Is Your Portfolio Swimming Naked?

"You only find out who is swimming naked when the tide goes out."
-- Warren Buffett

That's classic Warren Buffett above. Unfortunately, Buffett is so revered in most of the investing world that "classic Buffett" often becomes "cliched Buffett."

Cliches become cliches because they typically hold some useful kernel of wisdom. But once something is a cliche we tend to groan and gloss over when we hear it. I believe the same ends up happening for some of Buffett's better-known quotes.

We can get around this is by looking at the same basic concept in a slightly different way. Helpfully, in his new book The Most Important Thing, Oaktree Capital Management's Howard Marks throws a fresh spin on Buffett's quip:

Germs cause illness, but germs themselves are not illness. We might say illness is what results when germs take hold. Homes in California may or may not have construction flaws that would make them collapse during earthquakes. We find out only when earthquakes occur.

In other words, risk does not come up to you with hand outstretched saying, "Howdy! I could wreck your portfolio some day?" Instead, it can hide out for long periods of time like a Russian sleeper cell, waiting to wreak havoc when the conditions permit.

A stable foundation
To keep your house from falling down in an earthquake, you can verify that the construction is all up to snuff and there aren't any weak points that could cause problems if put to the test. We could draw a parallel by saying that in your portfolio you similarly want to make sure that you don't have any weak stocks that could crumble under stress.

But how exactly do you do that? While there are many signs of trouble to look out for, here are three that I think should top your list.

1. Poor management
Management is tough to evaluate and can be a particularly insidious risk for that reason. However, it's also one of the issues that can sink a company the fastest when it's tested by challenging conditions. Unfortunately, I learned this the hard way with Bank of America (NYSE: BAC  ) .

I never held former CEO Ken Lewis in particularly high regard and was skeptical of the acquisitions he made while at the helm. But the fact that the company was apparently doing very, very well let me repeatedly hit the snooze button on my concerns. Bad idea. When the bank was finally shaken by the financial market temblor, the cracks revealed themselves and led to billions in losses.

2. Dangerous balance sheet
Leverage is something that needs to be handled with extreme care by investors. On the bright side, it can supercharge equity returns and put more money in shareholders' pockets. However, it also has the ability to crush a company like a bug.

Take YRC Worldwide (Nasdaq: YRCW  ) , for example. The company is hardly a shining star by any means, though I think its operating business is much more attractive than the $0.82 stock price -- or the hefty losses -- suggests. But the company took on tons of debt in making massive acquisitions -- note that this ties into No. 1 above as well -- and when the business was stress-tested by tough times it had precious little financial flexibility. As a result, it's spent years struggling to just stay solvent.

Debt is hardly the only reason that YRC is struggling, but it has drastically exacerbated all of the company's other issues.

3. Valuation
When prices at a retail store go up, customers are bummed. But when merchandise goes on sale, they have a tendency to get giddy. In the stock market, investors generally have the opposite reaction -- they are happy when prices are rising and downtrodden when they're falling.

To some extent this is understandable, but the euphoria over the rising value of portfolios can sometimes mask the increased risk that comes with a higher stock price. As the price of a stock rises, the expected returns fall, and as expected returns fall, you are exposed to a greater possibility of unattractive returns or even losses.

I often harp on Netflix (Nasdaq: NFLX  ) because I don't think that the stock's forward price-to-earnings multiple of 56 gives investors nearly the cushion they need in case the company hits a rut. Many of my fellow Fools think otherwise, and I certainly recognize that the stock could continue to skip along merrily for quite a while. But I wouldn't sleep well owning that stock because I view it as a potential disaster waiting to happen due to its lofty valuation.

Cisco (Nasdaq: CSCO  ) , meanwhile, is in a very different boat. Its business hasn't been doing so hot lately and investors can't seem to sell the stock fast enough. While a lower stock price makes sense given the reduced future outlook, the fact that the stock has lost nearly a third of its value over the past year drastically reduces the risk that investors face.

One for the road
A risk not mentioned above -- but another very important one -- is business risk. My fellow Fools have put together a video outlining a big business risk that software giant Microsoft (Nasdaq: MSFT  ) may face in the years ahead. You can check out the video for free.

The Motley Fool owns shares of Microsoft. The Fool owns shares of Bank of America and also holds a short position in the stock in a different portfolio. The Fool has created a bull call spread position on Cisco Systems. Motley Fool newsletter services have recommended buying shares of Cisco Systems, Microsoft, and Netflix. Motley Fool newsletter services have recommended creating a diagonal call position in Microsoft. Motley Fool newsletter services have recommended buying puts in Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

Fool contributor Matt Koppenheffer owns shares of Microsoft, but does not have a financial interest in any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.


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