The word "risk" means different things to different investors. Wall Street tends to think of it in the context of volatility, where greater volatility equals greater risk -- even if the stocks trend higher as a result. We look at it differently, however. Fool co-founder David Gardner defines risk as "the chance that your investment outcome will be a substantial loss of capital."
Understanding this type of risk is a very important skill for investors, especially for those seeking the kinds of high-growth, high-return stocks David features in his Motley Fool Rule Breakers service. With that in mind, David and his team recently unveiled a new tool that you can use to assess the riskiness of any of your stocks.
The process is simple: Run your company through the 25 questions below, tally up the number of "no" answers, and see where it falls on the scale. I'll use iRobot
THE COMPANY (3/5 = "no")
1. Profitable: Is the company profitable over both the past quarter and past 12 months?
Yes.
2. Cash Flow: Is the company cash-flow positive over both the past quarter and past 12 months?
Yes.
3. Brand: Does the company's business rely on recognizable branding truly valued by its buyer base?
No. I'm going to play the skeptic here. The brand probably means a little bit to the government, maybe a bit more to private consumers, but I don't think it will mean much should viable competitive products be offered.
4. Diversified: Has the company diversified its buyer base such that no single customer accounts for more than 20% of revenue?
No. The federal government accounted for 27% of total revenue last quarter.
5. Raving Fans: Does the company receive, on the whole, positive word of mouth from its customers?
No. I originally assigned a "yes" here, but checking the company's products on Amazon.com changed my mind. Amazon has a wonderful customer feedback system (great to use for this risk tool), and the Roomba vacuum robot has an average of around 3.5 stars (out of five) and a lot of negative feedback. I've personally owned three Roombas and have been disappointed with the quality.
FINANCIALS (1/5 = "no")
6. Growth: Is the company growing its sales by between 10%-40% annually over the previous three years?
Yes. 34% annually.
7. Independence: Can the company operate its business over the next three years without relying on external funding?
Yes. There's no debt, and it hasn't issued significant amounts of new shares, all while the cash balance has been growing.
8. Disclosure: Does the company report to a high standard of disclosure, consistent with SEC guidelines in the U.S.?
Yes.
9. Transparency: Would an intermediate-level investor find the company's financial statements and management ownership disclosures relatively easy to sift through and understand?
Yes.
10. Well-Managed: Over the most recent fiscal year, did the company report a return on equity of 15% or higher?
No. ROE has been rather anemic the past few years, clicking up to only 8.6% over the last 12 months.
THE COMPETITION (3/3 = "no")
11. Underdog: Is the company free of any direct competitors possessing substantially (2x+) greater financial resources?
No. As management points out in the 10-K, Northrop Grumman
12. Goliath: Is the company free of any disruptive upstarts visibly challenging its business model?
No. Again being skeptically conservative, I'm a little worried about this.
13. Moat: Would potential new competitors face high economic, technological, or regulatory barriers to entry?
No.
THE STOCK (2/3 = "no")
14. Market Cap: Does the stock have a market cap of greater than $500 million?
No. At the moment, iRobot is just shy of the $500 million mark, so I'll say no.
15. Beta: Is this stock's beta rating over the past 12 months less than 1.3?
Yes.
16. P/E Ratio: Does the stock have a positive price-to-earnings multiple that is below 30?
No. Currently at 45 times trailing, and 35 times forward earnings, the stock carries a premium valuation.
PEOPLE (0/2 = "no")
17. Founder: Do any of the founders or founding family still have at least a 5% stake in the company?
Yes. Helen Greiner, co-founder and director, owns 5.4%. Collectively, the co-founders own almost 14%.
18. Experience: Of the top three officers, do they have more than 15 years of combined leadership at the company?
Yes.
SERVICE-SPECIFIC (0/2 = "no") ... here, Rule Breakers
19. Rule Breaker: Does this company meet a majority of our Rule Breaker attributes?
Yes.
20. Binary Destiny: Are the company's future business prospects easily able to withstand the shock of binary outcomes that go against it?
Yes. It's a tricky answer because of the different military/consumer components of the company, but I'd say robotics by its very nature has "many different futures." I've been disappointed thus far because I haven't seen many of those futures.
FOOLISHNESS (3/5 = "no")
21. Immaculate?: Is this company certain to be fault-free and fraud-free in all its corporate statements and deeds?
No. This is going to be a "no" for almost any company.
22. You: Do I want to know more about this company; am I willing to dig deeper, learn more, and ask questions on the boards to actively try to understand this company?
Yes.
23. Custom question No. 1: Ask and answer the most insightful question you can come up with when assessing this specific company's risk.
Can iRobot avoid being marginalized as "faddish" by consumers?
Yes. This was one of my early worries, but I've been impressed by the staying power of the products, if not their reliability/usability.
24. Custom question No. 2:
Can iRobot avoid being totally hosed by the government, and thus losing significant revenue over the next few years?
No. Approximately 40% of revenue comes from the federal government. There is real risk in iRobot not securing new contracts or not renewing existing deals.
25. Bulletproof?: Can you be certain that this company is invulnerable to external world or macroeconomic events such that you're sure you can get all your capital back?
No.
I count 12 "no" responses, giving this stock moderate risk on the RB scale:
Rule Breakers Risk Ratings Scale
High (20-25 points)
Moderately High (15-19 points)
Moderate (10-14 points)
Moderately Low (5-9 points)
Low (0-4 points)
It's great to go through these steps for any company you own; they'll make you think about things from different angles. I promise you'll come away with a greater understanding of the business and its future prospects!
