As investors, our job is to formulate a robust investment thesis to justify our investments in great businesses. And that includes potential risks.
A well-rounded thesis should include the company’s competitive strengths as well as catalysts for long-term business growth.
However, no investment thesis is complete without looking at risk.
Risks are present in every investment we make and have the potential to scuttle the investment thesis if they are serious enough.
The problem is that some investors may miss out on risks as they chase higher returns.
That could expose them to more risks than they are willing to accept.
Remember that risks are specific to a company or industry and there is no “one-size-fits-all” formula for assessing them.
Here are five types of risks that investors should consider for their investments.
Behind every great business, you are likely to find honest and capable managers.
When assessing any business, look out for signs that signal that management may either be incompetent or incapable.
Incompetence may be revealed by a manager’s inability to manage different business situations or to adapt well to changing economic conditions.
Some managers are neither upfront nor candid. Instead, they prefer to sweep problems under the carpet rather than openly addressing them.
Another sign of poor management skill is the poor allocation of capital, especially in acquisitions that destroy shareholder value rather than enhancing it.
Another tell-tale sign of lousy management is when they needlessly branch out into non-core pursuits that take up the management’s time and effort but produce little tangible benefits.
Industry risk is specific to the industry in which the company is operating in.
Some industries, such as shipping or commodities, tend to be more cyclical than others.
This situation means that companies within it may experience wildly fluctuating fortunes, on one hand, enjoying exceptional profits during good times but on the other hand, struggling to survive during rough patches.
It’s also instructive to look at whether the industry is growing, or shrinking.
Nascent industries such as artificial intelligence or gene sequencing have much more room for strong future growth.
In contrast, industries such as compact discs are sunset ones and are facing rapidly shrinking demand.
Finally, you should assess whether the barriers to entry for the industry are high or low.
A low barrier to entry industry would invite a flurry of competitors that may dilute overall returns for all players with predatory pricing.
Politics may play a major role in determining if one should invest in a specific country or region.
You should assess if a country has any history of political upheavals or coups, as a change in government may adversely alter the investment landscape for companies domiciled within.
Is there also political wrangling or stalemates over policies? An example could be a plan to construct new infrastructure (i.e. bridges and highways), but these plans have stalled due to an inability for the government to execute.
Political risk could be a major deal-breaker, especially if the country has a history of unrest or violence.
Some examples in history include Libya, which was embroiled in civil war after dictator Gaddafi was captured and killed in 2011.
Economic risk has to do with the general economic outlook for a country.
Some questions to ask would be — is the country experiencing steady GDP growth? Is there any runaway inflation going on?
Have businesses within the country prospered overall? Or are most businesses struggling to survive?
Another aspect to watch out for is the exchange rate. Has the currency been appreciating or depreciating against other major currencies, and why?
Investing in companies that reside in a country with a poor economic outlook may stunt their growth and render the investment thesis invalid.
The final category of risk to look at is legal risk.
Are there numerous legal restrictions affecting how companies operate?
Is the company in question a defendant in any lawsuits that may result in a significant financial or reputational loss?
If the reply is yes to the questions above, then legal risks loom large and may invalidate the investment thesis.
A final consideration is whether the industry may be a litigious one — examples include the tobacco or pharmaceutical industries where the health of consumers is concerned.
The risk of lawsuits being levelled against the company may deter investors from putting their money into it.
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Disclaimer: Royston Yang does not own shares in any of the companies mentioned.