Six Risk Management Strategies for Buying Stocks
Not to knock the popular mutual fund screening filters, but it seems a little deceptive to suggest that one can simply check off boxes for “low risk” and “high performance” to find investment opportunities that will reliably beat the odds in the stock market with minimal risk.
If lowering risk and attaining high rewards were as simple as ticking two boxes, why wouldn’t everyone do it? What incentive would there be to pick high risk and low reward stocks? And who would need the investing genius of Warren Buffett, the Joseph Piotroski F-Score system that gained 138.8% in 2010?
Well, the truth is that investing wisely isn’t that simple. There are some important factors and strategies that we, as investors, need to keep in mind when making our investment decisions.
Below are six of the most popular strategies to decrease the volatility and risk in your portfolio:
1. Choosing Diversified Sectors
You might be extremely bullish on the gold sector as you load up on precious metal stocks. When gold trades higher you will make incredible gains, but when gold prices drop, your entire portfolio will take a massive hit. The problem lies in the lack of a diversified portfolio with regards to industry sectors.
Stock market sectors come in broad categories:
There is nothing wrong with trying to pick smoking hot stocks. The key is to try to find them in a variety of sectors.
For example, gold stocks are found in the basic materials sector along with oil, silver-based investments, and chemicals. Pick the best few stocks in this category, but don’t put everything you have into them. Instead, head over and select a top performing stock in consumer goods, like an up-and-coming wine maker or toy manufacturer. Then judiciously scan for a healthcare stock such as one that treats cancer.
Add it all up and you have a portfolio with a reduction in downside risk to any one sector. You will also find your portfolio has less overall volatility since the stocks are not so tightly grouped around one commodity or service.
The best strategy is to pick great stocks across a variety of sectors to lower your risk of rising and falling sector momentum. Since sectors go up and down in packs, dragging the entire basket of stocks with them, diversification should be used to reduce the overall volatility of your portfolio.
2. Avoid Earnings Surprises
Do you find yourself tensing up when earnings are about to be reported? Does your heart rate rise with uncertainty as to whether they’ll meet or beat the Street?
While you may love positive earnings surprises, there is danger associated with them. Big surprises show that analysts have not been able to forecast earnings with accuracy. On the one hand, surprises are to be expected with lower-priced securities such as penny stocks, which are inherently much riskier companies. On the other hand, if your stock earns larger amounts (like 30 cents to one dollar per share), and analyst forecasts are considerably off the mark each quarter, you also face increased risk. This type of uncertainty makes it nearly impossible for you to have any confidence in predicting how the company will perform in the future.
What are some signs that a company might have future earnings surprises, both good and bad?
Limited Coverage. Perhaps there are only one or two analysts covering the stock.
New Company. The company is new, and therefore has much less history and performance that investors can use to predict future earnings.
Inconsistent Analysis. There is a wide dispersion of analysts’ estimates, reflecting the fact that there is a lot of uncertainty about the company’s future performance.
Whatever the reason, risk goes down when analysts covering a stock consistently and accurately estimate earnings with few surprises reported. If you find such a stock, look to the future earnings forecast. A bright future forecast by reliable weathermen significantly reduces your risk.
3. Consistently Rising Annual Earnings
Some stocks are like large boats. It takes them a while to get up to speed, but they are reliable in their movement. Quarter after quarter, year after year, these stocks deliver consistent earnings.
Take Balchem Corporation (NASDAQ: BCPC) for example. Their annual earnings per share have gone up steadily since 2004:
The company’s consistent past financial performance provides investors with confidence in their future performance.
Other stocks are more difficult to follow when looking at earnings trends. PS Business Parks (NYSE: PSB) is a great example of this. Earnings over the past three years alone have gone from $1.13, up to $2.70, and back down to $1.59. PSB’s volatile performance makes it extremely difficult to gauge how it will perform in any given year.
Though it’s impossible to know whether one of these stocks will perform better than the other in the long run, it is clear that the greater risk lies with the more volatile stock.
Of course, one may argue that a stock with a strong, steady record of earnings, such as you might find with a quality blue chip stock, may not give you the extreme upswings of the company with volatile earnings. This may be true, but you have to think, are those highs really worth the devastating lows?
Simply put, buying stocks with unpredictable earnings is like playing hot potato with a firecracker; you have a much higher risk of getting burned.
4. Low Beta Stocks
Beta is a hotly debated topic. Some feel it is still useful while others think it is outdated. In general, beta investment theory states that individual stocks each have their own correlation with the overall stock market. The higher the beta of a stock, the more volatile that company is relative to the stock market.
Here are 3 quick examples in a scenario where the stock market rises by 2%:
A stock that increased by 1% over this timeframe has a low 0.5 beta.
A stock that also increased by 2% over this time frame has a low 1.0 beta that is perfectly correlated with the market.
A stock that increased by 4% over this time frame has a high beta of 2.0. This stock represents the most volatile of the three here.
In essence, a low beta implies that a stock will earn less in bull cycles, but lose less in bear cycles.
To use beta wisely, scan for a low beta stock that is outperforming the market broadly. To help you out, this Finviz stock screener is set up to provide a simple example of stocks with a low beta of 0.5 or less, yet have increased by at least 50% over the past year, and are up strongly in the quarter too. The goal is to find stocks with reduced volatility but increased overall performance. It’s about the closest thing to the magic low risk and high reward buttons you will find.
