It's week 3 of Risk Month here at the RBI Podcast, and today we wrap up with points #21 - #25 of our risk scoring system. With these final questions we turn up the Foolishness and break a few of our own rules!
Rule Breaker Investing
Calculating Risk Foolishly: CRI vs. VA (3/3)
It's the Rule Breaker Investing Podcast with Motley Fool Co-Founder, David Gardner. Welcome back to Rule Breaker Investing, I'm David Gardner and March is, say it with me, yes, March is risk month and we are going to conclude our series on risk with this episode of Rule Breaker Investing. I have laid the track, I've laid the groundwork for today's podcast. We have gone over what risk ratings are at the Motley Fool, we've talked about how we come up with them. I've explained that it's a 25-point scale and two podcasts ago I took you through risk rating points number one to ten. We used our two example companies, Carters and Virgin America and then last week I took you through numbers 11 to 20. There are 25 points overall which means this week we'll be a little bit quicker and this will be points number 21 to 25 and some concluding thoughts, I think some important concluding thoughts about risk ratings. In fact, an interesting revelation or two awaits us at the end. If you don't have time for anything else, they just skip to the end because there's some key points there but why would you skip to the end when we had this time together each week and in this case we'll be going through 21 to 25. You want to feel like you've closed the loop on this system and this is I think going to be one of those series that I'm pointing to a year from now saying, "Hey, go back and listen to this for new listeners because we've been pretty thorough going and that's going to all come to an end today as we close out risk ratings in rule breakers and stock advisor." Just before we start with number 21, I do want to mention one special note. This Friday there's going to be a bonus episode of our Market Foolery podcast. Now I know that there are a lot of Market Foolery fans out there. I'm a Market Foolery fan too and with Chris Hill and the team, I got to be on this podcast. So I'm one of the people on it. We've got something fun that we're announcing so I hope you're going to tune in to Market Foolery this Friday. Oh and by the way, I want to mention that I'm going to be a way spring break the week of our mailbag which means we're going to tape it early. Therefore, if you'd like to be in this month's mailbag, we urge you to let us know right away so in the next 48 hours or so because I'll be taping later this week. If you have any thoughts or questions for Rule Breaker Investing the podcast, just tweet us at RBI podcast or email us at rbi@fool.com. Those are the two ways always to reach us for Rule Breaker Investing and for mailbags. So get your questions and thoughts in. All right, number 21 that's risk rating question number 21. We entitled this one Immaculate. Is this company fault free and fraud free in all its corporate statements and deeds? Is this is any company fault free and fraud free in all its corporate statements and deeds is is any company fault free in all its deeds? This was an intentionally written question to create a plus one for every company that you and I ever look at because as we develop the system, I started realize, you know, here's a potential problem. If any company gets a yes to every single question, what will it score be? And the answer as I think you know by now is it will be a zero. And does that message really translate? Does that send the right message to the world that any stock or company has no risk associated with it at all? And of course, the answer is no. So because I was the one helping devise the system and I like to think in simple numerical terms that plus one works until or if you ever get some situation where you never have a plus one for something and you tell the world, it has a zero risk rating. But this is the rigged question in our system. I'm glad that I'm letting you in on the secret here in podcast number three closing out this series. You need to know that nothing is immaculate. We are all human. We are imperfect, especially our companies and and there could always be mistakes. Sometimes, mostly, I would say unintentional mistakes. There are a lot of companies mine my own included where we have a good heart for what we're doing. We're trying to do our best, but we make mistakes. Then there are the cases where there is fraud involved and I've picked some of those stocks too. I'm sorry whether it's Satyam computer systems, which five or ten years ago was a major player as the sort of number one Indian software outsource company. So something like at least half of the fortune 500 were using Satyam for software development offshore in India. It was all real. It was, I presume, good software development. That's why some of the most esteemed names in the United States of America were using Satyam to do some of the software work. Here was the problem. The management team was cooking the books and so what looked to be big sales and lots of profits is it turns out we're a fair amount of sales and no real profits. And that stock declined on my watch under my advisement at Motley Fool's Stock Advisor more than about 90 percent, one of my very worst picks of all time. But similarly, not quite as fraudulent but similarly poorly managed and motivated was Krispy Kreme, those of you who are long time stock advisor members might remember that we lost about 90 percent somehow managed to lose about 90 percent