Well it's technically true that "Risk hai to Ishq Hai" but it's also true that "Kaisa hai yeh ishq hai Ajaab sa risk hai". It's one of the most important job of a business analyst and an entrepreneur to understand what all can go wrong in a business and what's the probability of that event happening. The one way street of only thinking about growths in revenue & profit without understanding the downside a business faces has more often than not resulted in very unpleasant outcome.
and boss, building worst case scenarios & probabilities are next to impossible. Being entrepreneurs cum investors we can say this with confidence the following things:
a) If you have faced some risk in the past doesn't mean you are better prepared for it today. Even the same risk comes up with different quantum/magnitude whenever it re-occurs.
b) You can not measure risk. As calculating risk means probability of that risk * downside when that risk strikes. In reality you can only calculate the downside and not assign a probability to it.
c) Let us give you a rule thumb - have three years of expense of your business in cash & gold + own your headquarters/Plants + always keep interest expense low (hardly 10% of your income on upper side) + Be prepared that if any risk of the past re-emerges with a 2x magnitude how will your business survive against and you are good to go in terms of regular business risk.
ohh but what about disruption for a new model đ?
We will tell you a funny thing we have seen risk as the shortest section in 99.999% of equity reports, i think mostly its inserted to just look smart that we have measure risk Vs return.
Risk begins when you have actually thought about every possible outcome. It's the unknown-unknown variable that actually provides a lot of trouble.
Let us demonstrate that using a glimpse from the famous sitcom - Big Bang Theory.
https://youtu.be/DMBBANfLqhA (0.29 - 1.14)
You see Sheldon did not see it coming!!! that's risk!!!
Howard Marks, one of the greatest debt fund managers in the world, once famously told a story his dad told him:
âI tell my fatherâs story of the gambler who one day hears about a race with only one horse in it, so he bet the rent money. Halfway around the track the horse jumped over the fence and ran away.â - Howard Marks
Especially when it's a bull market everything that management of a company says about the future is believed by market participants or a trend is assumed to continue till infinity or aggressive growth plans are cherished by taking stocks to upper circuits.
Here's a checklist of all the tools promoters can use to play tricks/frauds in a bull market:
https://twitter.com/amitmantri/status/935385741995024384
There is No Investment in the world without a downside - NONE!
Imagine it's 2011/2012 and you are analyzing Relaxo the company which went on to become one of the poster boys of Indian capital markets as one of highest return providing stock of the decade. This company was fraught with risks in 2012 like D/E of 1.5 in 2009-2010, private owned entities in similar business, litigation cases on key brands etc. These were the risks that a lot of savvy investors takes very seriously. although promoter corrected all the things and they settled the litigation too but the point is at every point of time even great investments have had some risks which are difficult to ignore.
Some good businesses also have had major drawdowns or long periods of sideways movement. Take the recent COVID effect on Bajaj Finance. Let's look at its chart.
A 60% fall in 2 months!!!
Another Compounder of India has seen two 40% (approx.) corrections and one 55% correction in last 5 years itself đ
On the verge of repeating ourselves, There is no Investment without Risk!!!
Please don't give gyaan of Uncertainty Vs Risk, Volatility is feature of market and not a bug blah blah blah!!!
We know that đ.
The point we are trying to communicate is one eternal truth of market is its painful to bear a 40-50% drawdown on positions which are 10% of your portfolio and even best of the best compounders can have such drawdowns.
