Nonsystematic Risk – Part I

Whether you are managing a business or analyzing a company as a potential investment, nonsystematic risks must be considered.

With qualitative analysis, knowledge and experience are key to proper evaluation. Each situation is different and one needs to be mentally nimble to identify the relevant risk factors and how to deal with them.

In two posts, I shall describe typical nonsystematic risks and raise a few of the questions I might ask when assessing a specific risk. The lists and questions will in no way be exhaustive – possibly exhausting for the reader though – but hopefully they will give you an idea of the kind of analysis necessary.

Remember that risk can result in higher than expected returns and not simply losses or lower than expected outcomes. As investors and business people fear negative results, I will concentrate on risk from a negative perspective.

Management Risk

The risk that decisions made by management will negatively impact profitability.

Management of a company may include its Board of Directors, its Officers (senior managers with the legal authority to bind the entity as defined in the corporate statutes), and potentially other managers with lesser authority but key functions in the organization.

Management has a tremendous impact on a company’s actions. Strong management will ensure that prudent decisions are made and that they exert proper stewardship of the company. Weak management will result in the opposite results.

For every company, there is a different management style. Better management improves the probability of success. Poor management increases the risk of loss to an investor.

Note that I do not state that good management brings success and poor management causes loss. Many well-run entities fail and other firms manage to succeed in spite of themselves. There are many other variables that impact a company’s fortunes. Quality of management is just one factor.

When analyzing a company to invest in, management should be a major consideration. This is especially true for investment vehicles such as mutual or hedge funds you plan to invest in.

For example, ABC investment company that has done extremely well over the last 10 years. Their funds consistently outperform their peers. You plan to invest your capital and expect continued high returns. Just before you invest, you read that the primary fund manager resigned to form his own firm and has taken several key analysts from ABC with him.

Is there a possibility that future performance may not reflect that of prior years? If the analysts that discovered the superior investments are no longer with ABC, can ABC continue its success?

What about if Warren Buffet unexpectedly passes away. Do you think shares of Berkshire Hathaway will fall? Or when Steve Jobs retires, will Apple shares suffer? In the short run, I would bet money that both companies’ share price reacts negatively on such news.

Questions to Ask

To address this risk, look at the longevity and performance of the current management team.

Has current management been responsible for past successes or failures?

If the track record of current management is not significant, is there a record for the senior management with their previous companies? Often new management will have been chosen from companies in the same industry. Past performance at a prior firm may indicate success or failure in the new job.

If there is new management, how has the share price moved since the change? If the public sees the change as a positive, the shares should have moved higher. If a negative, the shares may have fallen.

Has there been any recent and/or significant turnover in management? This might indicate a change in corporate philosophy or culture that foreshadows further departures. This could be good (sweeping clean all the dead wood) or bad (all the rats leaving a sinking ship).

For past or planned management changes, has there been a proper succession plan implemented? This helps to ensure that past success will continue with the new management? As Bill Gates stepped back from daily operations at Microsoft, Steve Ballmer assumed greater responsibilities and there were little, if any, continuity issues.

In smaller companies, especially private entities, succession planning is usually a potential red flag issue for investors. Be aware if investing or working in a private or small business.

Operational Risk

Operational and Management Risk are often combined in analysis. They overlap because management decisions directly affect the operations of an organization. But we will keep them separate in this discussion.

Operational risk is the risk associated with operating the specific business.

Specific risks differ for each company due to their unique nature. Even within a single company, changing events may create a wide variety of new operational risk issues.

For example, consider a mining company.

A cave-in occurs underground, injuring several miners. Besides insurance and legal concerns, production may be disrupted while the mine is repaired. There may also be a negative impact on the company’s reputation.

The company has labour contract difficulties and the union votes to strike. Production is shut for six months. This significantly impacts profitability and hurts the share price.

Finally, the mining company decides to hire two employees, Ken Lay and Bernie Madoff, to manage its hedging activities. Within a year, the company is bankrupt and being investigated by the regulators.

These are examples of operational risks.

In today’s news, look at British Petroleum and Goldman Sachs for operational risk issues in real life.

Assessing operational risk may not be an easy task.

