Levels Of Risk In Equity Portfolio Investments: Risks vs Benefits

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Do investments of a similar kind have the same levels of risk?

Certainly it is the case that some do.

But it is not the case for equities.

Buying shares in a blue chip company usually has a limited risk of company failure, although recent examples could be given of this not being the case.

However, a portfolio of blue chip companies has less risk of bankruptcy (thus losing all of your investment) than, say, a portfolio of 'junior' equities - not all of which will fail, but some could.

Each company, regardless of size, has its own unique set of circumstances that define the level of risk that you will encounter when investing in that company.

Each is a key feature that must be taken into consideration when determining the relative levels of risk between two similar companies:

• Management - how good or bad is it?
• Products - are they reliant on too small a list of products?
• Clientèle - are they reliant on one or two large customers?
• Suppliers - will the company be affected negatively if their suppliers increase prices?
• Workforce - are they flexible enough to meet changing circumstances?
• Flexibility - can the company itself change to meet a new sales environment?

This is not an exhaustive list, but it is a good start to make you think through the risks that may affect your investment decision.

How good or bad company management affects investment risk, is the first thing to consider when analysing whether or not an investment should be made.

But how do you determine management efficiency?

One way is to look at track record.

This can be determined by the performance of the company, over time, with the same management.

Your interest lies in the dividend performance and the equity price performance. In comparison to other equities within the same sector, has the dividend and / or price performed above or below the average. Those equities that have outperformed the average could be considered to have a good (investor perspective) management. It may be in spite of the management, but at least the management has not overly limited the performance.

Another way to determine management efficiency is to look at the performance of individual management members, especially when they have arrived from other companies. 

A determinant in whether or not to invest may be when management changes. An equity in the doldrums due to management incompetences can be turned around if a competent management team is hired. Always be on the look-out for management changes and decide if it is time to move in or out of that investment.

A company may shoot up in market price due to a successful launch of a product. However, if that company is reliant on the income from a single, or too small a diversity of, product, then it is vulnerable to the vagaries of the market. A sudden trend change can see plummeting sales and a highly uncertain future.

Do your homework and take into account the number of products that are available from that company. Check their income statements to see if any one product brings a significant proportion of income onto the bottom line.

A diversified portfolio of product offerings, as long as they are profitable, shows a stable base for a company to ward off the effects of a single product becoming unprofitable.

As with products, the risk of reliance on a single client to bring profitability, is a warning signal. Any client that has the power to make or break a supplier will likely take advantage of the situation.

It is not just the risk that the client will cease trading, but also the fact that they may decide to squeeze the margins and hold out for better pricing structures. Both of these are risk factors that you should determine and include in your risk assessment before going ahead with an investment.

What if the client went bust, owing substantial amounts to the company? The profitability of the company could be put in jeopardy. 

Reliance on a single supplier is also risky. 

What if that supplier finds another client to supply? Either the company will need to find another supplier or they will have to compete on the price they are willing to pay for the supplies.

What if the supplier goes bust? The company would need to find an alternative, quickly. And the new supplier may charge higher prices because their competition is less.

What if the supplies deteriorate in quality? Without a back-up plan the quality of product from the company could also be affected.

Each is a factor in determining supplier risk.

Workforce risk is a little harder to determine, but there are ways.

The best way is to keep your ears open and your eyes fixed on any news that may relate to any company workforce. 

Are the Unions resisting changes in working practices? Does the management need further flexibility to keep ahead of its competitors?

It is a matter of determining whether one or other of the companies within a sector has a more or less flexible workforce. The one with greater flexibility has a better chance of being the investment you make, all other things being equal.

Things change constantly. Company management techniques and methods must change to take advantage of any new environmental factor. Stand still and die.

Inflexibility can take a stranglehold on a business. 

Assess how flexible your target investment can be and reference that against the flexibility of others. The more flexible the company, the better it will be at harnessing any new factors that affect its market share, or its ability to compete in its market.

Whether it be workforce, management, products, clients or suppliers, each has an effect on a company. These risks and benefits, once analysed, are determinants in your decision to invest, or not, to strengthen your equity portfolio.