Identify Downside Risk Before It Is Too Late

By Louis H-P on September 21, 2020

Few novice investors will consider downside risk when they first make an investment. Often their first investment is in a company they have read about in the news and identify with. Tesla stock has been a case in point, where investors flock to it despite an increased nonsensical valuation. It’s recent profitable quarter was only from selling carbon credits, not from selling cars! 

What is downside risk?

Downside risk is the risk of your investment losing value. Within your investment there will be a positive business case but also some risks. These risks will stop the business from developing and should be considered before making the initial investment.

Speculate to accumulate.

To earn a return from your equity investment you need to take a risk. When you buy a stock, you are trying to buy it cheaper than it will be tomorrow. Ideally this is because the future value is increasing. Unfortunately issues will crop up in the conduct of business. These issues are often risks which damage profits and worse, bankrupt a business.

How to identify downside risk

in short, ask yourself a lot of questions about the business you are investing in. For example, if your mate asks you if your football team will win the league this year, your answer will often be instructive. Their question is driven because your team finished 2nd last year.

Yet your answer is a solid no, because you need a real goalscorer – you have just identified your team’s downside risk: without a goalscorer you will not move forward and win the championship.

Your team scored enough to come second, but in those key games when the opposition just set out to defend, you needed that one player to get that key goal.

Analysing the downside risk to a business is exactly the same. What is the businesses key product? What are it’s key competitors? If a competitor has a superior product at a cheaper price, is this not a downside risk?

Always be cynical…

For perennial bulls, it can be a shock when growth falls off a cliff. This is normal with an economic cycle, as ‘what goes up, must come down’. What is harder for investors, is when the only stock crashing downwards is their own. Although there are always risks to a business, occasionally it is risks which are deliberately kept away from investors that one should worry about.

Sadly despite rules and regulations to stop it, creative accounting has a habit of rearing it’s ugly head. Examples can include a department store chain which leaves it’s long-dated store leases off the balance sheet. If you have signed to pay rent for 20 years, then that is a liability. The only way of working this out is fundamental analysis.

Imagine a scenario where during a catastrophic period a business is unable sell anything but is still required to pay its rent. Worse because the lease is so long, the business cannot put pressure on the landlord to renegotiate… Taking a 20 year bet is a big risk when the world can evolve so quickly.

Future downside risk

As the world evolves, then so do businesses. It is worth keeping a close eye on thematic investing ideas. Next, the retailer, which is a well-run business, has been allowing clients to buy on credit. In effect becoming a form of bank, where it is lending to its clients. It is not impossible that during a recession, clients default on paying back what they owe.

Protect yourself from downside risk

Risk never goes away, it just reappears in a different form. Having some form of mitigation strategy is therefore useful and important. A margin of safety is a good start. This is something that Warren Buffet swears by. Diversification is also useful.

Mid sized companies found on the FTSE250 tend to be reliant on one product line, which means a profit warning is usually catastrophic for the share price. Large caps found on the FTSE100 or S&P500 have several divisions which do not all normally have a catastrophic time in unison.

Some retail investors, who have developed the sophistication required, use options to hedge their portfolios from downside risk. Options are complicated to use, and depending which side of the trade you enter into, can cause large losses. Used in a simple and conventional hedging strategy, they can reduce your losses.

Conclusion

Downside risk can come in many forms, your investment’s key product suffers a drop in sales, failing to notice your investment is leaving large debts off the balance sheet, or a ‘Force Majeure’ incident such as the Coronavirus disrupting everything.

If you have identified downside risk you can take steps to mitigate it’s effect – this will also help you to keep cool and not panic sell, but also give you the knowledge to know when to run for the hills,and sell (get) out if the risk is a terminal one.

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Louis H-P

Louis is a portfolio manager and a trader who brings a wealth of experience in private banking to The Lazy Trader. A fundamentalist and a trouble-shooter, Louis makes a firm contribution to the trading team.

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