My best recommendation is to look at each company or investment and list every possible operational problem that could arise.

Remember that the operational risk factors in one company may be significantly different from those in another entity. You cannot take a cookie-cutter (i.e. identical) approach when analyzing every company.

For each potential risk, consider what steps have been taken to minimize their impact should they arise.

The worse the potential outcome on the business or share price, the more focussed should be your consideration.

Questions to Ask

In keeping with the mining company example, one might ask what is the safety record?

While no guarantee, a strong history of safety indicates that the company is serious about the issue and that should reduce the probability of future problems. Another company that has been fined for safety violations may have learned their lesson. Or they could continue to be a future risk.

Are labour problems and production disruptions common within the company or industry? If so, you might have to endure periods where the company cannot produce their product which will cause financial difficulty.

Have there been regulatory or other issues arise? In the mining industry, one must be concerned about environmental violations that can result in fines, legal costs, clean-up costs, production shut-downs, etc.

Does the mining company operate in a geographic region that may cause financial problems? Some companies operate in difficult areas, such as mountainous terrain or the far north. The more difficult the mining conditions, usually the greater the cost of extraction. This lowers margins and profitability.

Or the company may be operating in a non-business friendly country. If so, there is the possibility of being harassed by the local government, up to and including nationalization of the company’s assets.

The list of potential operational risk issues is endless.

Focus on those that can have the greatest impact on profitability.

Competitor Risk

Competitor risk is that your competition will do something that negatively impacts your business.

A few years back, the Sony Walkman was the norm for portable music. Then along came something called the iPod and the music world changed.

You used to buy your books from the local bookstore. Today you are much more likely to purchase them from Amazon. Your bookstore is now the place to enjoy a Starbucks’ coffee and do some browsing.

Just because a business model has been successful in the past, does not mean that it will continue to be profitable. When considering investments, bear this in mind.

Questions to Ask

Knowing what competitors are up to may not be a simple task.

Following media reports, news releases, and reviewing competitors’ financial statements is a good way to follow their activities.

But you should also look at your own company (or the one you want to invest in).

What is your company doing to ward off the competition?

Are there any barriers to entry for competitors? The greater the barriers, the safer the product or company.

The iPhone is extremely popular, but there is nothing to prevent other companies from developing their own smart phones. In fact, as I write, there are a variety of alternatives to the iPhone.

Strong barriers to entry include patents on key products or processes, sectors that are expensive to enter, and industries that are heavily regulated and/or where there are monopolies present.

Examples include a pharmaceutical company with a long-term patent on a new cancer drug. Or perhaps you want to challenge the American auto makers. Unfortunately, the cost of entering the auto industry is extremely high. Or you think you could do a better job than the local water company. Unfortunately, the water authority probably has a monopoly on the market and you cannot legally open a business in competition to them.

That should be more than enough for today.

Next, we will look at a few more examples of nonsystematic risk.


4 Responses to “Nonsystematic Risk – Part I”

  1. TBK says:

    You may want to point out that public companies are required to have some discussion in their MD&A about important risks that have affected their financial statements, and risks that are reasonably likely to affect them in the future. Reading a public company’s securities filings may help to identify the risks that management thinks are most significant (depending, of course, on the quality of the MD&A).

  2. JMW says:

    Good point, thanks. MD&A is the Management Discussion & Analysis portion of a company’s annual report. There is usually excellent information on risk issues, future plans, etc. disclosed on the MD&A. I would also add that when companies conduct public offerings the prospectus will contain substantial information on corporate risks and activities.

  3. Emily says:

    Good point, thanks. MD&A is the Management Discussion & Analysis portion of a company’s annual report. There is usually excellent information on risk issues, future plans, etc. disclosed on the MD&A. I would also add that when companies conduct public offerings the prospectus will contain substantial information on corporate risks and activities.

  4. Amy says:

    You may want to point out that public companies are required to have some discussion in their MD&A about important risks that have affected their financial statements, and risks that are reasonably likely to affect them in the future. Reading a public company’s securities filings may help to identify the risks that management thinks are most significant (depending, of course, on the quality of the MD&A).

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