March is Risk Month here at the RBI Podcast, and today we continue with points #11 - #20 of our quantitative investment risk scoring system. The competition, the stock, and the management get the spotlight this time, along with a little secret sauce involving The Motley Fool's premium services.
Rule Breaker Investing
Calculating Risk Foolishly: CRI vs. VA (2/3)
It's the Rule Breaker Investing Podcast with Motley Fool Co-Founder, David Gardner. Welcome back to Rule Breaker Investing. I'm David Gardner. Thanks for joining me this week, and it is March, and it is the month of risk. That's what we've dubbed it here at Rule Breaker Investing. So we're talking about how to measure the risk of individual stocks. It's a novel thing, and it's even more novel when you make it into a number. So we put numbers on the risks of individual stocks and just to review a little bit about what we did last time. So every stock that we rate is on a 25-point scale, and the higher is the riskier. So a 25-point risk stock is the riskiest thing that we can never imagine. We would never probably buy that stock. So the lower is the lower risk, and we get there by asking 25 questions. Every single one of them is the yes or no question, and last week we went over the first 10. So this is part two of our three-part series on measuring risk. And I'm going to kind of dive back in right in the middle. I do want to mention before we start that if you're just tuning in to Rule Breaker Investing for the first time this week, I would encourage you, I would highly encourage you to go back and just listen to last weeks because it sets context and gets everything in motion for understanding what we're doing this week. But even beyond that, if you are new to Rule Breaker Investing, I would highly encourage you to go back to the start of this podcast and listen to our first five. In fact, the very first one that you should listen to is are you a Rule Breaker, a slight pet peeve of mine, the way we publish them to iTunes. It doesn't look like it's first, but that was the first one I did. It's a short podcast. I think it's about five minutes long. Are you a Rule Breaker? And then as long as I'm going to suggest you listen to the first five, I should give you the order. The second one is the what makes Starbucks, et cetera, and then you can go from there and you'll understand because I'm taking you through the Rule Breaker traits. And those are short podcasts, each is between about five or to 12 minutes. And so if you put all five together, you can do it in an hour or less, and it really gives you a grounding for understanding what I'm doing and what we're doing with this podcast every week. All right, I should also mention we have two example companies we're using for this series. We have Carters, the Baby and Toddler Apparel Company, and we have Virgin America, the airline. And as we left off last week, having gone through the first 10 questions, again, every single yes is good. That's a safe answer. Every no, since these are binary yes, no questions, every no is bad. That's a risky answer. As we left off last week, Virgin America had had two no's, Carters had had zero no's. So that's where we're headed. I also spoiled it last week by telling you what the final risk ratings would be. I will spoil it again. Virgin America is going to end up being a 12, Carters is going to end up being a five. So again, as of last week, it was two to zero. We're going to pick it up now this week with the next section because yes, our 25 questions are grouped in sections. And last week we covered the first two sections, which are questions about the company itself. We had five of those. And then we had five questions about the financials. So that was the 10 that set us up last week. This week we're going to have four sections that we go over for these next 10 questions. They're grouped into the following categories. The first we'll do is the competition. Then comes the stock. Then management. And finally, service specific, which I will explain when we get to it. So let's kick it off with number 11. This is the first of three questions about the competition. Number 11, we call underdog. This is the company free of any direct competitors that possess substantially greater financial resources. Right. So basically, is this company an underdog to some much bigger dog in its respective industry among its competitors? And you can see why this would matter because if a company is competing against a much larger entity with more financial resources, perhaps more employees, more customers, more history, that's riskier than if you were that much bigger, safer thing. Pretty straightforward. A lot of our questions this week are pretty straightforward. So there it is. And since we're going over our two example companies for Carter's, the answer is yes. Carter's is free of any direct competitors that possess substantially more resources. So it is not an underdog. Yes, it is the number one player in its demographic. So Carter's is safe. And by the same measure, make a guess here. What do you think? Virgin America, are there bigger airlines out there that Virgin America competes with? And of course, that is the case for Virgin America. So in answer to the question, is the company free of such competitors? The answer, of course, for Virgin America is no. The airline business is brutally competitive. Virgin America competes with some of the biggest names in the industry for flyers. So we're now up to three for Virgin America. And that brings us to the next one, number 12. And number 12 is kind of the opposite. It