Element of Risk

Ashok Kanetkar is a retired executive with senior-level experience at several companies, most recently Cummins India. Apart from his experience of the corporate sector as well as the engineering industry - he is an articulate and dedicated student of Graham, Buffet and other investment gurus.

Life is a series of events, some predictable, some unpredictable. Those that are unpredictable but turn out to the advantage of the individual are called 'pleasant surprises' while those, which turn out to be otherwise, is termed 'rude shocks'.

No one likes rude shocks and therefore there is a constant endeavor to shore up all defenses against them and this tendency gets accentuated as age advances. In matters related to investment this desire to seek protection against shocks is quite pronounced and investors spend considerable time and mental energy in analysing the risks involved in putting money in a particular area.

Further, in the field of investment, general perception is that investment in shares is riskier than investment in good fixed income bonds and deposits. Without going into comparison between the two it is necessary to take a look at the risks related to common stocks.

The first justifiable concern in relation to any investment is the security of the principal amount itself. The question, 'Is my money safe and will it be returned to me as per the promise given?' is uppermost in investor's mind.

The second concern is related to the return on investment. An investor needs an assurance that whatever is promised, will be delivered. In the case of shares the answer on both the counts is slightly complex. Correct evaluation of the risks involved in a particular share, therefore, becomes a little complicated exercise than what would be for a simple fixed deposit in a bank.

Let's look at the concern about the capital as perceived in relation to securities. Many people feel that decline in value is a major risk involved in this type of investment. Yet, since there is also a possibility that the value may increase we have to call investment in shares both safe as well as unsafe.

A lot depends on the initial evaluation of the company whose shares are purchased. If shares of good companies with standing in the market and those, which have survived for number of years, are purchased then generally there is no reason to worry about the capital. Yet many people buy shares without paying any attention to this aspect.

Investment is made more out of false grandiose promises on part of the management or on the recommendation of a broker or a friend without really taking a hard look at the company management, its financial resources and the product line. In such a case if the capital is lost it should really be attributed to foolishness on part of the investor and not to any undue risk.

Even with good purchases a decline can occur. If this decline is of temporary nature it need not worry the investor unless for some reason he is forced to sell his holding. So if we apply the concept of risk solely to the loss of value then we must agree that such a loss may occur through actual forced sale at a lower value, or caused by a significant deterioration in company's position or more frequently, as a result of paying more than the intrinsic value of the share.

Enough signs about deteriorating performance of the company are available to an alert investor so that he can cut his losses. If he fails to read them or if he miscalculates about the nature of decline then there is a possibility of a loss and to that extent we must agree that investment in securities is a risky affair.

A deposit in bank or bonds will have to be termed unsafe if the interest payment is withheld for some reason or principal amount is held back. Similarly a reduction or passing of a dividend in the case of a company share should also make that investment unsafe. For an intelligent investor signs of a poor performance are apparent if he is alert and watches the quarterly results. Thus if he senses that the dividend yield is likely to fall below his expectations he can exercise the exit route.

However if at that time if the market price is less than what he initially paid for the purchase then a loss will occur. If the investor reads the drop in dividend yield as a passing phase then he may continue to remain the owner of the securities. To arrive at a decision for sale an investor may look at average dividend yield over a number of years. Generally matters even out over a five-year period.

Frauds and scams, which have a habit of occurring from time to time, need not be considered specifically in relation to securities because they can occur in any area jeopardising the interests of the investor. Though share market scams get much greater publicity, a serious intelligent investor need not give too much importance to possible frauds because he is neither a speculator nor a short time investor.

Fluctuations in the market on account of scams are really not due to poor performance of the company and they mostly result in decline of value, which has been discussed earlier. A clever investor should really be taking advantage of them if he is confident about the performance of the company and if his reading of the economic conditions is sound. If the value of his holdings goes up beyond reasonable limits he should sell and book profits, and if it falls below he should buy some more of the goodies.

Benjamin Graham categorises investor into two types; a defensive investor and the aggressive investor. For the defensive investor he has made some valuable suggestions for purchasing of shares in his book 'The intelligent investor'. These take into account the elements of risk discussed above. These suggestions are:

(1) There should be adequate though not excessive diversification.

Do not concentrate your purchases in one or two industrial sectors. Economic cycles affect different industrial differently. Automobile industry may be facing a slump but housing loan industry may be enjoying a good progress. Diversity in holdings helps even out the matters.

(2) Each company selected should be large, prominent and conservatively
financed.

The statement contains adjectives and as Graham says "a criterion based on adjectives is always ambiguous." Yet, all these adjectives convey a notion. According to Graham an industrial company's finances are not conservative unless the common stock (share capital plus reserves) represents at least half of the total capitalisation. 'Large' and 'prominent' carry the notion of substantial size and a leading position in the industry.

(3) Each company should have a long record of continuous dividend payments.

In Indian context this would mean a continuous record of dividend payment of at least twenty years.

(4) An investor should impose some limit on the price he will pay for issues in
relation to its average earnings over say the past seven years.

This is related to the p/e ratio. Every investor has to form his own standards here. Within the standard an investor laying emphasis on dividend yield will strive for a lower p/e than one looking for value appreciation. Also for a defensive investor, the limit is bound to be low whereby many growth stocks may get eliminated, which generally trade at high multiples.

Growth stocks, though they are capable of giving spectacular profits to investors, are quite capable of causing a decline in value if too high a price is paid for the purchase. Defensive investors should be careful before venturing into these stocks with high P/E ratios. The doors are not closed to them but they should tread wearily.

Despite every thing, there is lot of excitement in investment in shares. Companies make profits, other investors notice what you noticed long ago and the share price goes up, or your company appears in newspapers and experts offer praises for the performance and you feel proud of yourself for having taken the decision to buy etc. etc.

The biggest thrill about shares is the possibility of a windfall, which no other investment can offer. Balzac, the French author, once said, " Behind very fortune there is a crime". An intelligent investor can overlook this statement because he can make a fortune in the share market and still remain completely above the law!