As promised, March is Risk Month here at the RBI Podcast, and today David lays out the structure of his unique 25-point system for quantifying the risk levels of your investments. This is not just a nebulous “high, medium, low” rating; rather, this is a methodical scoring system that you can use yourself to assess the long-term safety of the companies you love.
Rule Breaker Investing
Calculating Risk Foolishly: CRI vs. VA (1/3)
It's the Rule Breaker Investing Podcast with Motley Fool co-founder, David Gardner. And welcome back to Rule Breaker Investing. Well it's March and March is Risk Month. Well not normally. I'm not sure a lot of people equate March with risk. There is some madness in March for some of us. That might sound a little risky for basketball fans. But now I don't think that March should be any more risky than any other month. But for this podcast it is because in our first year of doing Rule Breaker Investing I wanted to get to this subject and I'm happy to say we started last July so I'm happy to say we're going to do that this month. The next three podcasts including this one are going to be on the subject of assessing risk in your investing and your investments. Now for some of you that probably sounds I hope interesting because you're curious what makes a stock risky. Why is one stock twice as risky as another? These kinds of questions for investors can be very interesting especially because I think a lot of the previous answers offered by history are kind of boring. We've talked about this in the past in this podcast but I'm not satisfied by people saying a stock is medium risk or even low to medium. I don't really know what that means. There's no real scale. It just sounds like a label. Sometimes at its worst it sounds lazy like somebody hasn't really done the work to assess whether something is high risk, medium risk or low risk. So again for some investors, some died in the world regulars, this is an exciting sounding subject. There will be other listeners of this podcast who might be thinking this right now. Should I take March off? I mean talking about risk for the next three rule breaker investing podcasts, well I hope to convince you, if I'm speaking to you right now, if that's you, I hope to convince you starting with this podcast, that it's a great subject. It's really interesting, it's fun and for us anyway and the way we're going to be doing this, it's going to be very educational because the way that we assess risk on my services at the Motley Fool, we have a number for every stock, is that we answer questions and the questions are ultimately questions that teach you how to think as an investor. And so I hope you're going to really enjoy these next few weeks. You can let me know, how about about three weeks from now, you can let us know, for our next mailbag, how about that, at the end of the month you can let us know, was this helpful to do enjoy it or not? How could we improve it? Because I'm sure I'll be going back to this in future. So risk ratings, risk, March, the risky month and we're going to be talking about risk ratings. So let me talk about risk ratings, we're going to do a what, a why and a how and then we're going to get into it. So the what? The what is that the Motley Fool Stock Advisor Service, Rule Breaker Service and Supernova Service, all employ risk ratings. And this is a 25 point system and so the system works like this. The higher the number, the higher the risk of the stock. And the way that we get to those 25 points is every single stock, we ask 25 identical questions of that stock. And as we ask that question, every single answer is either yes or no. So these are binary yes/no questions. The kind I really loved on my schoolboy quizzes, loved the yes or no quizzes, didn't like as much the multiple choice, really didn't like the short answer quizzes. This is the favorite quiz of all yes or no. And as we do this, and we're going to be demonstrating this in this podcast the next couple weeks, we're going to use two example companies, as we do this, if you're answering yes to the question, that is safe. That's a happy, safe feeling answer, yes. If you're answering no to any of these 25 questions, that's risky. That means it's a little riskier. So every no as we ask the 25 questions is plus one. So if we have 12 no's at the end of our 25 questions, the risk rating for that stock is 12. And that would be riskier than if we answer five no's for another stock. And I'm glad I used 12 and five because those are in fact the exact risk ratings of the two example stocks we'll be using for this series. And just so you know what they are, they are Carters, the toddler and baby apparel company, and Virgin America, the airline, the Richard Branson airline. So Carters and Virgin America, and I'll cheat, I'll give you the answers right at the start, Carters is a five by this assessment. And Virgin America is a 12. So Virgin America, which might seem like a more substantial entity, one that more people have heard of, you might have flown on it, I don't know how everybody assesses these things. But I think a lot of people might think that Virgin America would be a bigger kind of a safer company than Carters. But at least from our standpoint, and we like both stocks, both are active recommendations. From our