is the Yang to number 11's Yin. So this is Goliath. That's what we call this question. Is the company free of disruptive upstarts visibly challenging its business model? So here again, this is the exact opposite situation, but can be similarly problematic. So you generally don't want your companies to be getting disrupted by smaller players sometimes Silicon Valley financed with some cheaper, better model out there. That is risky. And so that's the question we ask. Number 12 of all companies that we look at, are they free of these kinds of disruptive upstarts? And in the case of Carter's, the answer is no. And this is the first no for Carter's because in addition to competitors like Old Navy and the Children's Place, which you may have heard of, that's another public company, it's a Nasdaq stock, there are numerous private labels as well. So it's pretty clear for Carter's that it is not an untouchable Goliath. Virgin America, interestingly, is also a no. Because there are other discount carriers out there that present an ever-present threat to Virgin America, JetBlue, Southwest Airlines, Heck, Spirit Airlines, which I don't think I've ever flown are notable examples, but so both of these companies get a no for number 12. Number 13. And by the way, for each of these questions, you may have noticed, we have usually a name for the question. So I'm kind of saying underdog or Goliath, we've named each of our 25 questions just for reference purposes. And so as a community on our discussion boards, we can use those terms to understand what we mean. And the question itself is, would potential new competitors face high economic, technological or regulatory barriers to entry? Are there hurdles in place that make it really hard for new competitors that have not emerged yet to come forward and threaten the profits and the success of the company that we're looking at? So I think that one's pretty straightforward. Let's look first at Carter's. Would potential new competitors face significant barriers to start making baby clothes? We think maybe you do too? No. I mean, generally speaking, it's an industry that doesn't boast high barriers to entry, making clothing. So, of course, the company's brand value is very high and it's tough to replicate by competitors. And that does represent, but we generally try to be conservative with our answers. And so we give this one a no for Carter's. I'm going to reiterate something right now I said last week. You might disagree. You might feel like it's hard to come in and compete with Carter's based on some other factors that are in your head. And if that's the case, you would give this a yes. And that would make Carter's for you a safer stock than it is in this case, in our opinion, on this question. So this is an important thing to note about our risk ratings through the Rule Breaker Investing podcast. It's a creative and subjective experience. And you and I can each look each other in the eye and disagree about the answers to any one of these. And that would affect. And I think that's a really good and true point. It would really affect the riskiness or not of the stock for each of us, respectively. And now let's go to Virgin America. And speaking of being subjective, this is a hard one. Because on the one hand, it's not that easy to launch a new airline. And so a lot of us might say yes. But in our case, in the Rule Breaker Service where the stock has actively recommended today, our analysts selected no. And I think what he was thinking is that new airlines are forming and starting all the time. It's not easy to do, but Virgin America is a relatively new airline. And so at least in his mind, the answer for this one is no. So we ding and say it's riskier because it's in this business. I do want to mention that Virgin America does a pretty good job trying to set itself apart from its competitors. And so you have to factor that into the company has unique branding and unique feeling. When you're on a Virgin America flight, you know you're on a Virgin America flight. If you've been on one, I think you know what I'm saying. And the company has satellite supported Wi-Fi for long haul over water flight. So if you're flying to Hawaii, for example, you've got Wi-Fi. So some nice key indicators, I think, of how the business tries to set itself apart. But for now, we're going to give them a no and that adds another point to the company's riskiness. All right, we just finished up the competition section and now we're going to go to the stock. And similarly with this one, there are three questions, three yes or no questions that we ask about each of these stocks. And in all three cases, these are purely numerical. So you and I just went through three very subjective questions where we ask ourselves about the competition. These are just straight numbers. Number 14, we call market cap. Does the stock have a market cap of more than $500 million? Why is this a question? Why do we care about this for risk? Well, in general, I think it's fair to say that the larger a company is, the more likely it is to be safer. It probably has more employees, more customers. It operates in more geographic territories. There are a lot of factors that lead to bigger things being safer. The unsinkable Molly Browns of our world are generally the S&P 500 companies. The 500 largest companies in America today. So does the stock have a market cap of more than $500 million? Now, that itself was just a number we picked out of there. There's nothing magical about that. But what we're really separating here are companies that are micro and small cap out