Today's article is the final installment of a two-part series on risk-averse investing in which I offer 15 guidelines to help individual investors reduce the risk of an equity portfolio while still achieving solid returns. If you missed the introduction and the first six guidelines, we'll wait right here for you while you go back and get caught up.
Let's move on to the rest of the list.
7) Avoid Stocks that Compete in High Risk Industries
There are many industries where the overall experience for the investor is bad, has always been bad, and is likely to always be bad. Airlines and steel companies come immediately to mind, but there are others. I wrote recently about the risk inherent in development-stage biotech stocks. To this list I would add property and casualty insurers, sub-prime lenders, and other industries where the business model is pretty high risk and hard to evaluate.
Avoiding such industries means missing out on the occasional "rose in the desert," like a Southwest Airlines
8) Look Out for Customer Concentration
Be careful when it comes to stocks of companies that have only five customers, or who are reliant upon one large customer for a very large percentage of their business.
9) Avoid the Glamour Stocks and Media Favorites
It sounds unintuitive, but stocks are most ripe for a fall when the CEO has just been featured on the cover of Fortune magazine, the talking heads of all the financial shows are calling it a "must own," mutual fund companies are loading up, and Wall Street analysts are issuing "strong buy" reports left and right. The stock runs up on all the hype, and simply gets priced for absolute perfection.
Unfortunately, there aren't any perfect companies. At some point the perception will change, and there is ample room to fall from a high valuation pedestal.
10) Consider Litigation Risk
I used to think that the market generally over-estimated legal risk for companies in litigation-torn industries like tobacco and asbestos. I don't think that anymore. Things have gotten a little out of control on the litigation side, and there is no assurance that things won't get worse. We used to joke that somebody was going to sue McDonald's or Hershey's for making them fat; we're not joking anymore. I personally won't touch stocks with any exposure to tobacco or asbestos liability because I can't quantify the danger, and I'm careful to review the risk disclosures in the annual reports of stocks I'm considering.
11) Look for Lengthy Product Lifecycles or Consumer Brands
Companies that must constantly produce new products for their survival are risky investments; Iomega
On the other hand, Coca-Cola
12) Limit Option Dilution
You'll need to learn how to read the proxy statement and the fine print in the back of the annual reports for this one. Let me just say that stock option dilution represents massive risk of equity erosion for shareholders. It's not uncommon to find companies that issue stock options at a rate that can potentially dilute the shareholders by 5% annually or worse. This is like a reverse dividend -- the longer you hold the stock, the more your ownership gets re-distributed from you to company insiders. Don't tolerate it.
13) Put Your Money On Owner Operators
Investors want managers who think and act like long-term business owners, not hired mercenaries who try to sneak money out the back door when nobody's looking. Owner operators are more likely to act in ways that enhance shareholder value, particularly when they are also large stock (not option) holders. They are more likely to employ conservative accounting, because they don't have any motivation to enhance the numbers over some arbitrary short-term period, and they are less likely to tolerate a culture of excess such as the one that existed at Tyco
Of course, there are also a few corporate managers out there who don't require large stock ownership to motivate them to do the right things for the long-term benefit of shareholders. Contrary to the scandalous headlines, these executives take their stewardship role seriously because they happen to be decent people. Unfortunately, they usually don't get a lot of media attention, so it does take time to find them, but you tend to get a better price this way.
14) Check out the Pension Liabilities
The "new economy" stocks have their egregious stock options, but "old economy" stocks often have a similar risk to shareholder wealth in the form of massive pension liabilities. Again, you'll need to learn to read the fine print in annual reports to find them, but it is worth your time to do the grunt work. If the stock market doesn't turn around soon, this problem could balloon into a crisis.
15) Buy Cheap Stocks with a Margin of Safety
The final rule of risk-averse investing is simple: buy cheap stocks. Buy stocks only at prices that compensate you for the risks inherent in equity ownership, and that offer good return potential without the necessity of optimistic scenarios. The key to low-risk stock investing is to learn to value businesses. If you can do this, and then cultivate the discipline to only buy when the stock is trading at a discount to a conservatively calculated fair value estimate such that a "margin of safety" comes built in, you will succeed as an investor.
Learn to Say No
Risk-averse investing means learning to say no. It means not owning stocks of perfectly good companies because they aren't cheap enough, or because they issue too many options, or because they don't have proven track records. It means not owning the stocks you hear about on financial television or see featured on the cover of popular business magazines. It means looking long and hard for those few stocks of good businesses, run by good people, selling at good prices.
Risk-averse investing requires that you think independently and take responsibility for your decisions. It isn't easy, and you may end up owning a bunch of stocks that your average mutual fund manager has never heard of. But then again, if you want to own the popular stocks that everyone's heard of, you might as well just buy an index fund.
Learn more about how to get the most return for your money with the amount of risk you're willing to take in our new online seminar. Perfect Your Portfolio: Asset Allocation for Long-Term Wealth starts June 2nd. Sign up today for 20% off!
Zeke Ashton has been a long-time contributor to The Motley Fool, and is the managing partner of Centaur Capital Partners, LP, a money management firm in Dallas, Texas. At the time of publication, Zeke did not own any stock mentioned in this article. Please send your feedback to firstname.lastname@example.org.