Investing requires us to choose between eating well and sleeping
well. If you want to eat well, be ready to take on the risks involved
in seeking higher returns. If sleeping well is what you are more
concerned about, be ready to give up higher returns in exchange. But in
either case defining risk only in terms of the probability of losing
money is not enough. Risk comes from various sources, so it is
important to understand the different types of risks that come to the
fore while picking an investment.
Business risk :
It is the
variability of a company’s earnings before interest and taxes (EBIT).
It is a combination of the following: one, change in demand. If demand
for a product/service is not stable or predictable, its revenue won’t
be stable or predictable either. Next is the company’s ability to
increase prices or absorb cost increases, which is crucial to sustain
profitability. Companies differentiating their products through
branding are better equipped to pass on cost increases and earn above
average profits. Third, if fixed costs are a substantial portion of
total costs, business risk is definitely higher (unless such a cost
also creates a strong entry barrier) since a company’s earnings then
are more susceptible to variations in demand and prices.
Credit risk :
Applicable to holders
of debentures, it is defined as the ability of a company to pay the
promised interest on fixed-income instruments and return the principal
on maturity. Rating agencies such as Crisil, Icra, Care and Fitch
evaluate and rate fixed-instruments of all types to help investors
understand the extent of credit risk. The quality of an instrument is
better if its rating is higher. A lower quality bond generally pays a
higher interest to compensate investors for greater credit risk. So
when a company promises higher rate of interest, remember it does so to
attract investors (and not because it can afford a higher rate of
interest).
Exchange rate risk :
This is the
risk arising from changes in exchange rate of the rupee versus the US
dollar or any other currency. Profits of companies who import a
relatively large part of their raw material are at risk if they are not
able to fully pass on cost increases when the rupee depreciates. A
weakness in the rupee also prompts foreign investors to withdraw from
the stock market by selling their shares and converting those rupees
into dollars. While they may re-enter at lower levels, that stock
indices tumble in the short-term is a big risk for the domestic
investor.
Financial risk :
Interest being
tax-deductible, equity shareholders welcome debt to the extent it
enhances their returns. But beyond a point, they are exposed to the
risk arising from a high level of fixed commitments. This describes
financial risk. It arises when debt represents a higher proportion of a
company’s capital structure (comprises net worth and debt).
Industry risk :
It is the risk
applicable to an industry. A large scale shift in demand, a rise in
input prices, regulatory changes are typical factors that would signify
such a risk. For example, a shift in demand for generic medicines
compared to innovator drugs would pose a big threat to big
pharmaceutical majors globally. Or, a shift in trucks from single-axle
trucks to multi-axle trucks will pose a major threat to companies
unable to produce the new type of trucks.
Inflation risk :
Inflation can hit a
company’s profits if it is unable to pass on higher costs to consumers.
This trouble is often faced by large manufacturing concerns and public
sector units through wage hikes that occur due to inflation. They are
not easy to pass on. Even if inflation eases, wage hikes can rarely be
rolled back. Worse, inflation can inflate corporate profits through
overvaluation of closing inventory. When a company uses the FIFO (first
in, first out; where the material that is issued first is priced on the
basis of the cost of material received earliest) method to value
inventory the charge to production is low in a period of rising prices.
This can inflate reported earnings, increase tax burdens and may prompt
a higher dividend—consequently the company is financially weaker.
Interest rate risk :
Since they come
with a fixed return, bond values fluctuate with changes in interest
rates. When interest rates rise, the value of an existing debenture
goes down, as it is paying a lower rate than what investors could earn
elsewhere. When interest rates fall, the value of a debenture rises as
they are now earning a higher rate than what investors could earn from
one that is newly issued. The longer the maturity of a bond, the
greater is its vulnerability to an interest rate risk.
Management risk :
It is simply
defined as the inability of the management to take decisions in the
larger good of its minority shareholders and the company. All decisions
that benefit only a company’s directors and its promoters would
classify as a management risk. But even a shareholder-friendly
management can be a risk if it is unable to manage a company’s growth
in both good and bad times or if it lacks the dynamism needed to lead a
company.
Market/Economy risk :
Risks that are
common across companies are known as market/economy risk: economy-wide
factors like money supply, level of government borrowings, changes in
industrial policy, a global recession and so on. It is also known as
non-diversifiable risk, since investors cannot avoid the risk arising
from them, however diversified their portfolios may be. |