from the rest. Now, I should define my terms. I think not everybody knows what market cap is. So really quickly, if for any stock, if you take the number of shares that company has in total and you just multiply it by the share price that's being quoted today on your internet screen or in the newspaper, you get simple math. The multiplication equals the market capitalization of the company, the total value of the company basically as measured by its common stock. So it's a quick way to know the relative sizes and values of individual companies. And $500 million and below, in my mind, in our minds of the Molly Fool represents micro cap to really small cap stocks that because they're that small are just riskier. They're usually less liquid as stocks. Sometimes if you try to get a big position, it would be harder to sell out of that position. There's just a natural, I think, tendency for larger things to be safer. And so this is the cut-off line that we have. And Carter's, the answer here is yes. In fact, Carter's has a market capitalization of just over $5 billion as I take this podcast today. So about 10 times what we were looking for. Similarly, Virgin America is also a yes. Virgin America has a market cap, significantly less than Carter's, but $1.3 billion. So that's all we need to give a yes to number 14. Number 15. Number 15 is beta. We're going to define this term again. Is this stocks beta rating in the past 12 months less than 1.3? All right. So a really short course on beta. So beta is a way of measuring how much a share price of an individual stock moves versus the overall market. To keep it as simple as I can, if a stock moves with the same volatility as the overall stock market, then it would have an exactly even beta of 1.0. So that means when the market tends to go up, these stocks tend to move about that much. And the stock market goes down. Same thing. It doesn't mean it exactly tracks the market. It just means that the standard deviation, if you will, the volatility of the stock mimics the feeling of the overall market itself. Now if the stock is significantly more volatile than the stock market, it has a higher beta than 1.0. And we're looking for stocks that have a beta of less than 1.3. Similarly, just to close the loop on this explanation, some stocks move less than the market. The market goes up and down, but the steady eddies out there just don't really move that much either direction, and those would be so-called low beta stocks. And now you know a little bit about beta. And I should add that beta was one of the inspirations for creating this whole DAGUM system in the first place because a lot of people simply equate risk with beta. They say that's a risky stock because look at its beta. And they're just saying the volatility is the risk. I think the really subversive, and I hope impressive and interesting aspect to our risk-rating system here at the Motley Fool is that we're saying no. Risk is about a lot more than just how much a stock moves in relation to the overall market. A lot of it is about the company itself. It's about the competition, the things that were going over in our 25 questions. So I did want to do a little breakout there just explaining number 15 beta, what it is, and how a lot of people think that is risk itself before letting you know our two example companies. Carters, when we did this, this is again, toward the end of 2015 when we last ran this analysis, it was at about zero.63. In other words, Carters was less volatile, significantly so, against the overall stock market, that's according to capital IQ, which is a research service that we use this. By the way, you can typically look up beta and find it on free sites like Yahoo Finance or Google Finance. This is a term that is out there. And you can find on your own, like all of these things are, which is why we designed it that way. And then let's look at Virgin America. Virgin America gets a no. Now at the time we ran this, it was a 1.30 exactly. And since our question, and yes, we are sticklers about this, since our question said less than 1.3, we give Virgin America a no. So yet another no for Virgin America. And let's keep going now. By the way, I'll sum up where those scores are shortly, but I want to close out this section, the stock section with number 16, and that's the PE ratio, the price to earnings ratio. I'm going to be in danger of trying to define too many terms this week and make this podcast run too long. So if you don't already know what a price to earnings ratio is, you can definitely look it up online and read about it at fool.com. I'm sure I've talked about it in past podcasts and I will in future. But for now, it's enough to know the question. The question is, does the stock have a positive price to earnings multiple less than 30? So lower price to earnings multiples, but they need to exist. They can't be zero or negative. So in the case of Carter's, when we ran this, the answer simply was yes. We didn't actually noted at the time. So you could go back and look it up in late 2015, still probably true today, a PE lower than 30 and same for Virgin America. In fact, the entire industry, the airline industry typically trades at quite low price earnings ratios. So in the case of Virgin America, when we ran it, it was about 7.6 on a trailing basis. So both of the companies get a yes for number 16. All right. And so now updating our scores since we finished both the competition and stock sections and Virgin America through those six questions had four no's. So Virgin America's risk rating went from two to six as we progressed