standpoint, Carters is significantly safer. And by the end of our series, it will become evident to you why. So I said the what, the why and the how, that's the what, 25 point risk system. We apply it to every single stock that we cover. Next, I want to answer briefly why, why do we do this? Well, we do this because we think risk matters. We think knowing how risky one stock is versus another is helpful. We are also dissatisfied by all past forms of risk rating, most of which take the form, as I mentioned earlier, of a single label with maybe a few sentences explaining why. It doesn't really show the guts of the effort or what went into it, not really systematic or methodological. And so the why of it for us is we wanted to bring some method, we wanted to bring some transparency and also some numbers to this. And so that's the why. And finally, the how. And I think I've actually already kind of answered the how, 25 questions. Same question of every company, yes equals safe, no equals risky. And the nice thing about the how is if you enjoy our framework, if you enjoy our approach, it's one you can use as well, because every one of these 25 questions is part of the public domain at fool.com and I'll be giving them all out right here on this podcast. And so you and really any member of the Motleyful community is encouraged to run this same test on any stock you're looking at, including even looking at the same stocks we're looking at, because as you'll see by the end of the series, if Carter's is a five for me, it might be a six or a four for you. So that's one of the lessons we'll be learning by the end, but overall, I think that there's a wonderful advantage to being able to do this yourself and to be able to learn along with us and understand exactly why something is a 12 and why something is a five. I think I'd like to point out I like numbers. I like numbers usually more than labels. Numbers allow me to do things like average. So if you like our methodology and you want to use it for your stocks, you could figure out that this stock for you is an 11 and other stocks are 12, you got some threes and you can average your whole portfolio and start to assess the overall riskiness by this methodology of your portfolio. You could individually wait each position. For example, if you owned your whole pie, if 8% of your whole pie is in one stock and 2% is in another, then you could make sure that that 8% is a higher weighted position when you're waiting risk. You can really be very numerical with ratios and averages in a way that's much more powerful than saying a stock is medium risk. Okay. So I think I've gone through the what, the why, and some of the how. Without further ado, let's get into it. It's the Motley Fool's risk rating approach. It's the system and this particular podcast, we're going to go over of the 25 questions. We're going to go fairly quickly through the first 10. Next podcast, we'll do 11 to 20. The final podcast will do 21 to 25 and final thoughts. So for each of these, I'll be giving you the question itself. So you know what it is and a thought or two about that question, and then I'll give the quick answer for both carders, which will end up being a five and Virgin America, which will end up being a 12, as I mentioned. So I want to be clear on our terms for us at the Motley Fool or in my services, we define risk like this, riskiness comes down to the chance that you will lose a substantial portion of your capital, your money invested. If you were to hold that stock for a good long period of time, let's say three or more years. So the risk here, the stock, the more chance we think you could actually even being patient and holding that stock over a good period of time, that you would actually lose quite a lot of that money. So that's how we define risk, a little bit different from the rest of the world, which often defines it like how much the stock jump up or down volatility, very different for us as fools. Now let's get into it. Okay, the first five questions are all about the company. So these are broader, bigger questions about the company. Number one, profitability. Was the company profitable during the previous quarter and past 12 months? Yes or no? As you might imagine, if we're saying yes, that means the company is profitable and profitable equals safer. Companies that are not profitable are clearly, take it all in all, riskier just based on that factor than companies that are profitable. After all, there's no real substitute at the end of the day for profits and cash flow for businesses. So maybe the most important question asked right out of the hatch, the first one, profitability of the enterprise and both Carters and Virgin America get a check mark. Both of those companies are profitable. Number two is, well, I just use the phrase actually cash flow. What is the company cash flow positive during the previous quarter and past 12 months? Now here we get into a little bit of investing speak because they're not always the same. Are they profitability and cash flow? For example, early on Netflix was cash flow positive, but not profitable. Let me explain that very briefly. When you are cash flow positive, it means that the money that's coming into you is in excess of your costs right in the here and now. So for anything you've ever