Share Safety: The Missing Link

Shares, Strategies & Common Sense

Knowing how safe (or risky) a share is can make the difference between making you a winner or loser as an investor.

I received a thing in the mail the other day called the "Hot Stocks Review." Phrases like "may even double again in the next twelve months," and "could have you crowing all the way to the bank" riveted my greedy eyes. Never one to pass up great investment opportunities, I decided to look into these "Hot Stocks." The blurb gave an 800 number to call for more information, but I prefer to do my own research.

The first thing I did was check my VectorVest database. Only two of the 29 shares recommended by the "Hot Stocks Review" were covered by VectorVest. This was not too surprising since only eight of the 29 shares are traded on American exchanges. Both of the shares covered by VectorVest had a below average Safety rating. Neither had a Buy recommendation.

Neither of these shares were covered by Value Line, so I checked Standard & Poor's Stock Guide which covers more than 7,600 shares. Only one share was found in this document. It was not ranked in terms of earnings and dividend quality. Obviously, if one were to invest in any of these shares they would have to believe the promotional material touting the shares, or use the information sent by the companies. There are two problems here. First, it takes a lot of time and effort to analyse a company's financial statement, and I wasn't sure I wanted to do this even for the eight shares traded on NASDAQ. Secondly, the investment caveats cited in company literature and prospectuses are designed to protect the seller not the buyer.

Of course, the publication featuring the "Hot Stocks Review" included the usual disclaimers that "all investments carry risks," and made it clear that "the publisher nor anyone else involved would be liable for any investment decision resulting from their recommendations." That's fine, but how does one get a handle on finding out how risky a share is any way?

Risk has two parts:
  1. The probability of an unfavourable outcome
  2. The consequences derived from that unfavourable outcome

Simply put, investment risk entails the probability of losing money, and the pain associated with the loss. Each of us needs to know how much money we can afford to lose on any single investment. We may be very comfortable, for example, with buying a lottery ticket even though the risk is extremely high because we can afford the loss. Buying shares, however, is a lot different. We're using serious money when investing in the that can make a difference in our lifestyles. Once we have established our "tolerance for risk", we can focus on assessing the risks involved with individual shares.

Good information on share safety is hard to find. Maybe that's because it's the last thing anybody want to think about. Even the few credible sources that provide some form of risk analysis, do so subjectively. Consequently, most investors do little more than plug intuition into their investment decisions. It's the missing link in assessing shares.

Knowing how safe (or risky) a share is can make the difference between making you a winner or loser as an investor. Here are the key factors used by VectorVest in assessing share safety.

The largest risk that shareholders have is that the company fails to meet earnings expectations. Experienced investors know that the moment of truth comes each quarter for every publicly traded American company. If a company fails to meet analyst's earnings estimates, its share's price often drops 30% in a single day. Therefore, the single most important factor in assessing share safety is in quantifying the probability that quarterly earnings will meet investor's expectations. If a company has a well established record of consistent, predictable earnings performance, it is much more likely to meet the market's expectations.

Companies like Abbott Labs, Coca-Cola, and McDonald's have exemplary records of consistent, predictable earnings performance. These shares have very high Safety ratings in the VectorVest system of analysis. They also have favourable ratings in Value Line and in S&P's Stock Guide.

It is true that the shares of large companies generally are safer than those of smaller companies. Many fund managers are forbidden to invest in companies with less than $500 million in annual sales. Obviously, larger sized companies aren't going to disappear overnight. Investors should not assume, however, that the shares of IBM, GM and Union Carbide are safe just because they belong to big companies. Size is not nearly as important to an equity investor as knowing where the company's earnings are heading. It is virtually impossible to forecast the earnings of IBM, General Motors and Union Carbide with any degree of accuracy. Therefore, the VectorVest ratings on these shares are below average.

The classic measure of price volatility is given by "Beta." Beta reflects the statistical movement of a share price compared to the market. If a share's price moves up and down exactly in sync with the market, it will have a Beta of 1.00. If a share's price consistently moves up 10% more than the market and down 10% more than the market, it is more volatile than the market, and it has a Beta of 1.10.

Fair enough. High Beta shares are more volatile than the market, and less predictable. Therefore, they are riskier than the market. Ironically, they are not necessarily riskier than some low Beta shares. Certain shares, such as gold shares,are very volatile, but tend to move counter to the market. These shares may have low or even negative Betas. Given this dilemma, I use Betas with a grain of salt. I prefer to analyse absolute price behavior to measure risk.

Absolute price behavior not only provides an unequivocal measure of volatility, but it allows one to assess risk in relation to the share's price history. Since all things tend to move toward a mean, shares which are above their price moving averages are more likely to move down, and shares which are below their price moving averages are more likely to move up. Therefore, a share which has moved well above its price moving average is riskier than one which has moved well below its price moving average.

It's better to deal with the devil you know, than with the one you don't. All other factors being equal, there's less risk in dealing with a company with a long track record than one which is brand new. Young companies offer some of the best investment opportunities, but they also bear potential pitfalls that could be fatal. Regardless of how good a share looks, it's risky if it hasn't been traded for at least 5 years.

A company doesn't have to pay a dividend to have a very safe share. But if it does pay a dividend, it must maintain or increase the dividend without exception. A cut in dividend is a black eye for any company, and reflects poorly on its management and share safety.

The US government allow companies to deduct interest payments as a business expense. That's nice, but some companies overdo a good thing. They load up on debt beyond the point of being able to report any net earnings. Time Warner is a classic example of such a company. Its businesses are very good, but its balance sheet is a mess. Its Relative Safety rating in the VectorVest system is well below 1.00 on a scale of 0.00 to 2.00.

Beware of companies with excessive debt. Don't be fooled by the line about valuing a company based upon its cash flow. A company that can't report positive earnings after interest and tax payments is in big trouble no matter how you slice it. Safe shares belong to companies with low debt/equity ratios.

The items cited above are only a short list of the many things that may be considered in assessing share safety. Anyone who has studied accounting or read Benjamin Graham's book, "The Intelligent Investor," knows that there are many other things to look for. Regardless of how one might assess share safety, it is important to do it systematically. Services such as VectorVest, Value Line, and Standard and Poor's use systematic approaches to assessing share safety. Investors should always factor risk into their investment decisions.

Mr. Graham spends a lot of time in his book, "The Intelligent Investor," discussing the difference between investing and speculating. Basically, this difference is a matter of using knowledge to reduce risk to the point where the odds of winning are in your favour. Mr. Graham approaches the reduction of risk by advocating the purchase of undervalued shares.

I approach valuation and safety as separate issues; then tie them together. In the previous chapter, High Growth vs. Low P/E shares, I showed how valuation and share safety are linked together in assessing a share's long term investment potential. Both factors also play key roles in establishing Buy, Sell, Hold recommendations. Intelligent investment decisions cannot be made without including a knowledge of share safety. Do not let share safety be your missing link.