through this framework and Carter's also received some no's, but just two no's during the competition section, Carter's passed with flying colors, all three questions about the stock. So that took Carter's from a zero to a two. So again, Virgin America's now a six, Carter's is now a two as we progressed to the final two sections this week, management and service specific. So the next two questions are about management. So of course, management matters a lot. It's a big part of almost any stock recommendation that I make and stock advisor or rule breakers. And it is also part of the risk framework. As we look at companies and the first of our two questions, both of these are numerical. The first of our two questions, we call insider stake. Do any key insiders have at least a 5% stake in the company? This one's pretty straightforward, right? We like it when people, managers themselves own the stock of the company they're managing. That's important. That makes me feel safer. If you own a lot of my stock and you're running things, I feel a lot better than if you don't own any of my stock and you're running things. So 5% is a good basic way of thinking about things. Some companies have very high degrees of ownership. The Elon Musk at Tesla owns about a third of his company. But for a lot more mature companies, it's hard for managers of a company 50 or 60 years old sometimes to have that kind of a stake as the companies grow and institutions buy up the stock and generations change over over time. So we like 5% as kind of a round number. For Carter's, the answer is no. The company was founded quite a long time ago. In fact, 1865. That's right. Carter's is get this 151 years old. Wow. Their ownership altogether is about 2% the CEO Michael Casey owns about half of that, just less than 1% himself. So we give Carter's a no on the insider state question and Virgin America. And interesting case because Virgin America was started came out of Virgin, which was started by the great British entrepreneur, Richard Branson. And Richard himself, Sir Richard owns about 27% of Virgin America's shares, which should make you feel good. It would make me feel good owning the stock. However, we're sticklers on this. He's not actually managing the company. He does not have a management role at the company. So he's obviously an important insider. But for the purposes of our question, and I told you tie goes to the conservative answer for us on these, we say no, we're being conservative here. No key insider with a management role owns 5% or more of the stock. If you feel differently, Branson makes you feel safer. You're welcome to answer yes. All right. Question number 18 question number 18 is just labeled experience to the top three officers have more than 15 years of combined leadership at the company. And this one is again common sense. The longer a management team's been together, I think the safer you and I can feel about something. If on the other hand, the CFO just changed out and we lost somebody who'd been there 13 years and we have somebody who's brand new or if the manager team's very young and this is a upstart new NASDAQ IPO, we probably don't feel as safe about that stock for that reason. So experience in the case of Carter's, the answer is yes. In fact, I mentioned Michael Casey, the CEO earlier. He himself has been with the company since 1993. So there's a gentleman who's been the CEO of Carter's for 22 plus years. In the case of Virgin America. The answer is close but no cigar. When we ran these numbers at the end of last year, didn't quite add up to even 14 when you took CEO David Kush, CFO Peter Hunt and COO Steven Forte. Now let me mention that we say top three officers. Some companies, the CTO, you might rank over the chief technology officer might seem more relevant than the cheap operating officer. Other companies, you might think the chief marketing officer is a critical role at that particular company. If you don't really know that much about business yet and you wouldn't know how to answer this question, you can just take those three big roles, CEO, the CFO, the chief financial officer, chief operating officer, which is what we did in this case. But again, I'm trying to convey that there's nuance here and you really bring something to the party. The more you get into this and study businesses, the smarter you're going to get with the ways, the right ways to ask and answer these questions. And so even though almost a year has passed since we ran this, we're still going to keep them down below that 15. But by the end of this year, we'll give Virgin America a yes, assuming that executive team stays together. Okay. We're down to our last two in our final section. I mentioned that we call it service specific. And what I mean by that is Motleyful Rule Breakers is a different service from Motleyful Stock Advisor. They're the two from which these companies are drawn. Virgin America is a rule breaker, Carter's is a stock advisor stock. But for each of those respective services, they have their own strategy. And so we have slightly different questions that we ask. So we slotted in intentionally so two questions out of the 25 that are specifically different based on which style or service we're looking at. So I hope that makes sense. So for this section, I'm just going to do the stock advisor ones with Carter's first, both of them at the same time. And then I'm going to go to Virgin America with the rule breaker question. So the two stock advisor questions, numbers 19 and 20, we call respectively the stock advisor way and conscious capitalism. So