Chapter 6: Uncover Enterprise and Share Price Downside Risks
Chapter 6: Uncover Enterprise and Share Price Downside Risks
Book Serialization | Quality Value Investing: How to Pick the Winning Stocks of Enduring Enterprises
Welcome to Chapter 6 of the serialization of my next book, Quality Value Investing: How to Pick the Winning Stocks of Enduring Enterprises.
I am writing the book on Substack Finance as part of the QVI Newsletter and look forward to subscribers’ support and feedback as we produce the manuscript in real-time.
Chapter 6 focuses on screening company and stock price risk profiles to uncover quality picks with the highest potential for a limited downside that preserves precious invested capital.
Chapter 6
Uncover Enterprise and Share Price Downside Risks
Manage the downside while letting the upside take care of itself.
Understanding and managing risk is more important than predicting market movements and stock prices. The goal is to buy shares of the stock when the overall downside is below the perceived market tolerance for acceptable risk.
Quality-driven investors focus on four vital areas that assess the company and its underlying stock’s measurable risks in the context of its potential behavior in a down market cycle.
This chapter will assess debt coverage, price volatility, short interest, and total return performance to determine the downside risks. In doing so, we aim to assign grades to the enterprise and its common shares based on several measures of investment risk.
Enterprise Downside Risks
The enterprise downside risks checklist discovers and rates the targeted company’s safety margins of its business model.
When assessing the enterprise downside risks of a company and its common shares, focus on three metrics that often predict the potential risk/reward of investing in a slice of the company.
Debt can be the lifeblood of a growing business or its death knell.
Dive into the last quarter’s balance sheet and look for three telltale signs of the ability of management to limit debt to sufficient levels. We want to know if the company can cover its deficits in a crisis. Accordingly, buy slices of businesses with balance sheets exhibiting the capacity to pay down short- and long-term debt with liquid assets.
The debt coverage rule offers timeless advice for quality-driven value investors. Trading distressed debt is standard practice in the financial services industry. However, retail investors buying slices of businesses without understanding the companies’ debt leverage and coverage have embarked on a high-risk endeavor.
Long-Term Debt Coverage
An essential measure of the downside risk is the long-term debt coverage of a company.
Current Assets to Long-Term Debt
Long-term debt coverage measures a company’s current assets divided by its long-term debt. This critical metric demonstrates balance sheet liquidity or an enterprise management’s capacity to pay down debt in a crisis.
Generally, at least one-and-a-half times current assets to long-term debt is ideal. We want to own businesses capable of paying down debt at least 150 percent above the current level using liquid assets. The exemplary company can pay off any long-term debt obligations using current assets such as cash and equivalents, short-term investments, accounts receivables, and inventories.
On the contrary, companies with current assets to long-term debt lower than 1.00 times cannot pay off 100 percent of debt obligations using their liquid current assets.
Long-Term Debt to Equity
Long-term debt to equity is another ratio used to evaluate a company’s financial leverage.
Calculate debt to equity by dividing a company’s long-term debt by its shareholder equity or total assets minus total liabilities. When assessing debt to equity, an ideal ceiling is 100 percent. In other words, investors should become concerned when a company’s debt is more than its equity.
As leveraged households often have debt loads that exceed net worth, the same holds for many companies. Using debt in a low-interest-rate environment is judicious. However, leveraging too far beyond net worth or net asset value creates a recipe for disaster—waiting for a market downturn or economic recession to cook the books.
Remember to avoid leveraged companies carrying long-term debt exceeding their current assets and outstanding shareholder equity.
The financial impact of the COVID-19 pandemic, followed by the inflationary trends, were stark reminders of the rampant illiquidity of households and businesses.
The good times are euphoric until they’re not.
Short-Term Debt Coverage
Measuring short-term debt coverage via the current ratio is another simple yet telling measure of the financial stability of a company.
The current ratio is total current assets divided by total current liabilities for the same period, with a result higher than 1.00 times being best.
The current ratio measures the short-term debt coverage to demonstrate if the liquid assets of the targeted or owned business adequately fund short-term liabilities such as accounts payable, accrued expenses, debt service, income taxes, and unearned revenue. Thus, it measures the short-term balance sheet liquidity of the operation.
Although the above-listed three debt ratios have served our family portfolio well, several other debt measures exist, including those relative to free cash flow, working capital, and interest coverage. In addition, the quick ratio serves as an alternative to the current ratio by focusing on the most liquid current assets. Whatever our choices, be wary of the debt burden as it decimates even the most competitive enterprises.
