Imagine this: You're flipping through news reports and you land on an item about a company in which you're invested. It says that a recent earthquake has damaged a key production plant, which will be closed until repairs are made. This is what happened to Tongjitang Chinese Medicines (NYSE:TCM), a specialty pharmaceutical company. The press release notes, "Tongjitang has halted production temporarily and will update investors when additional information is available. ... We are committed to the highest quality levels of production. Currently, we are working diligently to make sure that production will be resumed as soon as conditions allow."
When I saw this, I checked to see if the stock had plunged on the news. Surprisingly, it didn't. Investors must be keeping cool heads, trusting production to resume shortly, realizing that the problem is manageable and temporary.
Still, the event made me stop to appreciate how quickly a company can get derailed, even temporarily. Most of us probably don't factor earthquakes into the risks we consider when we evaluate companies as possible investments.
Spreading the risk
This is where diversification can be useful -- not in the sense of diversifying your money across many industries and companies, but in the sense of a company having a diversity of plants, and even businesses. If a firm makes mainly one product and it does so from mainly one location, then its risks are concentrated. If its business is typewriters, they may end up obsolete sooner than anyone imagines. Its factory may also burn down or suffer some other problem.
Meanwhile, big companies and conglomerates such as General Electric (NYSE:GE) have spread out their risks. If its jet engine business slumps, there's always the locomotive business, or the consumer financing business, or even wind turbines, to pick up the slack. Fortune Brands (NYSE:FO) is another biggie, with businesses ranging from spirits (Jim Beam, Maker's Mark, Courvoisier) to sports (Titleist, Foot Joy, Cobra, Pinnacle) to home and hardware (Moen, Therma-Tru, and more). Procter & Gamble (NYSE:PG), though focused mainly on consumer products, still has a wide range of them, from detergent to coffee to pet food to batteries (and more).
The 10-K knows the risks
It may be that you don't consider risks very much when you evaluate companies. If so, consider changing your ways. It's good to at least consider the risks involved in an investment, even if you decide to invest anyway. One good way to learn about many risks a company faces is via its annual "10-K" filing with the Securities and Exchange Commission (SEC). You can access most companies' 10-Ks here in Fooldom, under a tab on the company's page in Motley Fool CAPS.
For example, Harley-Davidson (NYSE:HOG), in its most recent 10-K, outlines many risks, including the risk that its manufacturing and profitability may be adversely affected by changes in regulations. For instance, if the Environmental Protection Agency suddenly requires much cleaner emissions, Harley-Davidson will have to spend to change its manufacturing process.
Here are some more risks that the company mentions:
- The Company's dealers may experience a decline in retail sales resulting from slowing economic growth, political events or other factors.
- The Company has a number of competitors ... some of which have greater financial resources than the Company.
- The Company's success depends upon the continued strength of the Harley-Davidson brand.
- The Company's prospects for future growth are largely dependent upon its ability to develop and successfully introduce new, innovative and compliant products.
- The Company manufactures products that create exposure to product liability claims and litigation.
- The Company relies on third party suppliers to obtain raw materials and provide component parts for use in the manufacture of its motorcycles.
- The Company's financial services operations are exposed to credit risk on its retail and wholesale receivables.
- The Company is exposed to market risk from changes in foreign exchange rates and interest rates.
I think you get the idea. Notice that most of these risks are borne by other companies, as well. Once you get used to thinking about risks, you'll be able to quickly come up with a bunch for most companies.
What to do
So now that you're thinking about stock risk, how should it affect your investing? Well, just remain aware of risks, and factor them into your thinking. If a company does a lot of business in South America, ask yourself how sure you are of the area's political stability. If it sells two-thirds of its products to a single retailer, like Wal-Mart (NYSE:WMT), be aware that Wal-Mart holds a lot of power in that situation and can make life miserable for the company.
If you'd like to see how analysts consider the risks that companies face, I invite you to take a 30-day test-drive (for free!) of any of the Fool's investing newsletters. We routinely discuss risks as we recommend companies that seem poised to perform well.