Now having understood the brief background of risk let's shift our focus to understanding broad buckets of risk (according to us):
a) Risk specific to the Industry you are analyzing: For example Steel is a highly cyclical business (with sharp upturn in profits & sharp drawdowns with huge losses). Hence as an analyst you need to be very careful while looking at recent financial data (revenue growth, EBITDA Margins etc.) and understanding whether recent growth & high margins (basically steel prices & RM prices) will sustain in the near future or not will be dependent on Industry level demand-supply dynamics. We will be posting sector specific thread soon that will cover entire analysis of sectors along with the risk of that particular sector.
b) Risk specific to a company you are analyzing: Think about a hypothetical scenario: A single promoter in the age bracket of 70's running a cyclical difficult to understand business with one daughter who is married and neither son-in-law or daughter seems interested in running the business and management has not been able to retain a senior level guy in the company for long term. The risk is who will run this business let's say in 5 year?
c) General Risk Patterns - "Base rates" & "pattern analysis" are two very powerful words especially when it comes to capital markets. It's as simple as if someone drives a bike at 100 km/hr everyday without wearing a helmet the probability of that guy injuring himself in a Road accident is very high.
Similarly there are failure patterns in Capital Markets. For example, if a company is growing inorganically by taking excessive debt with negative CFO (Cash flow from operation) generation especially into unrelated industry.
Understanding of such patterns are obtained by studying history of failed businesses. Especially, those who were great once upon a time and are now either bankrupt or on the verge of bankruptcy.
d) Forensic Accounting Issues: This topic does not need much introduction. This simply means that the accounts of the company are not portraying the true picture. It covers everything from studying historic amalgamations to reading form AOC & MGT to surfing MCA/Tofler to analyze related parties. We will be posting a separate blog on the forensic indicators that you can check in a company.
In this blogpost we will list down the general risk pattern and company specific risk factors along with Case studies:
1 - Betting on a star management to run a business and he quits - Great post on this by http://stalwartvalue.com/how-we-caught-dropped-a-5-bagger-story-of-agl/
2 - Mainly topline growth was driven due to increase in commodity price which eventually reverses - IOL Chemicals
3 - Mainly the margin expansion was driven by a decrease in prices of RM or some unsustainable items like inventory gains which eventually reversed - Avanti Feeds (RM) or textile companies (inventory gains)
4 - Countless number of global variables affecting the business - Natural resource companies like Steel, Oil etc.
5 - Persistent Labor Issues in a business - Tea Industry
6 - Low/negative CFO and company going for debt funded unrelated diversification - Jain Irrigation
7- Group level Corporate Guarantees - Bajaj Hindustan & Bajaj Steel
8 - Excessive Leverage funded acquisition of huge size (A company buying out another of equal or bigger size) - Tata Steel
9 - High Operating Leverage & Financial Leverage - Hotel Industry
10 - Huge Equity Dilution to take advantage of capital market high prices - Shemaroo Entertainment (2018) - An entertainment company entering into Food delivery business.
11 - Debt Defaults/Continuous restructuring - Sintex & Suzlon
12 - Unclarity about growth Plans/Cash Hoarding/Value Traps (businesses looking cheap due to high cash balances/unmonetized land etc.) - HMVL, MPS
13 - Dependence on End user capex/depends on capex of end users (NOT END USER Operating cost) - Buyers faces cyclicality --> Equipment suppliers to mining companies
14 - Litigation prone business/capital getting stuck - Infrastructure Industry
16 - Concentration in Part of value chain
a) One buyer - JHS Svenguard/RS Software
b) one Supplier - Huge KSM Raw material dependence on China of some commodity API players
c) One regulation - Noida Toll Bridge
d) one key Location - Mannapuram & Kerala
e) One key product with high market Share - Colgate Palmolive
f) Concentrated Distributors - Boat which is company up with the IPOs completely dependent on two e-commerce players Flipkart & Amazon. or take recent example of stovekraft. See the below image from the recent concall
17 - Reducing Entry barriers, especially efforts to scale - AMC Industry
18 - Low Pricing Power/Extreme threat of substitutes - Kukoyo Camlin
19 - Currency risk in case of independent international subsidiary - Sequent scientific Turkish Lira
20 - New Plant expansion delay - Mayur Uniquoters
21 - Pledging & Encumbrances - Bajaj Steel, Bajaj Holding, Zee, Yes Bank etc.
22 - Rapid change of technology - Moserbear
23 - Failure to scale up - Hawkins, Lovable
25 - Industry competitiveness increasing suddenly - 2g licenses episode of 2010-2012. 122 licenses in total were awarded suddenly.
