Risks are an inescapable aspect of investing.
Many investors make the mistake of gunning for returns while neglecting to watch out for the downside.
As a result, their investment portfolio may suffer from irrecoverable losses.
There are six major categories of investment risks that you should pay attention to.
They are i) Management ii) Industry and Competitive Moat iii) Political iv) Economic v) Social and vi) Legal/Regulatory.
This first part talks about risks relating to management.
Competent and capable
The first question to ask yourself when evaluating the management of a company is – have they shown themselves to be competent and capable?
This question should be answered objectively – either through measurement of the company’s return on equity, net profit, free cash flow or dividends.
If these metrics have seen consistent improvement, there is a high chance that management is competent enough to steer the business well.
The biggest risk is to be saddled with a management team that over-promises but under-delivers.
Alignment with minority shareholders
Management must show that its actions align with minority shareholders.
Hence, the team should avoid actions that seek to enrich only themselves.
An example would be an acquisition in which management is paid high fees but which ends up being a lemon.
Rogue management may also hoard excessive cash rather than using it for share buy-backs or dividends.
Some management teams also pay themselves exorbitant salaries without any justification.
Willingness to engage shareholders
Management should be willing to take time and effort to engage minority shareholders and explain the company’s plans and strategies.
It should be upfront when problems arise and be open to sharing the strategies to take to mitigate their impact.
A major risk is a management team that remains aloof when such “challenges” arise, all while keeping shareholders in the dark over what’s going on.
When things are going well, most management teams do not hesitate to blow their trumpets and shout out their achievements from the rooftops.
But when things go downhill, watch out for management that sweeps problems under the carpet and pretends that things are still going swimmingly well.
This deception is more common than you would expect.
Thus, candour is a much sought-after quality that you should look for in a management team.
Good capital allocators
Finally, you should judge whether the management team has been effective at allocating capital to achieve the highest returns.
Capital that is poorly allocated will erode shareholder value over time, making the company less valuable.
A way to observe if capital is allocated well is to observe where resources and money are being channelled.
Are they deployed into promising areas or disappearing into a proverbial black hole?
Throwing good money after bad is a poor strategy and may signal overconfidence or excessive hubris in management.
Watch out for the next part of this series where we will discuss industry and competitive threats.
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Disclaimer: Royston Yang does not own shares of any of the companies mentioned.