Every stock in the market comes with some level of risk. As Carl Richards wrote in the New York Times, “Living, let alone investing, is not a risk-free proposition. Simply existing means dealing with risk. Risk is what’s left over after we’ve thought of everything else.”
But it’s true that some stocks are riskier than others — a fly-by-night shell company that trades as a penny stock is going to carry more risk of loss than a 100-year-old blue chip. So how do you tell how risky a stock is?
As Motley Fool co-founder David Gardner wrote in his Stock Advisor newsletter service, “Most investors have never had an effective measure to rate the risk of their stocks. With no relevant data available, we would have to give it our best guess: ‘Medium’? ‘High’? Some services, including Stock Advisor, have made some effort to rate the risk of their recommendations. But guess what they ended up sounding like? ‘Medium.’ ‘High.’ Just words … and not very useful ones, at that. No clear methodology behind them, either.”
Better than Beta
Investment professionals and academics most commonly use beta — a measure of a stock’s past volatility relative to the market’s volatility — as their risk-rating methodology. So, if a stock tends to exaggerate the market’s own amplitude, we would call it “high beta” — aka “risky.” And because it’s such an easy (simplistic?) measurement, beta has become synonymous with risk.
“But I think risk deserves a more business-focused, rather than stock movement-focused, assessment,” writes David Gardner. “And I think rating a stock’s risk should be more forward-looking, more fun, more educational, and indeed, more numerical.”
David and his team assign numbers to assess each stock’s level of risk, which they define as the likelihood of permanently losing a large amount of your investment. They ask 25 yes-or-no questions of a business and its stock to reach their risk rating from 0 (no risk at all) to 25 (insanely risky).
David’s 25 Questions to Determine Risk Rating
- Profitability: Was the company profitable during the previous quarter and past 12 months?
- Cash flow: Was the company cash flow-positive from operations during the previous quarter and past 12 months?
- Brand: Does the company’s business rely on recognizable branding truly valued by its buyer base?
- Diversification: Has the company diversified its buyer base so that no single customer accounts for more than 20% of revenue?
- Raving fans: Does the company, on the whole, receive positive word of mouth from its customers?
- Growth: Did the company increase its sales by 10% to 40% annually in the previous three years?
- Independence: Can the company operate its business in the next three years without relying on external funding?
- Disclosure: Does the company maintain a high standard of disclosure, consistent with SEC guidelines?
- Transparency: Would an intermediate investor find the company’s financial statements and management ownership disclosures relatively easy to sift through and understand?
- Well-managed: Did the company report a return on equity of 15% or more in the previous year?
- Underdog: Is the company free of any direct competitors that have substantially greater financial resources?
- Goliath: Is the company free of any disruptive upstarts visibly challenging its business model?
- Moat: Would potential new competitors face high economic, technological, or regulatory barriers to entry?
- Market cap: Does the stock have a market cap of more than $500 million?
- Beta: Is this stock’s beta less than 1.3 for the past 12 months?
- P/E ratio: Does the stock have a positive price-to-earnings multiple that is less than 30?
- Founder: Do any of the founders still have at least a 5% stake in the company?
- Experience: Do the top three officers have more than 15 years of combined leadership at the company?
- The Stock Advisor Way: Is this a solid business with proven management and a stalwart balance sheet?
- Conscious Capitalism: Is management looking out for the interests of all stakeholders — customers, employees, shareholders?
- Immaculate: Is this company guaranteed to be fault-free and fraud-free in all its corporate statements and deeds?
- You: Do you want to know more about this company? Are you willing to dig deeper, learn more, and ask questions to actively understand this company?
- About This Company No. 1: Ask the most insightful question you can come up with to assess this company’s risk.
- About This Company No. 2: Ask the second-most insightful question you can come up with to assess this company’s risk.
- Bulletproof: Are you certain this company is invulnerable to external world or macroeconomic events such that you’re sure you can get all your capital back?
For a deeper explanation of each of these, to read co-founder/co-advisor Tom Gardner’s 25 questions, and to see how both teams have rated hundreds of companies, get a Stock Advisor membership today (give it a shot, see if you like it, cancel within 30 days for a full refund).