Risks to consider when investing in stocks

When you start investing in the stock market for the first time, usually your intuition is that the risk is in deprecation of the stock's value. Say you buy Alphabet at $2,451, will the price be more or less the next month, or in a year's time. This however is only a very narrow view of the risk.

This article will be a quick overview of the kind of things you should think about when gauging the risk of a stock. If you think there's something missing from the list, please drop me a line at thewealthyfinn@gmail.com or on twitter @thewealthyfinn.

So what risks are there? Here are some common ones to look out for:

The company cannot deliver

The most typical risk is with promised outlook vs. reality. For a stock to perform, it needs to deliver financial value to its shareholders. Often this is in the form of dividends, but in some cases only appreciation. In either case, the company needs to meet expectations.

When it doesn't, and something happens to deteriorate the company's performance, its value drops. The less time the company has been on the market, the more uncertainty there typically is. Growth companies often paint grandiose outlooks, where the business grows by hundreds of percentages per annum, which already is reflected in the price of the stock. Dividend yield might be zero and the company could be far from breakeven.

Look at Nikola's stock performance from April 2020 to March 2022. If you weren't paying attention, back in early 2020, Nikola was gaining a lot of interest from investors with claims they had a functional full-electric and hydrogen fuel cell truck. They had videos of the truck moving and hyped their progress in social media. With no revenue, Nikola was at one point valued at $34 billion, more than Ford. Until news came out that the picture they were painting, wasn't exactly accurate.

From a listing price of $10, Nikola went up to over $60 and just last month was traded at less than $7.

How to avoid: Growth stocks that have little or no revenue are dangerous and require tremendous research. Always look at earnings-per-share to understand if there is any actual business behind the stories. Try to understand what the valuation is based on. When the valuation is based on sales 7 years from now, it's probably very high risk.

Private placements can take you hostage

Private placement was a thing that caught me off-guard when I first started investing and the same has happened to so many investors especially in the travel and aviation industry. Last year, airlines undoubtedly took a massive beating. Have a look at Finnair's stock price for the last 2 years.

Pre-corona Finnair was trading at around 1.1€ per share. After corona hit, the price dropped quickly to around 0.7€ and had a low of 0.55€, half of what it used to be. Many new investors jumped in at this point thinking it was an over-reaction and there was good money to be made. "Things will get back to normal and I'll double my money in a couple of years", was what they were saying.

The reality was though that running an airline is costly, even when the planes aren't flying. You need to cover for some staff, maintenance and lease of the planes. The costs are staggering and the airline was bleeding cash.

What happened next didn't surprise long-term investors. In June 2020 Finnair issued a private placement where each share you owned gave the right to buy 10 new shares at the price of 0.40€. Those who didn't partake would see the value of their shares immediately go to 1/10 of the previous. You'd need a 10x to get even and 20x to get to the original target of doubling your money.

If you exercised the private placement rights in full, you almost 10-folded your stake in a company that was doing really badly.

How to avoid: When something looks dirt-cheap, there often is a reason for it. Check if the company is bleeding cash and how long it will last. Will they have time to turn around before they need to ask investors for more.

Increasing inflation will scare people away from growth stocks

Increasing inflation affects different kinds of stocks in different ways. Growth stocks typically don't make significant revenue yet, but the valuation is justified by expected future revenue - which is always uncertain. The discounted cash flow analysis (DCF) is one very common way to estimate what a stock is worth today.

When inflation rises, interest rates follow, which directly mean increased capital costs but also increased nominal returns for bonds. If the future expected cash flow doesn't change, but the discount rate of the DCF has increased, the value of a growth stock will decrease. Investors will consider the previous price levels of the stock as too high and will start selling.

How to avoid: Inflation is very tricky and while they might say otherwise, it's not very well understood. To avoid being too affected by the above situation you can diversify in value stocks as well, which tend to perform well in high-inflation times. You can also try to analyze if the company is such that they can increase their prices in high-inflation times (effectively cancelling the inflation effect by transferring it to their future cash flows), or you can make your own judgment about what is going to happen with inflation in the long run.

You take on currency risk when you keep cash in foreign fiat

Imagine you keep a part of your cash in USD, since you like to diversify in the US market in addition to Euro. In the last year, USD has deprecated by 10% against the Euro and all free cash in your account would have deprecated the same way.

When the FED is printing money in the trillions, it would be foolish to assume it will have no impact on the demand for the currency. Of course if there's more of it in circulation, interest for it will decrease. Supply and demand. But by how much, that's a great question.

When you own a share it's not really meaningful anymore what currency you own it in. Markets will ensure that there won't be any arbitrage between the different currencies. 

How to avoid: Keep your cash in your base currency, if you want to avoid currency risk. When you sell a stock in a foreign currency, invest the proceeds in another stock or convert to your base currency.

Shorting has unlimited downside

If you believe a stock is overvalued, you can sell it short. The idea is that you borrow a stock from somewhere, sell it on the market for 100€. It then goes down to 80€, you buy it back and return to the original owner, netting 20€ of the whole trade.

But what if the stock keeps climbing, to 200€, 400€, 1,000€, 2,000€ etc. You still need to buy it back in order to be able to return it to the lender.

GameStop's stock price went up from $10 in September 2020 to $350 in January 2021 in what is called a short-squeeze. The same is happening now to AMC that has gone up from around $2 in December 2020 to $48 in June 2021. The underlying fundamentals have little to do with it, but instead, what is taking place is a coordinated effort by private investors on Reddit to bankrupt certain hedge funds that have shorted the companies.

How to avoid: My recommendation would be against selling a stock short. A better way to bet against a stock would be options. If you believe the price of a stock will decline, you can buy put options. Put options give you the right, but no obligation to, sell a stock at a certain price at a given point in the future. The maximum you can lose is the premium you pay for the right to sell at your selected strike price.

Exotic countries can steal your stocks

Yeah, that's right. Look at what's going on in Russia. They already simply decided that the airplanes they had leased won't be repossessed due to sanctions, but instead be placed in Russian airlines' control. Russia placed their stock market on hold after sanctions drove huge amounts of companies to shut down their businesses in the country, and when they re-opened, they disallowed foreign investors to sell. Basically, money invested in Russian stock is frozen and cannot get out. It is completely in the realm of possibility, that Putin makes a law to churn all stocks owned by foreign investors, or that ownership of them is transferred to the state.

How to avoid: Always weigh political risk when investing. Don't invest too significantly into markets you don't trust to be civilized.

The price of the product drops

The most obvious example I can think of is mining companies. There's typically a certain price level at which individual mining companies are profitable. For the best mining companies that level is lower than for others, depending on the efficiency of their operations. If the price of the metal they mine drop below that level, they will be forced to halt operations.

How to avoid: This one is difficult. You should try to predict how the price of the commodity will develop over time by looking at global demand and supply, but sometimes that is very difficult. Also, you can try to hedge yourself against falling prices with bear derivates, but I personally try to avoid companies that don't have strong pricing power. You can prefer companies with a high moat such as Apple or Coca-Cola instead.

What else comes to mind?

Did I leave something important out? If so, comment below and I'll add them to the list!

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