Understanding the risks in shares

Before you start investing, you need to understand the risks involved in buying shares. Last month we highlighted the benefits and said that over time equities prove an excellent investment, although there are risks that need to be managed.

The interest earned from cash is considered a “risk-free rate”—basically, any return you earn above the buying price means you are taking on some risk to get an additional return.
When investing in the market you take on two types of risk: company risk and market risk.

Company risk is easier to manage because you can do your homework to ensure that the company you are investing in is a solid business case. Generally, the biggest mistake people make is buying on a “tip” from a friend without independently verifying what they are buying.

Warren Buffet, the world’s richest and most famous investor, believes you should never invest in a company unless you understand how it makes its money. A company may be surging to new highs every day, but if you don’t understand the business, you should resist getting caught up in the hype.

Even legitimate companies can come a cropper if they are not well managed, so be sure to stay on top of the company’s financials. Read everything that is written about it and be alert to warning signals. This can also pertain to issues around fraud or poor corporate governance.

Great emphasis is placed on a company’s management team. If analysts believe in management, and buy their story, the share can trade at a premium to other shares in its sector. This does, however, leave the share vulnerable to management walk-outs. If the golden team that is expected to deliver the goods leaves, the share price will probably fall.

The level of liquidity of a company is also very important. If you want to sell a share you need to know that you can. This tends to be a problem with very small companies, or so-called penny stocks that trade for a couple of cents.

Often management has a very large stake in the business and there are not that many shares freely available. The more illiquid a share, in other words, the less it is traded, the wider the variance can be between the buying and selling price. That means, when you come to sell your shares, you may have to drop your price considerably to find a buyer.

Another risk is that a company does not perform according to expectation. There is a joke among listed companies that CEOs work for analysts. Analysts are paid exorbitant amounts of money by stockbrokers to value companies and predict their earnings. These predictions have a material impact on the price of the share. If analysts believe a company is going to perform well then its share price might rise, but if the company does not meet those expectations the share price can fall sharply.

This is a much harder risk to manage as analysts are probably better informed than the average private investor and if a company does not perform to their expectations there is not much you can do about it.

While doing your homework can, to some degree, limit the risks of a “bad” share, market risk is virtually impossible to predict.

There are many external factors that can influence the stock exchange. For example, terrorism is currently one of the biggest external threats as demonstrated by 9/11. However, over the long term, the market adjusts to these threats. The second terrorism attack in the United Kingdom last year had less of an impact on the market than the first because the market had already adjusted to the new environment.

In South Africa we are vulnerable to collapses in the United States’s market as well as to markets in emerging economies. This is because a large portion of our market is driven by foreign buyers. At the first sign of increased risk, they will remove their money very quickly.

These are factors that are beyond our control. Still, over the longer term, the market moves according to valuation. Taking the overall value of the market into consideration is one way of assessing the levels of risk. When the market is undervalued there is less chance of losing money than when the market is overvalued.

In South Africa right now our market has been reaching new highs. Analysts are saying these levels are sustainable because companies’ earnings are going to increase considerably: But what if they are wrong? Larry Williams, a famous futures and commodities trader, who was recently in South Africa, believes that the market is looking overvalued and says that March is traditionally a bad month for the market. He recommends selling now and buying again in September when the market traditionally starts to recover. If he is right, there may be better buying opportunities later this year.

At the end of the day the market has inherent risks: it goes up and it goes down. In terms of general market movements it has always recovered and produced superior returns over the longer term.

In fact, the biggest risk to consider is which share to choose. A bad company doesn’t always recover and that is where you need to focus your efforts. Would you want to buy a Dimension Data, which was trading at R70 in 2000, but is now trading at only R5,27 despite a three-year bull market? Or would you have rather bought Absa in 2000 for R27,35, which is now trading at R118?

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