One aspect of investing many struggle with on a daily basis is identifying and quantifying risk. Let’s face it, none of us want to admit we have a risky portfolio. With all the valuation metrics available at our fingertips, how could we take on too much risk? The answer is simple. We don’t really know what risk is.
To the average investor, risk has a negative undertone. “Avoid risk” probably invades all of our subconscious. But should it? Can we even avoid risk? The answer, in my opinion, is no. Risk exists on many levels but the most common in the average investor mind is the risk of losing money. It’s a struggle for us all and one that should be considered. However, let me offer another risk. The risk of not growing your wealth ENOUGH. We all must learn to embrace risk and understand it’s unavoidable.
When we all choose to devote a portion of our portfolio to individual stock picking, we’re risking losing money compared to merely placing the same funds in an index fund. So why do it? It can be fun, perhaps our ego leads us to believe we can emulate the legendary investors of our time who regularly outperform the market. Maybe we just find indexing a little boring. Whatever the reason, there’s always that elephant in room. We must not avoid it.
Risk can be embraced and harnessed for what it is. A way to growth wealth faster. It may feel good to have a stock portfolio full of AT&T (ATT),Pepsico (PEP), Bristol Myers (BMY) and the like, but if your portfolio is made up of nothing but plain Janes, over most time frames, you’re going to be better off in an index fund.
A portfolio stocked with utilities and staples augmented by a muni bond ladder might provide some with a large enough return to satisfy their needs. Shouldn’t we strive for something more than merely getting by with satisfactory returns? Shouldn’t we try to find one or two stocks that boost our gains so greatly we don’t ever need to wonder if our utilities will raise their dividend? That would be nice right?
While every portfolio should have some stable stalwarts that should help cushion the blow during any market downturn, don’t make the mistake of using the same valuation metrics you used to find them to identify a more speculative portion of your portfolio. Be sure to ask yourself, “Am I taking enough risk?” vs. merely, “Is this stock too risky?”
The most fabled valuation metric is of course P/E which is what we are paying for a company’s earnings. Some people like trailing P/E, some folks like forward P/E. The truth is most people use whichever best defends their current view of a particular equity. This applies to all valuation metrics. Search your feelings, you know it’s true.
I don’t find P/E to be very helpful to be honest. We’re looking for stocks that can double, triple or even the elusive “10 bagger” as Peter Lynch would call it. There might be a few out there in the annals of history, but I don’t know many companies that trade at a 10 or 12 P/E that double or triple quickly.
On occasion, P/E can be helpful when comparing within a sector. When McDonald’s (MCD) was trading around $90 in early 2015, it’s P/E was around 20. For MCD, a 20 P/E is not cheap but when you compared to rest of its sector, it kind of was. I’m not talking Shake Shak (SHAK) either. Burger and fast food chains that have been around for decades were trading at 30-40x their earnings. With a 3%+yield at $90 and the idea that MCD could simply close the gap a bit between its peers, you’re probably going to get a decent return right? In this way, P/E can be helpful.
But don’t wrap yourself too tightly in the warm blanket that is P/E. Be wary, P/E’s can stay low for a looooooong time. Stagnant earnings, falling revenues, any number of things can paint a deceptive picture of a stock free from much risk. IBM is one of the best recent examples.
Judging a stock merely by P/E will keep you out of the best gainers. I like growing revenues. It’s hard to massage sales. I can assure you that if a company is growing revenues regularly at 20-40% year over year, it will not be trading at an attractive P/E. By the time it does, it could be decades later. The obvious examples of this are Amazon (AMZN) and Netflix (NFLX).
It can appear to be dangerous to pay “up” for companies like these and one day it will be. They’ll mature, start paying a dividend and graduate into a blue chip value stock, but that could be decades away. Don’t you want to be there for at least part of the growth stage? Can you risk missing out?
By the way, if you ever have a friend or casual market observer question an individual stock you own based on their own valuation simply reply, “It has asymmetrical risk to the upside”. They’ll leave you alone quite quickly. It’s also makes you sound really smart.
With the greatest risk, come the greatest rewards. The equity market is risky overall. It can trade down 20% at any given time for almost any reason. When it does, it’s the riskier equities that will outperform during the recovery. There’s always a recovery despite what you might read or hear. A portfolio free of what you might perceive to be risky assets will almost certainly underperforms.
Risk is not evil. You must embrace it and accept that it cannot be avoided. Don’t avoid a stock merely because it appears expensive. Dig deeper, there could be something there. The sooner you realize it, the better your investment returns will be.