Equity investments are fraught with various forms of risks. To be successful, an investor must identify these risks and understand their implication
TWO planes colliding into two towers half-way across the world brought down financial markets all across the world. A fortnight-long dry spell is enough for share prices of some companies to tank. Markets are meant to react to external events. Some traders make a killing by betting on such events, but a majority of retail investors emerge losers.
Equities, by their very nature, are susceptible to all kinds of risks. The reaction of the domestic market to the financial crisis in Greece is the most recent instance of how globalisation has increased linkages between Indian and overseas markets even if there is no direct connection between the economies.
Broadly, investors have to contend with two sets of risks — one pertaining to the markets or systemic risk, and the other specific to the company. Here is a look at how the risks impact returns and how to handle them.
Market Risks
You cannot ignore market risks while building a portfolio. There are instances, where all the company specific factors are in place but the price is not right, making it a risky bet. During a market rally, a boom phase creates a situation where an investor buys shares at a price far higher than what the company is worth. In a downturn it is the other way round where irrespective of a company's performance the price declines. Price volatility arising out of broad market movements is attributable to systematic risk. There is no one solution to this risk and diversification does not help. If you can keep your calm and pick stocks at lower levels then you are likely to face limited loss when the markets fall, as there is enough margin of safety. Some investors prefer to buy put options if they are worried about market health and have a huge portfolio.
Management Risk
Lending money to a dishonest person brings with it the risk that he may default. The same holds true for dishonest managements. There are instances where companies keep coming out with announcements of new projects followed by pump and dump operations. Despite the regulatory crackdown, investors lose their money as they are forced to exit at near-zero value. It makes sense to ask about those you are getting into business with. Track record of the management is a must check point. It makes sense to let go an opportunity from an unknown entity and instead invest in well-managed company with a good investor-friendly track record.
Business Environment
This comprises economic environment and regulatory framework. Corporate earnings grow along with the growth in the real economy. It makes sense to keep a track of the growth in real economy. But if the regulators decide to change the rules of the game, such changes could impact the fortunes of companies. Especially in highly-regulated businesses it is imperative that you keep a track of regulatory changes, as it may have its repercussions on margins and volumes.
Risks Related To Business Models
Not all companies in a sector work in the same manner. They may have focus on certain markets, certain geographies and certain customers. A pharmaceutical company engaged in contract manufacturing will have different risk-reward than that of a research driven company.
To gauge the possible impact of any variable on a company's earnings, investors must have a good understanding of the business model of a company. This can be acquired by visiting company website and reading annual report of the company. If you are bullish about a sector, it makes sense to diversify your holding across business models within that sector to ensure that there is less risk involved in a concentrated portfolio.
Gearing Risks
In a rising interest scenario, a company with high level of debt faces increased risks. As the interest rates rise, the interest burden also increases, taking its toll on the bottom line and adversely impacts shareholder returns. The worst scenario happens if the existing debt of the company matures in times of credit crunch, leading to terrible situation for the company.
It makes sense to go for companies with net positive cash flows. One can also look at zero debt or nominal debt companies. If you are keen to go for a debt ridden company, ensure that the valuations are really low to ensure that you have some margin to fall back.
Geo-Political Risks
Though the companies you invest are listed on Indian stock exchanges, they need not earn all their revenue in India. There are many companies that earn their revenue overseas. It is better to understand the geo-political framework of the countries. Especially in countries where democratic governments do not exist the risk is high. Recent issue of volcanic ash in European skies grounded airline shares. This underlined the risk associated with such 'low probability high impact' black swan events. Diversification is the only way out here. It makes sense to have some meaning full diversification by investing in markets sharing low correlation with each other.
Foreign Exchange Risks
Companies earning their revenue or paying for their raw materials in foreign currency run the risk of fluctuations in foreign exchange. At a time when the global markets are turning more integrated, it is imperative to have a close look at the foreign exchange movements. A weak local currency is helpful for an exporting company, but makes the life miserable for a company that imports its raw material but cannot Risks associated with equity markets. The only solution to this problem is to identify earning's sensitivity at various level of cross currency rates and accordingly take positions, other things remaining the same.
The reward of investing in stocks depends on how well you steer clear of risks or manage the risks that you really cannot avoid. If you find it difficult, you will be better off allowing entities such as mutual funds to manage your money.
