Tuesday, November 22, 2011

The Definition of Risk

Many people define risk in terms of price volatility and/or price movement. They believe a stock is risky if its price swings are wide or declining, and believe a stock is less risky if its price swings are narrow or rising.

My opinion differs greatly from the above. From my perspective, risk doesn't equate to volatility or price movement, it equates to what Ben Graham called a "permanent loss of capital". And by "permanent", I don't mean the day-to-day fluctuations in the mark-to-market value, I mean "permanent", as in "realized loss".

I use three categories of risk when analyzing a company for potential investment:

  • Fundamental Risk
  • Valuation Risk
  • Cash Flow Risk

Fundamental Risk is the risk associated with the company financials, such as revenues, expenses, debt, cash flow, etc. and requires thorough analysis of the financial statements. You wouldn't buy a used car these days without checking the CarFax, and neither should you buy a stock without checking the financial statements. To minimize fundamental risk, I look for wide or narrow moat companies that are financially stable, have sustainable revenues and a history of generating positive free cash flow.

Valuation Risk is the risk associated with the fair value of the company vs its current market price. If a stock is overpriced in relation to its fair value, there's a greater risk of loss. On the other hand, if a stock is undervalued in relation to its fair value, there's a greater potential for gain, and the more undervalued the better. As Buffett said "If you buy a dollar for 60 cents, it's riskier than if you buy a dollar for 40 cents, but the expectation for reward is higher in the later case". In other words, risk/reward are not always correlated. Sometimes, less risk means greater reward. To minimize valuation risk, I look for companies that are trading at a discount to fair value, and always with a Margin of Safety between 20-40% lower than fair value, just in case the fair value estimate is wrong or changes due to fundamentals.

Cash Flow Risk is the risk associated with investor cash flow, meaning cash flow generated as a result of an investment in a given company. This usually means dividends received, but for a CC/CSP portfolio, it also means premiums from the sale of call and put options. To minimize cash flow risk, I look for companies with a history of consecutive dividend increases. For a CC/CSP portfolio, I look for stocks with good option liquidity and premiums that meet my cash flow requirements.

If a company passes all three risk assessments, then I consider it low risk. I'll allocate up to a maximum 10% of working capital per company, but will leg in with smaller positions of at least 1%. I normally establish an initial position by selling a CSP 20-40% below fair value. In order to get assigned, the stock has to decline in price. So, where those who define risk as volatility or declining price will avoid this stock, I'm happy to take assignment and then sell a call at or above the purchase price. If the company still passes all three risk assessments, I'll even sell another CSP at a lower strike and greater discount to fair value. This second CSP is even less risky than the first (i.e. a dollar for 40 cents vs 60 cents). I'll repeat this up to 10% of working capital per company. Currently, my average position size is around 3%, with the max between 5-6%.

So, that's my definition of risk. What's yours?