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 Chipotle Mexican Grill
The company (0/5 = no)
1. Profitable: Is the company profitable over both the past quarter and past 12 months?
2. Cash flow: Is the company cash-flow positive over both the past quarter and past 12 months?
3. Brand: Does the company's business rely on recognizable branding truly valued by its buyer base?
Yes. A major part of a restaurant's competitive advantage lies in its brand name, distinct food, and distinct decorative style. A great example is the golden arches of McDonald's
4. Diversified: Has the company diversified its buyer base such that no single customer accounts for more than 20% of revenue?
Yes. Unless just a few people are eating every meal there, I think I'm safe on this one.
5. Raving fans: Does the company receive, on the whole, positive word of mouth from its customers?
Yes. Everyone I've talked with likes the food and it has received four stars out of five on epinions.com. Plus, it seems that the locations are always full.
Financials (0/5 = no)
6. Growth: Is the company growing its sales by 10% to 40% annually over the previous three years?
Yes. Nearly 22% annually.
7. Independence: Can the company operate its business over the next three years without relying on external funding?
Yes. There's negligible debt, it has issued barely any stock over the past few years, and it's proud that it opens new locations using funds from operating cash flow.
8. Disclosure: Does the company report to a high standard of disclosure, consistent with SEC guidelines in the U.S.?
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. The discussion is clear and the footnotes are not too dense.
10. Well-managed: Over the most recent fiscal year, did the company report a return on equity of 15% or higher?
Yes. Just a touch over 19% for 2009, which is pretty good considering the recession. That's better than Buffalo Wild Wings
The competition (3/3 = no)
11. Underdog: Is the company free of any direct competitors possessing substantially greater financial resources?
No. As management points out in the 10-K, the "fast-casual segment of the restaurant industry is highly competitive and fragmented." Panera Bread
12. Goliath: Is the company free of any disruptive upstarts visibly challenging its business model?
No. Fast food continuously has new competitors coming to market.
13. Moat: Would potential new competitors face high economic, technological, or regulatory barriers to entry?
The stock (1/3 = no)
14. Market cap: Does the stock have a market cap of greater than $500 million?
Yes. Quite, sitting at $4.4 billion.
15. Beta: Is this stock's beta rating over the past 12 months less than 1.3?
16. P/E ratio: Does the stock have a positive price-to-earnings multiple that is below 30?
No. It's at 32-times trailing, but with a 24-times forward earnings, ratio. The stock is not priced cheaply.
People (1/2 = no)
17. Founder: Do any of the founders or founding family still have at least a 5% stake in the company?
No. Steven Ells owns just over 1%, and as a group, insiders own just less than 2%.
18. Experience: Of the top three officers, do they have more than 15 years of combined leadership at the company?
Service-specific (0/2 = no) ... here, Rule Breakers
19. Rule Breaker: Does this company meet a majority of our Rule Breaker attributes?
20. Binary destiny: Are the company's prospects easily able to withstand the shock of binary outcomes that go against it?
Yes. I answer this way because there really aren't any binary outcomes, such as drug approval, that can affect it. Customer tastes do change, but so far, it has weathered them.
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?
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 Chipotle avoid being marginalized as "faddish" by consumers?
Yes. Any food concept can fall out of favor, but the company has been growing for 17 years, and healthy eating is becoming more important to more people.
24. Custom question No. 2:
Can Chipotle successfully transition into an international company?
No. I feel I have to answer this way right now because it hasn't proved yet that it can. At the end of 2009, it had only one international location, in Ontario, Canada.
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?
I count eight "no" responses, giving this stock moderately low risk on the Rule Breakers 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 prospects.
Fool editor Jim Mueller owns shares of Chipotle and has a bull call spread on Yum! Brands, but has no financial interest in other companies mentioned. Chipotle is both a Motley Fool Hidden Gems pick (as is Buffalo Wild Wings) and a Rule Breakers choice. Motley Fool Options has recommended a bull call spread position on Yum! and a write puts position on Jack in the Box. The Fool owns shares of Chipotle. The Fool's disclosure policy is tasty.
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