In investing, as in life, risk comes in many guises. A journal entry I wrote in December, which looked at some commonalties among great managers, touched briefly on the idea of separating a company's operating risk from its stock's price risk. I find that breaking down risk along those lines is a particularly helpful way of looking at stocks, so this journal entry takes a closer look at the concept.
So what are operating risk and price risk? Operating risk is the risk to the company as a business. That includes anything that might adversely affect the company's market or its profitability (such as volatile raw-materials costs or rising labor costs). A high debt load compared with industry or market averages would also make for higher operating risk because it would magnify the bottom-line effects of a drop in demand. Basically, anything about the business that makes its earnings less certain or more unstable qualifies as operating risk.
Price risk, on the other hand, has more to do with the stock than the business. There are different ways to look for price risk, but the most common is probably looking at a stock's price multiples, such as P/E or price/book, against that of the industry, the market, or any other index that will yield a meaningful comparison. A stock whose multiples are comparatively high carries more price risk than one whose multiples are lower.
When I look at a stock, I try and figure out how its operating risk balances its price risk. To think why that might be important, imagine a company in a turnaround situation--that is, one that carries a fair amount of operating risk. If the stock is expensive, I probably wouldn't be interested because much of the potential improvement in earnings is already figured into the price. And if those earnings don't materialize, the chances are good that the stock will tank. But if the stock is cheap, I might be inclined to take a chance on those theoretical, risky future earnings. The potential upside is great if the company comes through, and downside risk--or the price risk--is comparatively limited.
I usually visualize the balance between operating and price risk as a four-box matrix, and I try and fit stocks into one of the four categories: low operating risk and high price risk, high operating risk and low price risk, low operating risk and low price risk, and high operating risk and high price risk.
Low operating risk and high price risk The leading stocks in today's market mostly fit into this box. These are the Coca-Colas, the Gillettes, the Microsofts--companies that have advantages such as leading market position, brand-name franchises, and superior profitability that enable them to post reliable earnings and growth, year in and year out, quarter after quarter. Smaller or less well-known companies with good managements or strong market niches can also end up here. These companies--though they occasionally post lower-than-expected growth or weak earnings--have delivered over the long haul.
And the market has noticed. Clorox, for example, now commands 31 times its trailing earnings, a P/E that's 50% higher than its average P/E over the past five years. In other words, the market has raised the premium on its future earnings, in large part because the company has been so reliable in the past. If these companies don't meet or exceed those high expectations, these stocks could be in for a long period of sub-par returns until earnings catch up with the prices. And any glitch in earnings--and every company has glitches, no matter how steady it is over all--could send these stocks into a tailspin.
High operating risk and low price risk Cyclicals--with their reliably unreliable earnings--tend to crowd into this corner, though other companies, with less-than-ideal markets or mediocre managements, fit as well. In large part, these stocks can make up for their lack of earnings stability--a la the turnaround example above--or their choppy growth, with their low price risk.
Low operating risk and low price risk These stocks are the Holy Grail of value investors. Warren Buffett's stocks fit into this category when he bought them, before they moved into the low operating risk, high price risk box. The big problem with this box is finding stocks that fit into it. As you've probably realized by now, most stocks tend to congregate in the two boxes above. Since the market is more or less efficient, it tends to exact a higher price for higher quality and a lower price for lower quality.
High operating risk and high price risk This playground is pretty much off limits to all but die-hard growth investors. Most often, hot start-ups and small tech plays end up here. These are companies whose businesses are new, or are so small that they carry a lot of operating risk. But they are also usually in popular or glamorous industries, which means that the market has put a high price tag on those uncertain earnings. In order for their high-priced stocks to do well, these companies need turn in some convincing evidence that they could be the next Microsoft.
What's important is really the exercise of considering which of the above categories is more appropriate to the stock and why. Because once you have a handle on that, you can compare the stock to your investment style and decide if it fits. A stock that's risky because its operations are unstable is a different kind of investment than one that's risky because it's expensive. An investor who might consider one might not consider the other. It's a case of investor know thyself and thy stock.