Foolish Book Review: Profit From "Strategic Risk Taking"

IBM (NYSE: IBM  ) co-founder Thomas Watson famously said that the fastest way to succeed is to "double your rate of failure. You're thinking of failure as the enemy of success. But it isn't at all." That risk-taking attitude is right at the core of professor Aswath Damodaran's book Strategic Risk Taking.

Damodaran is a fellow Fool, perhaps best known for his copious collection of freely downloadable valuation spreadsheets and other financial tools and lessons. But when he's not teaching his NYU classes (or the world) the fundamental tenets of investing, he's found time to take the history of business risk to the next logical step and condense it all into this lucid volume.

The first three-quarters of the book serves as a fine primer or refresher on risk theory and valuation techniques. You'll learn about discounted cash flow valuation and decision trees, risk measurement and stock options. But the real meat sits at the end of the book. The last four chapters (out of 12) describe Damodaran's "risk management" strategy, which marries risk hedging strategy with competitive advantages, and outlines how one leads to the other.

Risk is always bad, right? Right?
Risk management means looking at all the risks your company is facing, and then deciding which risks to hedge against -- and which ones can give you a competitive advantage. "Competitive advantage? But risk is bad!" I hear you cry. Yes, that's the traditional economist's view. But to Damodaran, risk is both a blessing and a curse, which makes it a strategic consideration.

Step one is to understand the risks a company is facing. As an example, Damodaran uses regression testing to show how Disney (NYSE: DIS  ) suffers from a strong dollar but benefits from a weakening one, and increases its operating income when inflation or interest rates go up. Ergo, it's a non-cyclical company with strong pricing power, and it depends heavily on incoming foreign money.

Those are macroeconomic considerations that every company must face. Other risks can be firm-specific, such as rising and falling computer memory prices for memory makers, like Micron (NYSE: MU  ) , or their customers, like Hewlett-Packard (NYSE: HPQ  ) . To HP, memory pricing is a fairly small financial risk, while Micron lives and dies by it.

So then you look at what risks can be hedged against, and which ones should have a hedge. For example, a retail chain can hedge away its exposure to real-estate markets, and it makes sense for many retailers to do so. But a company like Walgreen (NYSE: WAG  ) or McDonald's (NYSE: MCD  ) probably shouldn't, because real estate is a competitive advantage for them.

Risk, meet reward
You cannot exploit risk to your advantage if you hedge against everything. Damodaran says that "good risk-taking organizations treat failure and success not as opposites but as complements because one cannot exist without the other."

Google (Nasdaq: GOOG  ) comes to mind here. The company is often accused of wasting time, money, effort, and talent on projects that add nothing to company value, and engineers are encouraged to spend 20% of their working time on their own pet projects. That, my friend, is the Thomas Watson quote at the top of this page -- put to work in a real business.

Failure happens, but it isn't punished. Some of those 20%-time projects end up commercialized and successful. And if you only ever go after the obvious and the safe, chances are good that someone else is doing it, too -- and might be doing it better.

Foolish finale
Strategic Risk Taking comes to some of the same conclusions that Jim Collins' Good to Great does, but from an entirely different angle. Management should figure out what the company is good at, and then drive those advantages to the hilt. Feel free to reduce risks that aren't central to your core concept, and focus your management efforts where they do the most good instead.

If this sounds a lot like the Rule Breakers mentality, that's because it is. You won't find any dithering, diversified conglomerates on our ultimate-growth service's scorecard, and if you apply Damodaran's risk-taking approach to the picks you do find with a free 30-day trial subscription, you'll find them very well aligned. These are companies unafraid of risk and change, ready to turn their respective industries upside down with new, bold innovations and dashing tactics.

Damodaran's book is a great manual for finding iconoclastic successes on your own. At the very least, you'll come away with a solid understanding of risk theory and valuation, with a side of swashbuckling panache so daring that Big Blue was built on it.

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