of our investment on donuts and a long time well branded company is still alive today, mismanagement at the CEO level on down. So sometimes even though we've asked all our questions and we've done our best research, you will be simply flat out shocked or disappointed by what your company's done. Sometimes we're shocked or disappointed, but by what our own family members have done are our friends. Life is full of surprises. I'm happy to say I hope most of them are good surprises, but you just never know. And so immaculate number 21 makes that point. I hope it drives it home and ensures that Motley Fool risk ratings always are at least a one. Number 22, number 22 is labeled you as in Y O U U. Here's the question. Do you want to know more about this company? Are you willing to dig deeper, learn more and ask questions on the discussion boards of the Motley Fool in order to actively understand this company? So if you're already getting a sense that some of our final questions here are sort of the meta game I've taken you through questions about the company. Questions about the management, questions about the financials and the competitive set. All of these things really kind of 101, investing 101 kinds of questions here. We're getting into some of the meta game of how we think at the Motley Fool. And one of the things that I think is that your risky stock might be my safe stock and vice versa. It's not always just about the objective thing that's separate from you and me. It's a stock where risk resides, is it? It's often in our own hearts and minds. And if we're not studying something or not as interested in that thing, then it's risk year for us. So for example, when I talk about Carter's or Virgin America is either of those companies, one that appeals to you, one that you would personally to use our language again, be willing to dig deeper, to learn more, to ask questions about. Or is either of those businesses or any other that you're looking at something that you would say, no to that, no, I'm not willing to dig deeper or learn more. I'm just not that interested or I don't know much about that company or industry. And I don't feel positive energy toward wanting to do more of that research. And so this is a really important question that's solely focused, not on the company, but on you and me. And I tend to answer yes to most of the companies that I look at and really all of the companies I recommend, because if I'm not motivated to learn more, then it is riskier for me. And probably I'm not going to do as good a job as a stock picker or as an advisor here at the Motley Fool. But even within my yeses, there are some really strong yeses like, yes, I love this company. Like, let's see, Activision Blizzard, a video game company, I love video games and I love their video games. And I also love Netflix and lots of other companies that I can answer really strong yes to. And then there are the lighter yeses. And I would say both Carters and Virgin America, for me personally, are lighter yeses. Yes, I am interested in apparel. And I think focusing on the babies and toddlers markets is really pretty cool and a great niche. And I like to learn about the corporate history here, but am I a real shopper myself, not as much for this company? I was back in the day. Virgin America, I like the brand. I enjoy the experience being on the airlines. I'm definitely motivated to learn more about it. Am I looking to be an airline industry expert? No. And I think my stock picking record will show that. So even within the yeses, there are relative strong or weak yeses. Anyway, I think you get the point. So now we can answer both of these questions for Carters and Virgin America. I think you already did it and know it for number 21. Are these companies immaculate? The answer is no and no, respectively Carters and Virgin America. They are human. They are probably not fault free. And number 22, only you can answer. But for us, we answer yes to both of these. So we don't need to add any pluses for these two companies. But if you don't feel that interested in either or both of them, then you should give it a no and score your risk accordingly. And now we get into numbers 23 and 24. And here again, we're being creative and doing something a little bit different. And I hope you'll get this. I think you will. So each of these two questions is specifically about the company itself. And it's freshly written by you or me or our analyst. And you're simply encouraged to ask and answer the most insightful question that you can come up with when assessing this specific company's risk. I'm going to take you through Carters and Virgin America in a second. But so number 23 is about this company. Number one. And number 24 is about this company. Number two, and again, you are literally asking the first and second most insightful questions you personally can come up with when thinking about this particular company's risk. I hope you can see why we devise these questions as number 23 and 24. We wanted at least a few of the questions to be unique to each of the companies that we're looking at. Every company is different. Even operating within the same industry, there are whole different dynamics to companies. How old are they? How well managed? Who's got a brand? Who doesn't? All these questions, everything is unique. And so this part of our system embraces the idea that there are two important questions that you could only ask of this or that company. So I will now take you through the ones for Carters. I'll do 23 and 24 at the same