subscribed to like Netflix or the Motley Fool or Time magazine, you probably paid that subscription upfront. That company took in all the money right then and took it in as cash flow. And if you're running that kind of a business, it's a nice business to run because you typically get your cash upfront. Now when you actually expense it and your accountants sit down with you and you're the CEO and you go over this, you're not going to be reflecting in your earnings all of that money right away. It's a 12 month subscription like let's say Netflix for 8 bucks a month over 12 months. Netflix and its actual financials has to reflect that as $8 for each of the succeeding 12 months. It doesn't come in all right away. So for earnings for that first quarter, they're only going to be showing $24, 8 times 3. And they're going to have that other $72 waiting. But in real life terms, going back to cash flow, they got it all right away, $96 up front. I hope in that quick explanation. I made it clear the difference between profitability and cash flow. So that's why we separate these out as two separate questions. And the question is again, was the company cash flow positive during the previous quarter and past 12 months? We like to know both by the way. We like to know not just like last quarter were they, but we like to know, you know, the last year. On the other hand, we don't just want to know the last year if they've had a really bad previous quarter because it might still look like a really great last year. But the reality is if they had a bad last quarter, we like to be able to know the answers to both of these. That's why each of these first two questions asks you for both the previous quarter and the past 12 months. And now to go to our quick two example companies, sure enough, Carter's and Virgin America have both been cash flow positive over the past 12 months. By the way, we tend to run these risk ratings about once a year. So these may not be updated for the most recent earnings, but we at our staff, we're not so intense on these that we think you have to keep up with them every week or so. I think each of these was run at the near the end of 2015. So it should still feel and be accurate and right, but it might be slightly off. Number three, number three is brand. Again, these are five questions about the company. This is the first one that is qualitative. Does the company's business rely on recognizable branding truly valued by its buyer base? Why is this question there? Well, in our experience, one of the safer things you can have is a business where people recognize your name. I think I told this story many moons ago on this podcast, but I remember once walking into a New York City cafe, just one of those delicatessen and I wanted orange juice. So I opened up the glass refrigerator there in the delicatessen and I immediately pulled out Tropicana and I just bought Tropicana. And then as I walked out, opening up my Tropicana, I briefly cast a glance of scans back at that same glass refrigerator and I noticed right next to Tropicana, there was another orange juice. It was called Just Picked, P-I-K-T and I had not even given it the time of day. I saw a brand that I recognized, I might have been a little bit of a hurry. It's a safe choice, you know your brands. So I just bought it right then and that's a great business position to be in. To be Tropicana in that particular example, I know Just Picked, no doubt has its fans out there. But this is the power of branding, this is why Starbucks is Starbucks and you and I and our coffee shop aren't Starbucks and many others besides Amazon, the list goes on. So does the company's business rely on recognizable branding truly valued by its buyer base and for both Carters and for Virgin America, we say yes on this. In fact, the Carters brand is well over a century old and Virgin America is one of those, in my experience anyway, few airlines where people are like, "Yeah, I'm actually looking forward to that. It's fun." I feel if you've ever taken a Virgin America flight. Now I want to point out as we move to number four, that these are my answers. You might actually think, "No, Virgin America is not that special brand." And in that case, you would answer no to this question. And for you, that would make Virgin America a riskier stock than it is for me. So we see here that risk ratings, this is a profound point, are subjective. One person's risky stock may not be another person's quite so risky stock. And this is an important point to learn. I think not just about risk ratings, but about life that we all see things differently. But this was an important as we developed this framework for Motley Fool Services. It was important for us to show that, that it is subjective and a lot of these questions, as you'll see, are similar to this one to number three, asking you what you think of the brand. Okay. Number four, diversification. Because the company diversified its buyer base, so that no single customer accounts for more than 20% of revenue. All right, well, we return here again to the objective, not the subjective. This one is quantitative, not qualitative. And this is an important point, of course, for businesses. Because if a company is wholly reliant or largely reliant on just one or two customers, if you and I are small