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This article is part of our Rising Star Portfolios series.
While risk means many things to many people, Fool co-founder David Gardner defines it as "the chance that your investment outcome will be a substantial loss of capital." In order to help understand the concept, David recently developed a risk rating tool for his Motley Fool Rule Breakers members.
The process is pretty simple and involves answering 25 "yes" or "no" questions. Let's consider Ebix (Nasdaq: EBIX ) , which was a candidate for my Rising Star multivitamin portfolio. We'll run the insurance software provider through the wringer.
THE COMPANY (five questions)
1. Profitable: Is the company profitable over both the past quarter and past 12 months?
2. Flow: Is the company cash-flow positive over both the past quarter and past 12 months?
3. Brand: Does the company's business rely on recognizable branding truly valued by its buyer base?
Yes, management even specifically mentions promoting its brand.
4. Diversified: Has the company diversified its buyer base such that no single customer accounts for more than 20% of revenue?
5. Raving Fans: Does the company receive, on the whole, positive word of mouth from its customers?
Yes, positive word of mouth, sure. Raving? Not so sure.
FINANCIALS (five questions)
6. Growth: Is the company growing its sales by between 10%-40% annually over the previous three years?
No, 48% annually. Much of this is due to acquisitions.
7. Independence: Can the company operate its business over the next three years without relying on external funding
No, I could have gone either way with this one, but management clearly indicates it's willing to tap the capital markets for more funding in order to satisfy its acquisitive appetite.
8. Disclosure: Does the company report to a high standard of disclosure, consistent with Securities and Exchange Commission guidelines in the U.S.?
No, a prior restatement of earnings, KPMG resigning as auditor, musical auditors, and BDO Seidman expressing concerns about "deficiencies" in Ebix's internal controls mean it doesn't get the benefit of the doubt with me.
9. Transparency: Would an intermediate-level investor find the company's financial statements and management ownership disclosures relatively easy to sift through and understand?
No, the high number of acquisitions make it tough to get a clear picture of the financials and can provide apples-to-oranges comparisons.
10. Well-Managed: Over the most recent fiscal year, did the company report a return on equity of 15% or higher?
THE COMPETITION (three questions)
11. Underdog: Is the company free of any direct competitors possessing substantially (two times or more) greater financial resources
No, as stated by management in the 10-K. Two that are named by Ebix are Delphi Financial Group (NYSE: DFG ) and Computer Sciences (NYSE: CSC ) .
12. Goliath: Is the company free of any disruptive upstarts visibly challenging its business model?
Yes, none that I can see at this time.
13. Moat: Would potential new competitors face high economic, technological, or regulatory barriers to entry?
Yes, Ebix is benefiting from a network effect and has become the standard in some areas.
THE STOCK (three questions)
14. Market Cap: Does the stock have a market cap of greater than $500 million?
15. Beta: Is this stock's beta rating over the past 12 months less than 1.3?
Yes, but just barely, at 1.25.
16. P/E Ratio: Does the stock have a positive price to multiple that is below 30?
PEOPLE (two questions)
17. Founder: Do any of the founders or founding family still have at least a 5% stake in the company?
18. Experience: Of the top three officers, do they have more than 15 years of combined leadership at the company
Yes, though it's close.
SERVICE-SPECIFIC (two questions) ... here, Rule Breakers
19. Rule Breaker: Does this company meet a majority of our Rule Breaker attributes?
20. Binary Destiny: Are the company's future business prospects easily able to withstand the shock of binary outcomes that go against it?
FOOLISHNESS (five questions)
21. Immaculate? Is this company certain to be fault-free and fraud-free in all its corporate statements and deeds?
No, this answer is always "no."
22. You: Do I want to know more about this company; am I willing to dig deeper, learn more, ask questions on the boards -- actively understand this company?
23. Company question No. 1: Ask and answer the most insightful question you can come up with when assessing this specific company's risk.
Can I trust that management will steer a smart course in its acquisition strategies?
No, I just think too much can go wrong here.
24. Company question No. 2: Ask and answer the second most insightful question you can come up with when assessing this specific company's risk.
Can I trust what I see on the financial statements?
No, after reading John Del Vecchio's assessment of Ebix in our Big Short service, I realize that acquisition accounting makes it tough to calculate a true growth rate and assess cash flow quality.
25. Bulletproof? Can you be certain that this company is invulnerable to external world or macroeconomic events such that you're sure you can get all your capital back?
I count 10 "no" responses, giving this stock moderate risk on the Rule Breakers scale:
Rule Breakers Risk Ratings Scale
High (20-25 points)
Moderately High (15-19 points)
Moderate (10-14 points)
Moderately Low (5-9 points)
Low (0-4 points)
You should try this exercise with every company you own; it makes you think about things from different angles. I promise you'll come away with a greater understanding of the business and its future prospects!
If you're interested in keeping up with Ebix, be sure to add it to your watchlist.