Are You Earning Enough Reward for Your Risks?

Investing is a financially risky activity. You can directly lose money in virtually every investment, and even those that appear safe (such as CDs, savings accounts, and U.S. Treasury bills) face purchasing power risks after taxes and inflation. Given that you're taking risks with your money, it's important to seek sufficient financial rewards for those risks.

It's not always easy to either figure out how much potential return is "enough," or whether a given level of risk is low enough to justify accepting a lower rate of return. That's especially true in a stock-based portfolio, as even a company that seems solid one minute can find itself in trouble the next when business conditions turn against it. After all, as Warren Buffett has said, "Only when the tide goes out do you discover who has been swimming naked."

How much is enough?
On the message board for the real-money Inflation-Protected Income Growth portfolio, a recent discussion centered on the trade-offs investors make between risk and reward. A participant who uses the ID of "kelbon" suggested that beverage titan Coca-Cola (KO 0.54%) was a superior pick to recent iPIG selection Scotts Miracle-Gro (SMG -1.11%). Kelbon made a great point that because the companies had similar yields, and Coca-Cola was a lower-risk company, it would have been a better selection for the iPIG portfolio.

While it's true that Coca-Cola is an awesome company that owns one of the world's best-known brands, it's also priced in the market like the fairly low risk, high profile company that it is. Coca-Cola was considered for the portfolio, and only its valuation kept it out. Even then, it's not so much that Coca-Cola looked expensive as much as the fact that at its market price at the time, it only looked reasonably priced when discounted against a single-digit potential rate of return.

Yard care titan Scotts Miracle-Gro, on the other hand, was priced as the riskier company that it is. Scotts Miracle-Gro, after all, doesn't exactly have a recent track record of strong year-over-year earnings performance. In addition, many of its competitors have had trouble consistently producing profits at all recently, suggesting that the entire industry may be a challenging place to earn money.

Still, at the time it was selected, it was priced such that if it delivers to expectations over time, Scotts Miracle-Gro looked reasonably priced when discounted against a 12% required rate of return. From the available financial data, Scotts Miracle-Gro looks like a higher risk company than Coca-Cola. Still, when picked, Scotts Miracle-Gro was priced in a way that appeared to provide an adequate potential reward for that very real risk. And that makes all the difference.

Is it different this time?
Whether the Scotts Miracle-Gro selection will ultimately work out for the iPIG portfolio will depend on the company's ability to generate cash, profits, and dividends over time. While the company's recent past is rocky, it has made plans to ease debt covenants and institute other changes to lower its cost of borrowing by roughly $5 million-$7 million per year.

Lenders don't usually ease restrictions or lower rates on companies they sense are headed for worse troubles. As a result, that better borrowing profile suggests the guidance the company gave in December for a 10%-15% improvement in adjusted earnings from continuing operations per share for 2014 may well be achievable.

If Scotts Miracle-Gro does succeed in recovering its business, it could join top-performing iPIG picks Walgreen (WBA -0.62%) and Raytheon (RTN) as companies where a rocky past paved the way for a reasonable entry price. No turnaround is ever guaranteed, of course, but if the potential reward justifies the risk, an investment may make sense in the context of an overall portfolio.

In Walgreen's case, the drugstore chain was finishing up a battle over pharmaceutical reimbursement rates when it was selected. As that battle wound down and Walgreen's business returned closer to normal, its shares recovered nicely. For Raytheon, the worry came in the form of the defense sequestration, which hit just before it was picked for the portfolio. Once it became apparent that its services were still needed to defend the country, Raytheon's share price recovered.

Only time and its ability to execute will tell whether Scotts Miracle-Gro delivers its own recovery successfully. It's a risk, but one in which the iPIG portfolio bought at a price that suggests a reasonable return if the company succeeds and a moderate margin of safety against the possibility that it doesn't.

How's that working out?
While Scotts Miracle-Gro was one of the better performers for the iPIG portfolio since last week's update, it is still way too soon to know whether the company will deliver on its recovery. Overall, as the table below shows, the iPIG portfolio has been holding up well enough so that even if this particular investment doesn't live up to expectations, the overall portfolio should survive:

Data from the iPIG portfolio's brokerage account, as of Jan. 10, 2014.

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