Remember to reference the company’s most recent and historical quarterly and annual balance sheets to understand the enterprise’s long- and short-term debt coverage.
Upon research completion, assign an enterprise downside risk rating of low, below average, average, above average, or high to the company based on the weighted measures of management-related investment risk.
Businesses interpreted as buy-and-hold candidates often present with below-average or low enterprise downside risk profiles.
Share Price Downside Risks
When assessing the downside risks of a company’s common shares, focus on three metrics that harbor the potential risk/reward of the stock price.
Stock Price Volatility or Beta
Beta is the fluctuation of a stock price to changes in the overall market and gauges the volatility of traded shares.
Although a controversial metric, look at the five-year trailing beta to see how movements in the stock price measure up to market volatility or lack thereof. Nonetheless, remember that risk is more related to the permanent loss of capital than up-and-down price movements.
The US stock market assigns the S&P 500 Index a perpetual 1.00 beta as its primary benchmark. Despite the low market volatility of the post-Great Recession bull market, the stock’s beta should remain part of a quality-driven value investor’s research, targeting below one and a quarter or fewer than 25 percent volatility to the benchmark. A lower beta than 1.25 is ideal insurance for protecting invested capital against systemic risks. Avoid stocks with high betas to bypass companies with the makings of consequential downsides.
Our family portfolio tends to outperform the market on significant down days, and such optimum behavior reflects its collective below-average market volatility. Hence, own shares of companies with a history of outperformance in declining markets regardless of the level of performance in up markets. Remember, in the long run, the best opportunity to outperform the market is to beat it on those down days, weeks, months, or entire bear markets.
Low-beta common stocks contribute to a positive down market portfolio strategy by limiting potential losses. Any upside market activity generates alpha for our portfolios.
Short Interest as a Percentage of the Float
The short interest as a percentage of the float is the ratio of outstanding common shares sold short as traders bet that the stock price is poised to drop because of decaying fundamentals, high valuation multiples, negative catalysts, or other special situations.
The short interest represents the percentage of outstanding shares that investors have borrowed to sell short and have yet to cover or close the position. The short interest provides a sentiment indicator of whether the so-called smart money in the market is betting the stock price will fall. Think of short interest as the hedge fund consensus since the Wall Street money manager elite executes a significant shorting of stocks.
Nevertheless, stock market history suggests that the bulls are more often on the right side of the trade than the bears over time.
Defer shorting of the stock market to the professionals who walk the tightrope of such speculative practices. Nevertheless, don’t worry about the prospects of the market plundering a mid- or large-cap stock if the short interest is in the single digits. As a general rule, target stocks with short interest as a percentage of the float under 5 percent. Shares should be under 2 percent short to earn a low downside risk rating.
Whether the speculative bets are right or wrong, higher short interest on a stock signals that investors think something is awry with the company’s fundamentals, the valuation of the underlying shares, or the subindustry encompassing the enterprise. Thus, it is best to avoid such stocks upfront or investigate if the current holding or targeted buy on a watchlist converts to a proving ground for short-sellers.
Buying stocks sold short at high levels is more akin to deep value trading than to exceptional quality-driven value investing. Thus, buy-and-hold investors—a.k.a. those on the long side—must be aware of any counterintelligence against the stock.
Stock Total Return Performance History
Measure the total return performance of the researched stock versus the sector or broader market.
Adjust the total return performance of the shares for splits and dividends from the date added to the portfolio or watchlist. Compare the five or ten-year performance of the stock against the sector’s and S&P 500’s total returns for the same coverage periods.
History suggests that market-beating stocks are poised to keep achieving alpha going forward.
Suppose we purchase bargain-priced stocks of well-managed, shareholder and customer-friendly companies with excellent competitive advantages and palatable downside risks. In that case, the prospect exists that most of the holdings outperform the benchmark over time, such as the legacy holdings of our family portfolio. The likelihood increases for the winners, outnumbering the losers in the portfolio. Also, by equal-weighting, there is no need to overweight by speculating what holdings will outperform the targeted benchmark.
When inclined to underweight a stock, ask, “Why do we own it in the first place?”
Look for companies with a history of alpha achievement, as investing in individual common stocks should aim to beat the benchmark indices over time. If not, average returns from index investing make more sense than underperforming the market.
For example, the best-performing stock in our family portfolio was Microsoft MSFT 0.00%↑ as of this chapter’s writing. Since it was added in June 2011 at a cost basis of $20.12 per share, adjusted for dividends, MSFT’s total return was +2,080% vs. +341% for the S&P 500 Index (.INX) for a 1,739 basis points alpha performance. Remember that past returns are not indicators of future results.
