Sure, snake oil salesmen sometimes make people feel better, but more often than not they just prevents folks from getting useful treatment. The same holds for finance pros. Many say they can measure investment risk as if it were a science, and that risk measurement, equated with price volatility, can be used to spot hidden gems. Don't believe it, Fools. There are better ways to size up risk.
Analysts love to blather on about beta. On its own, beta is a fairly simple idea. It's also pretty useless. A stock's beta is a number representing its volatility relative to the overall market. The higher a stock's past volatility in relation to the market, the higher its beta. If a stock perfectly matches the market, its beta is 1.0. High-beta stocks are supposed to be riskier than low-beta stocks.
If you took beta seriously, you would have to say that General Electric
Let's be frank, no magic formula exists to reveal real risk. Beta tells you how much a stock bobs around, but it scarcely gets at more fundamental risk matters. Is there a risk that the company's industry will suffer a slump or, even worse, it won't be around in five years? Is the company vulnerable to competition stealing away its market share? Is there a risk that top executives are cooking the books? Even worse, is there a risk that you are caught up by momentum and are paying 10 times what the stock is worth? Fussy measures like beta don't come close to capturing risks like these.
So, what should investors do to size up risk and spot a hidden gem?
For starters, have at look the company's fundamentals. Risk assessment begins with a look at financial strength. Financial strength starts on the balance sheet. Pay attention to debt-to-equity ratios and cash positions. Which software company has more strength, Microsoft
Make sure accounts receivable (money owed the company) and inventory aren't growing faster than sales, as it suggests things are getting out of control. Think Dell
Consistency and reliability of earnings also signal investment risk. Starbucks
It doesn't stop there. How safe are earnings and cash flow into the future? Does the company have the ability to sail through hard times? That means factoring in fundamentals like industry outlook, business cycles, competitive position, and management capability.
And yes, price does matter, when looked at against those fundamentals. Indeed, Warren Buffett, chairman of Berkshire Hathaway
Roll up your sleeves
It's clear that a good bargain carries less risk and higher reward potential. When you buy a stock, you are buying a part of a business. To know whether or not you are getting a good deal, you must evaluate the business. Valuing companies can be tricky sometimes, but it's not impossible. Yes, it probably means a lot more work than just looking up betas. But it's this kind of fundamental research that allows investors to curb their risk.
Forget the snake oil. If a stock has solid business fundamentals and is available at a significant discount to its value, the risk is lower and the prospect of reward is higher. Face it, unearthing hidden gems doesn't mean balancing risk and reward. It's about finding high returns and low risk in the same stock.
Tom Gardner searches for undervalued stocks each month in Hidden Gems. Sign up now for a free trial.
Motley Fool contributor Ben McClure hails from the Great White North. Ben owns shares in Dell, ExxonMobil, Starbucks, and Southwest Airlines.