being substitutes for each other, the fall in sales or margins of one can be compensated by another.
Spreading out country risk exposure is correspondingly important.
Consider Apple’s (NASDAQ: AAPL) movement away from the Foxconn factory town in Zhengzhou, or Volkswagen’s (FRA: VOW3) multiple partnerships with semiconductor specialists from different parts of the world.
Besides diversifying, companies with a stronghold over their value chains are also favoured.
Vertically-integrated companies like Walmart (NYSE: WMT) are not only behemoths with strong bargaining power, but they can channel resources either upstream or downstream to remain efficient and economical.
Managing supply chain risks requires a delicate balance between achieving scale while maintaining nimbleness.
3. Inflation risk
Inflation is a key theme for 2023.
There are multiple ways a company can deal with inflation.
The first is to pass on higher input costs to consumers, implying that the business must have pricing power.
Pricing power often stems from the value a product or service is perceived to have by associating it with a well-recognized brand.
An example of such a brand is LVMH Moët Hennessy Louis Vuitton (ENXTPA: MC).
Despite raising prices due to higher manufacturing and transportation costs, the Group still achieved year on year revenue and profit growth, posing a record year in 2022.
As consumers are more willing to pay higher prices, these businesses can maintain their margins even during an inflationary climate.
The other component of revenue is volume.
It is helpful to assess how resilient the demand for a company’s goods and services is as consumers pare down spending.
Sectors such as financials, consumer staples, real estate, and utilities intuitively come to mind.
Due to the importance of these products and services, these industries may enjoy government subsidies, which then allow companies within them to recoup some of their expenses.
However, this works both ways – regulations may also limit price hikes and force these companies to absorb higher costs.
Get Smart: Managing the risks
As all investments harbour risks, we believe it is neither possible nor practical to try to avoid risk.
Instead, you have to learn to effectively manage the risks within your investment portfolio.
You can start with the three described above while also reviewing your stocks for other pertinent risks that may crop up over time.
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Disclosure: Tan Ke Xuan does not own shares in any of the companies mentioned.