time. For Carters, our analyst's most insightful question was this. And I quote, "Has the company's online sales growth been outpacing total retail sales growth?" And that was written in 2015. It might have changed since then. As I mentioned, over the course of the series, we're using slightly dated info, but mostly current. So here was the answer to that question. The answer to that question is yes. As e-commerce continues to be an opportunity for Carters, the results are proving that management can execute. Last quarter, our analyst wrote, "Retail sales grew 12% while e-commerce sales increased a solid 14%. So yes, online sales deemed to be an important part of Carters' future and a risk factor are outpacing regular sales." And then number 24, the second most insightful question, our analyst, in this case, it's Jim Mueller, for those who know Jim's work at Motley Fool Stock Advisor, Jim's second question was this, quote, "Is the company taking steps to capitalize on potential sales in emerging markets?" and the answer to this one is yes. Early in 2015, again, this was written later in 2015, looking back at that quarter, the company had opened a store in Riyadh. That's right. In Saudi Arabia, the ninth store Carters has in Saudi Arabia, just one example. So international sales, China, et cetera, even places like Saudi Arabia, an important part of the Carters' mix, and so Carters gets a yes and a yes for both of these questions, keeping its risk rating at just four as we enter the final question. And now I want to briefly, before I go to Virgin America, just opine and observe, I should say, one thing about asking these questions and answering them, because I'm hoping you'll try these at home with a company you're looking at. And I hope you can realize that what you're really able to do here is you're able to phrase the question any which way you'd like, which means you could essentially make the question say yes or no based on simply on how you've written it. For example, Jim could have written that in such a way, that question about potential sales in emerging markets, that he answered it as a no, even still making the same point and providing the same facts. The question that you ask and how you phrase it sets yourself up to answer yes or no. Now that might sound like a little bit of a rigged game. You mean I can simply ask it in such a way that I could give it a yes and keep it safer looking? And the answer is yes, you could do that. We designed these questions, not just for you to ask and answer the best questions you could about this company in assessing its unique risk, but further looking over the number that you're seeing for this company as you become an experienced person doing and using this system. You might feel like this stage, Gee whiz, Carter's you might think is really a pretty safe company and a four at this stage is pretty appropriate for it. So you know what, I'm going to make sure it stays as safe as I think it is by making sure the questions answer with yes. On the other hand, if you felt that Carter's was riskier than that and you wanted it to be a five or a six, you could simply set up these questions so that they would be answered no. And so this is again part of the creative process, but also using some of the wisdom that you gain, the pattern recognition you gain as an analyst over time, you can start nudging these scores up to two points either way, right? So there's a plus or minus two that you control directly when you create a risk rating for a company and it allows you to notice nuance and put something at sort of the number where you feel it should be. You don't have mass control over the system. There are 23 other questions you're going to have to answer yes or no based on the question, but this one is really your opportunity to add some intelligence of your own. And now to Virgin America numbers 23 and 24. The best question that our analysts in this case, it's Tim Byers, those who know Tim's work in Motley Fool Rule Breakers. He's the one who's been doing the work here that I've been sharing with you these last few podcasts. Tim asks of Virgin America his best question he could come up with in 2015 was can Virgin America grow sustainably even as it faces increased competition on popular roots? That was Tim's question and he gave that company and that answer a no. Tim wrote, we're being conservative here because we just can't know for sure. The forthcoming Boeing 737 MAX and the A320neo should allow more discount carriers to fly to Hawaii and other over water destinations, which have traditionally been the domain of legacy carriers, Virgin America must set itself apart in order to win and keep customers. So Tim's being conservative and he gave them a no in terms of being able to grow sustainably as it faces increased competition. Obviously the reason we recommend the stock is we think this is just one factor in thinking about the stock, but no and plus one for Virgin America for question number 23. And number 24, can investors be assured that Virgin America will produce long term profits and in the process market beating returns? That was Tim's question about Virgin America stock and to that question he gave the answer, no. He wrote again, we're playing it safe. We're watching for incremental fair increases from enhanced services such as fast in-flight Wi-Fi as well as larger buys as passengers agree to fly longer distances with Virgin America. Becoming all Airbus fleet should help keep maintenance costs in check in the meantime. But again, he wrote, can investors