Upon research completion, assign a share price downside risk-weighted rating such as high, above average, average, below average, or low-risk profiles. Stocks interpreted as buy-and-hold candidates more often present with below-average or low share price downside risk profiles.
Manage the Downside | Let the Upside Take Care of Itself
Returns are unpredictable, while risks are controllable.
Measuring, understanding, and accepting the downside risks of a company and its common shares from an unforgiving market offer the best opportunities for investing with a tolerable, asymmetric risk/reward profile.
Thriving investors are rewarded more for limited portfolio downside in bear markets from a disciplined approach to risk-managed investing than from the upside in bull markets driven by overexuberant participants.
As often happened during the post-Great Recession boom, the inevitable downturns develop into official corrections—10 percent or more off the market closing highs—or head fake buying opportunities in a continuing bull market. Regardless of the cause and effect, it is imperative to understand our risk profile before buying the value-priced common shares of quality enterprises.
When executing with precision, quality-driven investors enjoy the magic of compounding total returns from capital gains and dividend income over several market cycles from an acute understanding of the downside risks. In practice, they throw a cast net encompassing investments with wide safety margins. With perpetual discipline, these defensive investors revisit the risk profiles of the holdings regularly following the initial purchases.
Stock markets and share prices are forever rising or capitulating. Trying to time the inevitable roller coaster ride is the equivalent of predicting volcanic eruptions. Nevertheless, many investors embark on such a journey despite a subconscious understanding of the contrary.
Successful portfolio management lies in the ability of investors to understand and manage the controllable downside risks instead of the impossible task of predicting future market movements and stock prices.
The market releases the bulls or the bears at its convenience and, therefore, requires thoughtful preparation on our part. Counter with established ownership of quality companies that run with bulls when the mood allows but, of utmost importance, are less inclined to retreat with or go as far as the bears.
Although lowering the downside risks is preferable, zero liability is unobtainable. I have learned from experience and observation that stocks rated with low and below-average risk grades tend to decline less than the S&P 500 or the market on the whole during crashes or bear markets.
A portfolio of the stocks of quality companies purchased at sensible prices that underperform the market when it is flying high has the propensity to outperform the market on the downswing, thus increasing the potential to exceed the market over time. Any sudden downturn in the market reminds us of the cornerstone of disciplined investing—understanding the downside risk profiles for each holding.
A practical exercise for quality-driven investors is due diligence in uncovering and managing the downside risks of owned or targeted publicly traded companies. Those assessing risk tend to experience less volatility in bear market cycles or during corrections from surprise socioeconomic or geopolitical events.
Quality-driven value investors profit from the inept who act against glaring lessons from market history. Remember that a risk assessed, understood, and well-managed is likely worth taking.
The inevitable reminder or repeated lesson of unexpected and sudden downturns in the stock market, an industry, or a company is limiting ownership to the stocks of enterprises that we have assessed the downside risk as manageable and tolerable.
Managing downside risk is more controllable than trying to predict future returns. A top priority of defensive investors is the preservation of capital. Thus, assessing downside risk is an essential research component and measurement tool.
Seek profitable, predominantly dividend-paying, wide-moat companies that are less volatile than the market and have the free cash flow and liquidity to pay the short- and long-term bills.
Regardless of the cause or ultimate duration, any market downturn delivers a stark reminder that assessing enterprise and share price downside risks is paramount to quality-driven value investing.
Preserving capital on the downswings supersedes the pursuit of any potential upside because alpha more often happens on the downside.
Copyright 2024 by David J. Waldron. All rights reserved worldwide.
About the Author
David J. Waldron is the contributing editor of Quality Value Investing and author of the international-selling book Build Wealth with Common Stocks: Market-Beating Strategies for the Individual Investor. David’s mission is to inspire the achievement of his readers’ financial goals and dreams. His work has been featured on Seeking Alpha, TalkMarkets, ValueWalk, MSN Money, Yahoo Finance, QAV (Australia’s #1 Value Investing Podcast), Money Life with Chuck Jaffe, LifeBlood with George Grombacher, The Acquirer’s Multiple, Capital Employed, Amazon, Barnes & Noble, Apple Books, the BookLife Prize, and Publisher’s Weekly. David previously enjoyed a 25-year career as a postsecondary education executive. He received a Bachelor of Science in business studies as a Garden State Scholar at Stockton University and completed The Practice of Management Program at Brown University.
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