the stock advisor way is, is this a solid business with proven management and a stalwart balance sheet? Now what do we mean by calling that the stock advisor way? Well, that's a pretty good way of thinking about what we're trying to do in Motleyful Stock Advisor. Find these proven management teams, stalwart balance sheets, great companies. That's the feeling of a lot of Motleyful Stock Advisor. So the answer for Carter's is yes. Yes. In fact, if you wanted to look at ratios like net debt to earnings before income taxes, depreciation and amortization, if it does, some people say, I don't want to slog through too many terms this week. It stands at about 0.5 x, come to generate plenty of cash to serve its investment needs and financial commitments. And yes, it is a solid business. We talked about a hundred plus years. So yes for Carter's. And conscious capitalism, question number 20 for stock advisor, is, is management looking out for the interests of all stakeholders, customers, employees and shareholders? And conscious capitalism is something I may have referenced in past podcasts, perhaps. Well, actually I'll say we're very likely to talk about it some in the future, but it's a framework that we use. It comes out of John Mackie of Whole Foods fame and Raj Sasodia, who wrote a book together a couple of years ago, called Conscious Capitalism, I highly recommend it to you. But all you need to know for this podcast is that we like companies that are looking out for all their stakeholders. They're not just trying to say we're maximizing shareholder value. That's the purpose of our corporation. And so in the case of Carter's, as we looked at it, we feel that the company is indeed paying good service, not just to its shareholders, but to its employees, a good place to work, into its customers, products, people truly appreciate. So yes and yes. And that closes out Carter's this week as we go through its 20 at a three. The only no in that last section was that key insiders don't have that 5% stake. So Carter stands at three as we close this week's podcast. And now we go to the Rule Breaker two questions. And since it is after all the Rule Breaker service, number 19 is we call this one six signs of a Rule Breaker does this company meet a majority of the Rule Breaker's attributes. Now again, if you're not familiar with those attributes, go back to those first five podcasts or look up Rule Breakers on the web. Maybe you remember, they're pretty much out there. We put them out there a lot. I wrote a book called Rule Breakers Rule Makers had them there. So I'm not going to go through the six, but suffice it to say that in the case of Virgin America, we feel that yes, Virgin America does meet a majority meets four out of the six. We feel like Virgin America has the following four, a sustainable advantage, strong past price appreciation when we recommended the stock and had done well since its IPO easily at performing the indices. Good management. We gave it a yes and strong consumer appeal. We gave it a yes. So that meets the majority of the Rule Breaker attributes and thus for our risk rating, we say in answer to number 19, yes. And finally, number 20 for Rule Breakers, we call this one binary destiny. Are the company's future business prospects easily able to withstand the binary outcomes that go against it? And to give a quick example of what we mean by binary outcomes, picture a company that has a new biotechnology and it really is hoping that the FDA will pass its drug. And if it does, we're all going to make a lot of money together. And if it doesn't, it could go to zero. That's kind of what we mean when we talk about binary outcomes and for a lot of disruptive innovators, whether it's biotech or some new idea of how to use the web or some new approach to through an app or electric cars, will they be killed or not? A lot of these companies have these kinds of, if it goes one way, we're going to make it rich. And if it goes the other way, we could lose quite a lot. And so this is an important question for Rule Breaker like companies. And the answer for Virgin America, as you probably would guess, is yes. This company could withstand, there aren't really those kinds of binary outcomes for a business like Virgin America. It's a mature enough airline that it should be flying probably for as long as Richard Branson wants. And let's make sure I tally up the numbers to close out Virgin America. It ends this week at an eight, getting plus three, remember, plus is bad, plus three from competition plus one on the stock and plus two on management. So that's where we're going to close it out this week. My reflection on our first two podcasts, the first two of this series of three is that I'm giving you a pretty meaty framework. And I hope this translated okay via audio. Of course, we do a lot of this work online with text where people are reading and scanning down a web page to see all of the work that I'm sharing with you comes directly from the Motley Fool Stock Advisor and Motley Fool Rule Breaker's Premium Services. I hope you're already a member and if not, you might be interested in checking us out. But I do realize that this might be a little too meaty. We won't do this every week. But I hope you've had fun. I hope it's been really educational. And next week, we're just going to have the final five and final additional thoughts about this framework as we continue the riskiness that is March Fool On. As always, people on this program may have interest in the stocks they talk about, and the Motley 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]