be assured that Virgin America will produce long term profits and beat the market? And he wrote, no, which sounds right because I don't think we can be assured of much, especially in the airline industry. So in so doing and asking himself two questions that produce nose, Tim ratcheted up the risk rating to the level that he felt was appropriate. Again, those were his two best questions if we talk to him today and you can join the Motley Full Rule Breakers and come right to our discussion board on Virgin America and ask Tim whether he has new questions in mind today. But if he were updating this for 2016, he might come up with the same questions again or maybe even better questions in light of where we are now in March 2016. All right, so we've now set the stage for the final question. And if you're getting an anticlimactic feeling, you're right to feel so because we don't actually have any real drama at the end of our risk rating surveys. In fact, I would say the real fireworks of the grand finale here were questions 23 and 24, not just for the creativity and the interest and the extra effort that they require of the analysts, but also for the colorful variety that we get in those questions and the ability to move up or down the risk ratings. So here comes number 25. And if it sounds somewhat like the immaculate number 21 question, you would be right in observing such number 25 we call bulletproof. Are you certain this company is invulnerable to external world or macro economic events such that you're sure you can get all your capital back? Now the answer to that question in every risk rating we've run so far in Motley Fool history is no. And it's kind of another way of ensuring that we have a minimum risk rating, I guess, not just zero, but maybe even above one. Now it's certainly possible that you or I for a given company might answer. In either the case of number 21 immaculate or number 25 bulletproof, yes. But I would submit it's very, very, very unlikely. So there could be some far-flung day where we do actually give a yes to some company for some reason. But the reason we wrote this one up is not just to kind of add another plus one to the risk ratings and bulk them off a little bit and haven't started to, but really to remind the risk greater and the student of investing and anybody running the system that even though you may have picked a great stock that matches up with most of the good stuff we're looking for as an investors. And even though that company may be doing everything right, unfortunately, there are factors well outside the control of every employee of that company, every customer of that company, you never quite know what can change macroeconomically or in terms of world events so that it would be possible despite having made a great call and invested well to still lose a substantial portion of your capital that you never get back. That's why we call it bulletproof. We don't really think anything is bulletproof and we encourage you as an investor to recognize outside of the company and the industry itself that there are factors external to those that could mess with our profits as investors. So I hope you get the point and I hope you'll also agree with me, it's kind of an anticlimactic way to end risk ratings, but before I do end, I do want to tally up and give the final scores. I've talked about these repeatedly through the series, but if you've done the math with me, Carter's today received two more nos and I bet you can remember which they were immaculate and bulletproof. Carter's in our esteem is neither and that puts Carter's at a final risk rating of five, which is quite low on the overall risk scale. And if you're keeping score at home or while jogging or the kids in the car, then you'll possibly know or have noticed that Virgin America got four nos today. The only yes it got was our yes on the, do we want to know more about this company? We give that a yes, but all four others have dinged Virgin America pushing its risk rating up as we conclude to 12 significantly riskier than Carter's. And now a few concluding points. First, I hope you'll now recognize that when I did on February 10th, my five stocks to feed the bear podcast, which got pretty good response overall, and we picked five stocks there during a really dark time for the stock market, I hope you'll now, if you were to go back and listen to it, you'll recognize I was talking actively about risk ratings during that week's podcast. In fact, I was saying we've pulled stocks that are only fives or sixes as I put this list of five stocks together for you. And so now you'll see that they were more like Carter's than like Virgin America, as I was thinking through them and picking them. And as it turns out, Carter's was one of those five. And just for the fun of it, we're taping the afternoon of Tuesday, March 15th, just a day before this podcast goes out. The stock market is up eight percent since then. Our worst performer of those five is Planet Fitness. It's up five percent, so it's three percentage points under the market, rats. Second worst is IPG Photonics. It's up eight percent as well, so it's even with the market, so the news is going to get better from here. Our third best was Carter's. Carter's is up 18 percent since we, since I put that stock out there as a good stock in this bear market, it's up 18 percent, 10 percent points ahead of the market. And then the two stars, Mercado Libre, up 29 percent and LMA, up 33 percent. So if you do the math on that little five stock portfolio, we created together