26 - Consumer Behavior shifting - Gillette India
27 - Disruptive Start-ups shaking the incumbents business models:
28 - Sectoral valuations risk - Episode of 2022 where software companies were taken to price to sales multiple of 15-20-40 justifying high growth rates and majority of them has fallen 50% from all time highs whereas NASDAQ has only fallen 10% from all time high (this was as of 18th jan 20) Or taken our own Indian examples of Infra Valuations of 2005-2007 (DLF has not seen its IPO price for 10 years now) or Recent IPOs of PAYTM, Zomato or FY 21 when commodity API Companies traded at FMCG multiples.
29 - Natural Risk which becomes frequent in nature - Gujarat Fluorochemicals (plant fires & production halts in hazardous chemical manufacturing industry) or massive fast spreading poultry diseases in case of Hester Biosciences or long periods of rainfall deficit for companies in agriculture value chain.
30 - Execution & Commitment track record issues - Mukta Arts
31 - key Man Risk & succession Risk - Sinclair Hotels & Cupid Limited
32 - Shareholding pattern unclarity - Fiberweb, Adani Green etc
33 - Fund Diversions against minority shareholders - Gujarat Automotive
34 - Private owned entities in same business with bigger turnovers - Venky's, Saint Gobain, lot of MNC companies
35 - Secretarial Dues & Tax Issues - Oceanaa Biotek
36 - Promoter Amalgamating Private owned entities with complex structures or at absurdly high valuations leading to increase in Promoter's stake: Meghmani Organics
37 - Growth driven through inorganic acquisitions and consistent write-offs: Quess Corp
38 - Awkward acquisitions: Thomas Cook (a travel & resort company) buying a football club.
Please note that we have intentionally avoided all the forensic accounting indicators as those wil be covered in detail in another blogpost.
Apart from sources of risk, its very important to understand the impact of risk. According to us the below format seems to be of great use while interpreting the risk factors of a company
Start with understanding the sources of risk (as mentioned above)
Understand the impact of risk on the business - if a particular source of risk emerges where will the effect come - Revenue growth, margins, Re-investments, valuation multiples
As per history what is the general recovery mode available to a company after a particular source of risk emerges and a guesstimate of a timeline in which the recovery may happen
Is your company doing something in particular to mitigate that particular risk.
As a sample we have uploaded below few risk table of some business our students analyzed at a point of time. This will clearly help you understand the above methodology of Risk Analysis.
Company 1
Company 2
Ps: You may or may not agree with their assessments of risk. The main purpose is to highlight the angles in which risk can be judged.
Also a very relevant angle to analyze is their will be exceptions to everything in markets. For example:
a) You will find top5/top10 client concertation in lot of IT companies but still they have been performing well by cross-selling products to them or a Suven pharma where the concentration of revenues is between top3/4 clients but those clients are sticky due to inherent development phase of 10-15 years of a molecule.
b) Also taking excessive debt to expand is considered bad but look at Deepak Nitrite which expanded its balance sheet almost 4x in 4 years completely funded through debt and business & stock performance has seen one heel of a upward journey since capex. Look at debt/Equity blasting between FY 11 to FY15 and assets going approx. 4x
Hence, its very important to judge the risk of a company in a very holistic manner and not like a checklist pattern.
Mandatory Reading
1 - If you want to just read one thing in life about understanding risk and Uncertainty we recommend this Memo by Howard Marks written in 2006 (according to us best paper on risk till now) - https://www.oaktreecapital.com/docs/default-source/memos/2006-01-19-risk.pdf?sfvrsn=afbc0f65_2
2 - And if above excited you do read these 2 books by Nassim Nicholas Taleb - Antifragile & Fooled by Randomness (https://www.amazon.in/Books-Nassim-Nicholas-Taleb/s?rh=n%3A976389031%2Cp_27%3ANassim+Nicholas+Taleb)
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