FOOL ON THE HILL
Big Risk Sinks Ships

Some investors who held fallen companies like Global Crossing and Enron were in complete denial even as the companies descended into bankruptcy. Every single one of us is going to be blindsided at some point by a risk factor that we had not accounted for, but that shouldn't stop us from looking for great investments. We should just be a little more prepared.

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By Bill Mann (TMF Otter)
April 12, 2002

About 15 years ago on the grounds of a New Jersey boarding school, a groundskeeper was backing up a truck when he hit a lamppost. No big damage, except the post had a slight lean, and since the post still seemed sturdy, the school opted to leave it alone until they did their regularly scheduled maintenance on the post.

What the groundskeepers did not know was what had happened below the surface. The lamppost had leaned ever so slightly, but it was enough to cause contact between the metal and an underground power cable. Not too much later, an instructor on campus was walking his dog. When they came to the lamppost, the dog, being a dog, thought that it offered him a pretty good opportunity to urinate. The dog lifted his leg, started to go, and -- POW! -- got the shock of his life as a jolt of electricity -- well, it traveled upstream is what it did.

Obviously, the dog got the raw end of this whole deal. But I'd like to pose a simple question: If you were trying to assess blame for the risk that was taken in this situation, where would you lay it?

On the people who originally laid the cable, since they put it so close to a post?

How about on the people who placed the post? Certainly they had to know that they were mere inches away from a power cable.

Maybe it was the groundskeeper, for not making absolutely sure that the lack of damage above ground wasn't hiding a problem.

Or how about the instructor? Should he have let the dog go on that certain spot without checking it first?

Yeah, I know, let's blame the dog.

Tough to really assess where the risky action was, isn't it? Well, guess what? To the dog it mattered not a whit HOW it happened, just the fact that it happened.

In investing, you are the dog. If there are risks being taken by companies you hold, you are the one who will suffer the most direct damage. That's the cold, hard truth. Thing is, those who are taking the risks may not recognize them as such. All the more reason for you to be awfully picky about companies you invest in.

Unseen risks are still risks
This is one thing that has been missing in the whole discussion about Enron. Yes, Enron's executives and its professional consultants took great pains to hide some of the risks that the company was assuming. But I can guarantee that 99% of the people who bought Enron never once sat down, put pen to paper, and tried to sort through Enron's financial footnotes searching for risks. How could they have? Some of the smartest accounting minds in the country have disclosed that Enron had been a "black box" -- a complete mystery to them.

We're never going to have ALL of the information. Companies are under no obligation to reveal their internal operations to outside investors, but were people asking the right questions? I don't think so. And like the dog in the story above, they got burned by their own actions, innocent as those actions may have been.

You've heard it before. Investing is all about risk. The more risk you take, the higher your potential returns. And this is all correct, except for the fact that it is exactly wrong. Investing is all about perceived risk. Where you as an investor have an advantage is only in situations where you can correctly assess that the market has overestimated (or underestimated) future risks. That requires knowledge.

In banking they say that every loan looks like a good deal to them on the day that it is signed. Obviously, this is untrue; some people default on their debts. As I've discussed in the past few months, the rate of loan write-offs has skyrocketed in the past year, forcing banks to reserve much larger portions of their capital for potential future bad debts. It hurts banks pretty badly when their loan losses spiral upwards, and it makes current-year earnings look bad. But at what point was the damage done? Was it when the loans went bad, or was it when the bank gave the loan in the first place?

Ask the people at Providian (NYSE: PVN), which has been throttled in the past six months as its credit card customers defaulted in record numbers. In fact, two weeks ago Warren Wilcox, a top manager at Providian, said that the company had been "too aggressive in the past," and this has caused massive loss of shareholder value and a restructuring of the company. Outside shareholders didn't have much to do with the operational decisions that caused Providian's downfall, but you can rest assured that there is no one standing in line to restore their investment losses.

Always ask questions
In the same way, insurance companies had to line up this past year and disclose their potential exposure to the damage caused by the World Trade Center attacks. These are insurance companies -- they're supposed to pay claims, right? Well, the problem was that almost none of them had been charging for terrorist coverage. Once again, the time to have considered these risks was well before the claims started rolling in. As a result, several insurance companies, most notably Copenhagen Re, have folded.

I'm not trying to inspire a feeling of helplessness here. Occasionally bad stuff is going to happen to a company you hold, and in many cases it will come from a direction that you have not considered. (Now, isn't that better?) There is no shame in this -- after all, your money was in fact at risk. But many risks are quite visible, be it the billions a Global Crossing had in debt or the risk of asbestos litigation against Halliburton (NYSE: HAL). Your job as the steward of your money is to consistently make the negative case toward the company that you hold. You simply must be able to spell out and then account for the likeliness of a problem arising, and how much it would cost you were it to happen.

Matt Richey, Tom Gardner, and I once wrote a piece where we spelled out the problems that Lucent (NYSE: LU) was facing. In it we mentioned that the company's balance sheet condition had been deteriorating for two years. And yet, at the time, Lucent was the most widely held company in America, and enjoyed nearly universal acclaim from Wall Street analysts. The thing that blew me away was that it took me less than a minute to see that there was a BIG problem with Lucent, one that was a long time in coming.

These were risks that were in plain view, and yet people didn't see them. I can only think that the cause for this is that they didn't look for risks, only potential rewards. To beat the dog analogy to death, this wasn't a deep down power line -- this was an exposed one, lying on the ground, electricity arcing everywhere.

Do yourself a favor. Start building out a list of risks to the companies you own. Heck, the companies themselves even do some of this for you: There is a risks section in their annual reports. But go deeper, think on your own: What is out there that could cause my investment to disappear, or even underperform? Asking yourself this question now might save you a bundle later.

Fool on!
Bill Mann, TMFOtter on the Fool Discussion Boards

Bill Mann is Senior Editor for The Motley Fool. Please view his profile for a full disclosure of his positions. The Fool has a disclosure policy.