Tags: quality | junk | stock | PE

The Best Way to Manage Risks

By    |   Monday, 19 August 2013 07:56 AM

Ideally, it would be great if we could obtain great returns from something that carried almost no risk whatsoever. However, that simply doesn't exist.

Therefore, we either have to go with low-risk instruments that offer almost no return — and could offer a negative return when accounting for inflation — or we've got to go into assets that can be more volatile, but could return more growth. It's the latter road that I'm taking.

And I've found that there is a smart way and a stupid way to go down that road. Honestly, many investors go down the stupid road unintentionally. So let's talk about the smart way to get great growth and a great return out of investments while taking the least amount of risk possible.

When some people think of risks, they think of avoiding lots of risk by placing stop-loss orders on their stock trades and diversifying among many stocks within many sectors of the economy, etc.

However, for me, risk management starts with the asset at hand. In other words, what are you buying? Is it quality or practically junk?

Some people buy a stock just because it's popular, in the news a lot or just because it's cheap. However, none of those are good enough reasons to own a stock, in my opinion.

Don't buy bad assets even if they are at cheap prices. Buy good assets at discounted prices instead.

Lately, I've had people ask me about buying Detroit bonds or American Airlines (AMR Corp.). They seem to love going after something just because it's cheap. But some things are cheap for a reason. You don't want cheap. You want value. And value is created when you find good assets trading at a discount.

In order to find this, you'll have to look for stocks that the investing community hates and even shuns right now. From there, you sift through what is a quality company and what is truly junk.

Most people, for some reason, go for the junk. I think it's the greed inside of man that loves to gamble rather than invest. But true wealth is gained over time through investing, not through rolling the dice on a junky company's stock.

How do you find quality companies? First, look for the biggest companies in the hated sector. Now this is doesn't tell you that you've for sure got a great company, but it's a great starting point.

From there, look at things like its price-earnings (P/E) ratio and its price-book ratio. From these metrics, you'll see how the stock's price compares to its earnings or its net assets. The lower then number, the better.

If they don't have a P/E, then that means they don't make any money. Why in the world would you invest in a company that doesn't make money when there are plenty of companies out there that have made money for the last 50 to 100 years?

Remember, a business is a true business because it ultimately makes money. I know in the start-up phase of a business, there is an exception, but most people should never be invested in start-ups or IPOs when they don't have a well-developed portfolio of solid stocks already.

Next, look to see how much cash they have on their books. If you really want to consider risks, this is a huge metric to look at. The less cash, the more risk you're taking on, the more cash the company has on its books, ultimately, the more likelihood that the company is going to survive and thrive over time.

How much debt do they have? If a company has over 50 percent of its company as debt, pass on that stock. If they have a third of the company as debt, then you're taking on less risk.

So in the end, if you can start hunting for stocks in shunned areas of the stock market, that's where you'll find the "bargain bin" worth sifting through.

From there, a lot of sifting is required to dodge the land mines out there. By using the metrics mentioned above, you can end up owning a portfolio of 20 to 30 stocks over time that carry far lower risk than the average stock out there does and likely has more upside growth in the stock price relative to the average stock out there too.

One final note, when the major stock market averages are at historically high P/Es, it will become tougher to find bargains. But after huge stock market corrections and even a stock market crash, you'll find that bargains are a bit more abundant.

So if you've got some cash sitting on the sidelines, you might reserve some of it and have it allocated just for severe stock market corrections. That alone can help you gain an edge on your investments over time.

Remember, true successful investing doesn't happen in an instant, it happens over time. It's not a sprint ... it's a marathon. So take a long-range view. Don't expect your stocks to go instantly into the profit zone.

Warren Buffett and others don't have this happen, yet they're ultimately successful because they pick great assets by using metrics I've discussed above and they are patient and give those great companies the proper time to do what they do best. And in doing so, the investors in those companies reap great profits through stock appreciation and increased dividend payments through the years.

About the Author: Sean Hyman
Sean Hyman is a member of the Moneynews Financial Brain Trust.
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Ideally, it would be great if we could obtain great returns from something that carried almost no risk whatsoever. However, that simply doesn't exist.
Monday, 19 August 2013 07:56 AM
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