some six weeks ago or so. We've gotten outstanding results. Rarely do we have six weeks where we can expect a few of our stocks to go up more than 30 percent or so, but that's kind of how the market's done. It's bounced back significantly up eight percent about what it makes in a typical year in just the last six weeks. So that's, it's fun now to look back on that and I hope you can now appreciate a little bit more what I was doing there. I was intentionally trying to pick stocks that were less risky, but I, as you'll also recall, I was picking smaller cap stocks, which typically snap back because they get knocked down more in down market. So I was picking stocks that I thought might snap back higher. We'll see how it really plays out. Six weeks doesn't matter that much to me. It's still fun to keep score. And finally, a last thought. And this is maybe a new insight for me of potentially developing insight that I'm going to share with you. This is really the first time I've talked about this. So there's a potentially surprising insight coming from this work on risk ratings. And it first came to my attention when a Motley Fool member named Tom Rooney, TP Rooney III on the Motley Fool discussion boards, a member of stock advisor, posted his own look at risk ratings and how they'd performed. He was just looking since 2002 at our scorecard of stock advisor picks and he was looking at risk ratings, which we've been doing for some years. And he said, for stocks held at least five years, what are the chances that each of them would be beating the S&P 500 with that stock today, given its risk rating? So what are the chances that for at least five years you'd be ahead, given different levels of risk rating? And this is again, one member, we're not backing this up with deep data. I haven't even gone back over these numbers myself. But I also appreciate the extra work and I wanted to share it with you. So Tom Rooney's work reveals that for stocks that were 13 or higher, 0% were beating the S&P 500. By the way, this is not every stock we've picked. These are stock advisor stocks that have been held for a while. And so please don't think that anything 13 plus is poison and stock advisor rule breakers or anything else we do. But for this study and what he was doing, ironically, during, I would say also kind of a bear market, like not a great time, late 2015, a lot of my kinds of, especially some of my riskier stocks, it just had a really bad year. So there's probably some bias, just the timeframe that's being picked. But from there, let's go to the very best performing group and the very best performing group were stocks that had a risk rating of 4 to 5. That's right. 86% of those were beating the S&P 500. And if you care, the 6 to 7s were 47%, the 8 to 9s were 70%, and the 10 to 11s were 59%. So it's kind of a mix, but more beating the market than not in the single digits. But the very best group were the 4s and 5s. Now I want to hasten to add that the risk rating system was not devised at all for the purpose of trying to assess what will beat the market or not. As Tom Rooney mentions in his study, he's not actually looking at by how much you beat the market. It's just did the stock, yes or no, binary question beat the market or not. So if you were to actually add in the different returns, you might see that you'd really want to own this group, not that group, because the winners might have won by so much that they wipe out the losers. So this is only looking at just the chance of a stock beating the market. But given that, and given my own intuition, there's a possibility that risk ratings over time might not just be measuring risk, but might actually help you and me do a better job identifying which stocks that we might buy are more likely not just to not lose us money, which is how I defined risk two podcasts ago, a substantial amount of our capital held over the long term. But instead potentially to help guide us to the stocks that are more likely than not to beat the market averages. So there's a final thought and a bonus to this work that I've shared with you over the last three weeks, the possibility that this might even be aiding you to finding next year's market winners. All right, I want to thank you very much for bearing with me throughout this series. You know, my general goal for our podcast is to be kind of like 15 to 20 minutes for the last three weeks we've been running more like 25 plus minutes because it's a deeper system. It's longer form audio. I hope you've enjoyed it. I've certainly enjoyed presenting this to you and we've gotten some really nice comments on Twitter, which I always appreciate in some good reviews too. Thank you very much. So thus concludes our risk ratings. I declare the rest of March risk free. In fact, next week, we'll be coming back with greatest quotes volume two, which I'm really looking forward to do. I shared greatest quotes volume one some months ago, so it's time to bring the second one back in that series. And I should just mention enclosing again, we'll be taping our mailbag episode this week. So if you want to be included in mailbag with a thought or a question, remember to tweet us or email us in the meantime. I hope you have a wonderful and relatively risk free week full on. As always, people on this program may have interest in the stocks they talk about and the Miley fool may have formal recommendations for or against. So don't buy or sell stocks based solely on what you hear. Learn more about Rule Breaker Investing at rbi.fool.com . [BLANK_AUDIO]