What You Don't Know About These Stocks

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As early-payment defaults on subprime mortgages have increased, almost three dozen subprime lenders have failed or been acquired in recent months. Earlier this month, Accredited Home Lenders (Nasdaq: LEND) lost almost two-thirds of its value in a single day after it announced that it was exploring options to shore up its liquidity in the face of accelerating margin calls from its lenders.

Investors are learning the harsh lesson that subprime lending is particularly vulnerable to "known unknowns" (risks that are known but can't be modeled, such as accounting risk and macroeconomic risk), but it's hardly unique in this respect.

• Commercial banking: According to a 2006 paper, "What We Know, Don't Know, and Can't Know About Bank Risk: A View From the Trenches," non-financial risks (i.e., operational risk and business risk) account for a whopping 30% of bank earnings volatility. Even so, measuring and managing operational risk is still in its infancy -- there is as yet no standard framework to do this. One way to mitigate the risk is to focus on "best practice" institutions, such as JPMorgan Chase (NYSE: JPM) or Citigroup (NYSE: C).
  
  
• Investment Banking: Hedge funds have become an important source of revenues for investment banks that provide prime brokerage services -- settling and clearing trades, reporting, and the like. Goldman Sachs (NYSE: GS) and Morgan Stanley (NYSE: MS) are leaders in this area, but despite their deep expertise in managing risk, their commitments to hedge funds raise some concerns. For one, banks may not be aware of the full amount of leverage their clients are employing. Furthermore, the liquidity risk of large or illiquid hedge-fund positions is difficult to model and can increase dramatically in an adverse market.

Before you accuse me of creating unreasonable constraints on your search for superior investments, let me be clear: A rational investor needn't exclude any of these industries. After all, we recommended Fannie Mae (NYSE: FNM) -- a poster child for accounting risk -- at Motley Fool Inside Value. In fact, allow me to offer up some pointers that may be useful for your due diligence and investment processes:

1. For every company you are researching, understand the "known unknowns" the company may be exposed to as part of its business -- risks that have been identified but are difficult to model, even for industry participants.
   
   
2. Look for clues regarding the way management thinks about these risks, as well as those risks that are essentially unknowable. The best places to look are interviews, investor presentations, and earnings calls. Are the people in management constantly emphasizing profitability and growth, or are they focused on loss avoidance? Do they appear overly aggressive, even foolhardy, or can they balance a sense of confidence in their organization with a naturally skeptical approach and a healthy respect for risk? If the former is true, I recommend that you move on to another company.
   
   
3. Always invest with a margin of safety! This is the rational investor's first commandment. Paying less for a stock than a conservative assessment of its intrinsic value is the last line of defense against risks that are unknown and, perhaps more important, against those that are unknowable.
   
   
4. Diversify. I'm a focused investor, but I recognize that companies in some industries are less suited to concentrated portfolios because of the nature of the risks they bear. As one value-oriented hedge-fund manager remarked at a recent investment conference: "We don't think technological obsolescence risk is acceptable in a concentrated portfolio."

These are some of the guidelines my colleagues and I follow to ferret out superior companies and investments at Inside Value. If they make sense to you and you want to learn more about our market-beating approach, consider a 30-day trial to our service. There is no obligation to subscribe.

Fool contributor Alex Dumortier, CFA, does not own shares of any company mentioned. JPMorgan is an Income Investor recommendation. The Motley Fool has a disclosure policy.