Just remember that this is based on past performance only, and does not include forward-looking forecasts. Ideally, you should combine this strategy with the other tips mentioned here.
5. Caution Needed with Extremely Low P/E Stocks
Some investors think that beating the stock market is easy; all you really need to do is find a stock that is trading at extreme bargain levels. So, how do investors attempt to find such “deals?”
One method uses the price-to-earnings ratio, or P/E ratio. This simple metric is produced by dividing share price by the amount of earnings per share. If the stock is earning a relatively high profit compared to its share price, investors using this method feel that it is cheap and undervalued. New investors may attempt to use this ratio to find screaming hot deals without realizing that they are inadvertently increasing their risk.
There is an undeniable lure of finding low-priced stocks. Unfortunately, in the long run, they are usually anything but. One example is the semiconductor stock, Kulicke & Soffa Industries Inc. (NASDAQ: KLIC):
The stock recently made $2.00 per share of profit in 2010
Yet the share price is only $9.00 giving a price-to-earnings ratio of 4.7
The industry average P/E ratio is 15.3
You might immediately assume that this stock should be trading over 3x higher simply based on this one ratio.
However, stocks with abnormally low P/E ratios have been punished by investors for a number of reasons. The earnings could be erratic from year to year, or the company may be in financial distress with an increasing debt-load. It may be that the stock looks cheap based on the P/E ratio, but because of the increased risk of the unknown, investors have accounted for this volatility in the form of a lower share price.
To continue with this example, KLIC could have a low P/E ratio based on its volatile earnings, both positive and negative, over the past decade. Perhaps next quarter, the P/E will look sky-high to investors if the company reports disappointing earnings.
This example makes it pretty clear that you need to consider other earning ratios instead of simply focusing on one ratio or number. For instance, if you compare KLIC’s share price to its cash flow per share, and then compare this to the industry average, you will find that this semiconductor stock is fairly valued. That analysts are having a hard time assessing future value is borne out by the wide range of price targets from $6 – $15.
In conclusion, when a company boasts a low P/E ratio, there is often a reason behind it which can in turn lead to added investment risk.
6. Young, High Growth Stocks Can Be Volatile
High growth stocks (or “glamor” companies as some call them) often have very volatile share prices. In addition, these stocks have volatility in another form: reported earnings. While these companies may be awarded big growth forecasts, the estimates are not always realized, increasing the downside risk to investors.
So why do high growth companies, especially young or newly listed ones, often miss earnings forecasts?
One problem lies with the overly optimistic forecasts of analysts. They see a promising new company with a great product and they put on the rose-colored glasses to give a best case scenario. They fail to consider that new businesses often have all sorts of glitches that need to be worked out.
A new or growing business might run into the following problems:
Not enough warehouse space to facilitate growth
Inadequate training for growing staff requirements
Lack of cash for payroll and new asset purchases
New companies that are aggressively expanding have many growing pains that need to be addressed, and these are often somewhat overlooked by analysts. Thus, if you buy a stock in its infancy while forecasts are highest, you might find that share prices underperform their full potential as the company has difficulty meeting overly bullish forecasts.
There is also the problem of company failure. Many new companies fail. High growth companies are typically early on in their maturity cycle. Small companies can grow for the first few years at incredible rates, largely because they are small and any growth seems proportionately huge.
Yet many of these companies meet stiff opposition by bigger competition, or are delisted for numerous reasons during the first few years of operation. Also, high growth firms often do not have significant company assets of value as shown by their high price-to-book ratios. Thus, if the company falls on difficult times, there is little financial padding from these existing assets. They have the unpleasant decision of trying to acquire more secured debt, which is difficult without assets, or to sell more shares which dilutes the shareholder value.
With that said, remember that this is all about averages. Many high growth companies go on to become some of the best success stories, like Apple. But others become distant memories of hype that never translated into anything real. Just look to the myriads of failed high-tech companies during the 2000-01 bust. If you do not have experience separating the gold from the iron pyrite, you might be better sticking closer to value stocks.
What Are Value Stocks?
Value stocks typically have low price-to-book values, or at least significantly lower values than the industry average. Growth rates are often much lower, perhaps under 10%. Share prices trade closer to intrinsic value because, while they may generate large and consistent cash flows, they are not aggressively expanding.
Admittedly, there is little glamor or flair in such boring companies, but they can provide lower risk to investors. In one research paper (Value Versus Growth: The International Evidence, Fama and French, 1997), it was found that certain classes of value stocks outperform high growth stocks by 7.6% per year. This is a broad average using global portfolios.
The bottom line is that if you have a difficult time cherry-picking stocks and prefer to use wide averages for a safety net, value stocks might provide you with that extra bit of cushion for basic stock selection.
Risk is an inherent part of investing. You do not get something for nothing after all. But with a little planning and careful consideration, you can significantly reduce your risk and increase your earnings in the market.
Focus on diversifying and spreading your risk across many sectors. Pick stocks that have historically accurate forecasts. Take a look at earnings reports and choose those that consistently rise between quarters and years. Look for low beta stocks that outperform the market, and be wary of price-to-earnings ratios. Lastly, add a majority of value stocks to your portfolio until you are comfortable discerning what makes one high growth company stand out from the next.
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