Risk Factors

Risk factors are the 10 elements of every business affecting the value of the earnings. Risk factors consist of stability of earnings to market conditions to staff issues; all have a bearing on the final value of the company.

Value Investing – Pools of Investments (Lesson 14)

Value Investing Pools

Value investors utilize pools of similar companies all belonging to the same industry in order to reduce risk, create accurate buy/sell models and manage their portfolio of investments in their investment fund. It is essential that all potential investments in a pool have similar attributes including market capitalization, comparable operations, indistinguishable balance sheet relationships and reporting formats. As explained in Lesson 11, all the members of the pool should have similar key performance indicators.

It is impossible to single handily manage hundreds of potential investments and design/build a separate buy/sell model for each company. To simply and efficiently create an investment portfolio, value investors create a group of five to eight very similar companies in the same industry. This is referred to as a ‘Pool’. Since this pool is dedicated to a particular industry, the investor can appreciate the research and due diligence required to understand the industry’s terminology, operational standards and performance outcomes. It is the most efficient use of time.

Most value investors can only manage one or two pools of similar companies. However, one or two pools is insufficient to maximize a value investment portfolio. Thus, it is best to turn to a club whereby several pools are available to the investor. In effect, all club members share the knowledge of their own respective pool with other club members and this diversifies the portfolio for all members. When an opportunity arises, all members are alerted and the club is rewarded as all members benefit from participation.

This lesson explains the benefits of using pools of similar potential investments as a value investor. Pools reduce risk exposure due to the comprehensive understanding of the key performance indicators and industry standards learned from research work and review of multiple similar reports. Secondly, with this knowledge, value investors can create highly accurate intrinsic and market price models to set the buy/sell points for investment with each member of the pool. Another advantage pools of investments create is the ability to efficiently utilize time to update the models. This in turn, allows the investor to focus on properly carrying out the systematic buying and selling of stock to generate excellent returns.

Value Investing – Principle #1: Risk Reduction (Lesson 6)

Value Investing

With value investing, steps are taken to dramatically reduce potential financial losses. Risk associated with financial loss is addressed through three important practices. The first and best defense against losses are the type of stocks purchased. Only the best are considered with value investing. The first section below explains this in more detail and illustrates the different tiers of stock and why the lower tiers are ignored with value investing. The second best practice to reduce risk is a comprehensive understanding of the respective industry where value investors trade. The second section below goes into a comprehensive explaination of how knowledge of the industry is essential with reducing financial risk. The final best practice to defend against losses is a fundamental understanding of a company’s financial depth, the ability to withstand years of economic turmoil. The third section below introduces this mathematical algorithm for the reader. In addition, it introduces the first financial term of many that are used with value investing – book value. This term is used throughout value investing as a standard to compare other investments against and of course the ability of the particular investment to withstand long-term negative forces and quickly recover from any unusual events.

There are still many other practices and tools to reduce risk; they include understanding how operating cash flow must be positive, using business ratios to understand trends and finally, using key performance indicators to assess productivity.

Value Investing – Risk Aversion (Lesson 2)

Value Investing

Value investing does require some volatility with the market in order to have opportunities to buy low and sell high. A static market, even one with level growth will not work with value investing. Fortunately, the market isn’t stable and volatility does exist. This volatility is driven by multiple forces: politics, interest rates, consumer patterns, environmental conditions and more. Thus, opportunity exists for value investors. However, value investors seek opportunity with minimum risk.

Investing in any financial instrument comes with risk. The absolute worse case is full economic chaos created by a meltdown of governmental authority. If this were to happen, it would not matter what kind of financial instrument an investor holds, all of them are worthless as you can’t eat paper. Some would say physical possession of gold is the only pure investment because it would be tradeable in case of world disaster. This would be true if there exists a government to enforce some resemblance of order allowing trade between producers and consumers.

Ignoring total breakdown, financial instruments do have a hierachy of risk associated with their potential to become worthless. Understanding risk aversion starts with understanding the spectrum of financial instruments and their inherent risk factors. In addition, this is further refined by size, i.e. market capitalization of the respective issuer of the financial instrument. Finally, risk aversion is also a function of the dynamic range of the respective company backing the financial instrument. The following sections provide this holistic thinking related to risk aversion, specifically as it relates to stock investments.

Shareholder Dynamics in Small Business

Shareholder Dynamics

The majority of small businesses are owned by a single individual. An additional pool is family owned or controlled. The balance usually involves friends or relatives that are passive in ownership. These forms of ownership create some interesting shareholder dynamics and if not thought out, can create some legal and financial issues in small business when a life changing event occurs. 

Vertical Integration in Business

Vertical Integration

Vertical integration in business refers to the process of gaining control over more steps of the product production stream. Whenever a business obtains or can greatly influence any one of these steps along the process of producing and selling a product, it is referred to as vertical integration.  

How Much is a Fair Profit? Part III of V – Risk

A third factor in determining a fair profit percentage is risk. Risk is divided into two types. The first is insurable and the second is uninsurable risks. Insurable risks are mitigated and have very little to no effect on the profit formula due to transferring the risk to a third party known as the insurance underwriter. Uninsurable risks are non-transferable and therefore the profit must be adjusted to compensate for this type of risk.

Stability of Historical Earnings

Stability of Historical Earnings

No other element of the Multiply Discretionary Income Formula has as much weighted value as the historical earnings of the company. Every knowledgeable business entrepreneur, accountant, lawyer, broker, you name them; they look for this information first. There’s a reason for this.

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