How Risky is My Stock? Start with the Business.

When investors and market observers talk about risk, they often highlight market risk: stocks could correct, enter a bear market, even crash. While broad market events have significant implications, one of the most important measures of risk is business risk.

As Warren Buffett argues, a stock’s performance over the long run is tied to the performance of the underlying company. Rather than fixate on stock-related risk, it’s important to focus on risk relating to the company: its market, its strategy and the competitive landscape.

Here are some things that can help you think about business risk.

Buffett has said, “Well, we think of business risk in terms of what can happen — say five, 10, 15 years from now — that will destroy, or modify, or reduce the economic strengths that we perceive currently exist in a business.”

As Buffett biographer Alice Schroeder relayed (‘hat tip’ to Saber Capital), “The first stop in Warren‘s investing process is always to say, ‘What are the odds that this business could be subject to any type of catastrophe risk — that could make it (the business) fail?’”

Types of Business Risk

Business risk can take several forms.

One relates to debt. If a company has excessive debt, then during an economic downturn, they may be unable to make their debt payments and thus go bankrupt. That’s a scenario where the stock can go to zero.

Another risk relates to capital intensity. Buffett observed, “There are certain businesses that inherently, because of long lead time, because of heavy capital investment, basically have a lot of risk.”

Buffett’s partner Charlie Munger has previously highlighted commercial airplane manufacturers as being structurally problematic. Manufacture requires a large capital outlay, and any issues with building the planes could jeopardize the entire company.

In addition, Buffett highlights commodification as a risk: “Our textile business was not the low-cost producer. We had fine management, everybody worked hard, we had cooperative unions, all kinds of things. But we weren’t the low-cost producers so it was a risky business.”

In a commodified industry, if you are not the low cost producer, you risk getting undercut and ultimately going out of business.

Another facet of risk is time horizon. Buffett: “One key aspect to risk is how long you expect to hold an investment, i.e., stock in Coca Cola might be very risky if bought for a day trade or to hold for only a week. But, over a 5 or 10 year period it probably has almost no risk at all.”

In other words, over longer periods of time, the relative performance of the stock will ultimately converge with the performance of the underlying company. This is a reason to invest, rather than trade.

Obsolescence is another form of business risk, which is why Buffett famously has avoided investing in many technology companies. And certainly there are others.

These concepts are not exhaustive. The main point is to think about the stocks you own as they are — a stake in businesses — and develop an understanding of the factors that may impact those businesses over time.

Learn more about various business risks in the pros/cons section of company profiles on the Tornado website and app.

Keep up with the latest developments and high quality discussion on Tornado. If you have any questions on a stock you can also ask former Wall St. pros (e.g., former Institutional Investor-ranked and multi-billion dollar fund analysts).

Community Thought Leaders are select members of the Tornado community who receive compensation from Nvstr Technologies Inc. for their contributions.

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