How to Dramatically Reduce the Risk in Your Stock Portfolio
From a Daily Crux interview with Dan Ferris | Thursday, August 26, 2010
The Daily Crux: Dan, in your latest issue of Extreme Value, you wrote about the three biggest risks all investors face. Can you tell us what these risks are?
Dan Ferris: The three big risks are pretty simple to understand, but they're probably the biggest reasons people lose big money in stocks.
The first one is business or earnings risk. This is the risk people generally think of most often. This is the risk that a company suffers a loss in its earning power through any number of causes— like economic problems, industry changes, management missteps, or even fraud.
Now, what has become the classic way to avoid this risk is to find a business with an enormous competitive advantage. In the simplest terms, what you want to do is find a business whose earnings are extremely likely to recur again and again. A great example is a company like Wal-Mart. There's little doubt it's going to keep making money because it has a huge competitive advantage. It can undercut everyone else on price.
It's easy when you buy the world's best companies, like the World Dominator stocks in the Extreme Value portfolio. It can be trickier when you're dealing with other stocks. You need to make judgments about the business, its competition, and what the future may look like… but it's important to consider this risk before buying any stock.
The Daily Crux: OK. What's next on the list?
Dan Ferris: The next big risk is balance sheet or financial risk. By far the biggest mistake most investors make here is they tend to buy companies that use a lot of leverage. Leverage is dangerous… It goes both ways, as we saw with financial companies over the past several years.
Sure, it can allow you to earn more and get higher returns on equity when things are good, but it can also cause you to go bankrupt surprisingly quickly if things get bad. This one's probably the easiest to avoid. Just stay away from highly leveraged companies, especially highly leveraged financial companies. You need to take a look at a company's balance sheet. Avoid companies with lots of debt… Try to find companies that have little or no debt and plenty of cash on the balance sheet.
A great example here— that we own in the Extreme Value portfolio— is Forest Labs. Its management has made it clear it likes to have a really strong balance sheet. It uses zero leverage. It started the year with around $4 billion in cash and zero debt. And it's otherwise a great business: pharmaceuticals.
The Daily Crux: Got it. What's the last risk investors face?
Dan Ferris: The last risk is valuation risk. This is the one risk investors have complete control over, but it's probably the one people most often overlook. It's simply the risk that you pay too much for a stock.
The price you pay plays a huge role in whether you're going to make or lose money in a stock. It could be a really great business with low earnings risk. It can have a really great balance sheet and little to no financial risk. But if you pay 50 times earnings for it, you're basically guaranteed to lose money. It's an extremely rare business that's worth that much.
So even if you avoid the first two risks, you still have to understand what the business is worth. And it's much more difficult to value companies that have financial or earnings risks. An example here might be an oil and gas drilling company… a company that's highly cyclical. It's much harder to avoid valuation risk with a driller to the extent you would with a business that has low earnings risk and low financial risk.
If you're looking at a great business, like a World Dominator, that's got a great balance sheet and low earnings risk, it's much easier to figure out how much it's worth. Take Intel, for example. It's a great business that owns 80% of the microprocessor market. I might not pay 50 times earnings for it. But when I see it selling for less than 10 times cash flow, as it is right now, I don't need to worry about losing money.
The idea behind these strategies is— if you do them right— you'll know exactly what you're buying, exactly what to pay, and what kind of risk you're taking. If you do these three things, your chances of losing money go way, way down. Most people don't think in those terms. They want to see a lot of upside, and they want a sexy story. But investing is kind of like a seesaw… When you can dramatically lower your chances of losing money, you've dramatically raised your chances of making it.
The Daily Crux: That's a great point… When you look at the most successful investors in history, they've tended to approach investing from that viewpoint.
Dan Ferris: Right. Jim Rogers always said that he looks down first. He looks down before he looks up. Warren Buffett said rule number one was "Don't lose money". And his second rule was "See rule number one."
That's what all the successful investors do. They first figure out their risk. [[which is definitely NOT simply price volatility, as Wall Street would have you believe…: normxxx]] They're obsessed with figuring out how much risk they're taking. Only then do they think about the return.
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