suppliers and we're selling through Walmart and Walmart's just everything to our business, we're much riskier than if we are Walmart, where we have thousands and thousands of customers and suppliers and we're not wholly beholden just to a small group or just one other. And so it's a critical question. Is the company diversified? And for both Carter's and Virgin America, the answer is yes, there are a lot of people buying apparel and there are a lot of people flying on the plane. So both of these companies get a check mark for diversification. And number five, the last of the questions about the companies in general. And this one is all about fans. It's the raving fans question. Does the company on the whole receive positive word of mouth from its customers? There are a lot of businesses. I won't besmirch any names on this week's podcast. There are a lot of businesses that I don't think we'd say this of. But I would say the majority of businesses don't have a lot of fans. A lot of us are, for example, maybe choosing that particular cable supplier, cable TV because it's the only one in our neighborhood or might be same of your utilities or there are a lot of buying decisions that we make mechanically and sometimes because we don't have that many choices. But for businesses where we do have choices and we consistently choose one because we really like it and you see lots of other people in the world doing the same thing. These are the businesses with raving fans. There's a good book on marketing called raving fans by Ken Blanchard, a book no doubt many of you may have read. It's kind of one of those old-time classics. I would recommend it to you if you haven't read it, especially if you're a small business person looking to make some more raving fans in your business. Take a look. So this is the raving fans question and the way that I answer for both Carters and Virgin America is yes. Check mark for both of them. I believe that both have active if not completely raving all the time fans of these brands and these businesses. And by the way, not surprising that I would think that because these are stocks that are active recommendations of ours in Motley Fool Stock Advisor and Motley Fool Rule Breakers. Now, we do recommend some stocks that don't have raving fans. That happens too. But in general, you're going to expect that I'm going to think that of the companies that I'm recommending, part of the reason I'm recommending them is because I love companies with good brands and good customer experiences. Okay. I'm going to line under it, hit pause if you like, go get a quick drink of water. We just made it through our first five. Those are the ones about the company. And now to close this week's podcast, we're going to go over numbers six to 10. And these are about the financials and critical element to assessing risk of any for profit enterprise. Really, any, not for profit enterprise is understanding the financial backing that that business enjoys or maybe does not fully enjoy. So let's go over numbers six to 10. All right. Number six is growth. Did the company grow its sales by 10% to 40% annually in the past three years? Growth is good growing enterprises. That says a lot of good things. More people are buying from you this year than last. They might be buying more from you or it might be more people are buying from you or it might be both those are less risky businesses. The opposite gets riskier. Nope. Fewer people are buying or we're just not growing at all, not nearly as strong as those that are growing. And yet we do have a parameter there 10% to 40%. In other words, we're not particularly impressed by companies that have 3% sales growth. That doesn't feel that impressive to us. On the other hand, and this is kind of a contrary point, we don't feel as safe about companies that have blisteringly high growth. So if a company is average in excess, 41% somewhat arbitrary number 41% or more sales growth over the last three years, while hugely impressive, in our minds also can set the company up for Wall Street selling off its stock, if in fact, it doesn't keep that growth rate up. So when you see those really high growth rates that probably aren't at sustainable percentages, these are where we start to say impressive, but not that safe. So now you understand the question and to give the answers, this is the first time that one of our companies gets a check and the other gets an X. And the company gets a check is Carter's. As of late 2015, looking back over the previous three years, its compound annual growth rate of its sales was 10.1%. So that's a check for Carter's, however, Virgin America, we cannot say that about airlines do tend to be a slower growth business. Virgin America is no exception, of course, longer term. We can expect affordable, let's call it long haul luxury to boost results materially. That's kind of the business that Virgin America's in, but it has not had impressive sales growth. So this is the first time that we start saying Carter's is safer than Virgin America. Number seven, independence, can the company operate its business in the next three years without relying on external funding? Pretty critical question. Companies that are profitable and or have a lot of money in the bank don't need any bankers or bond salesmen. They don't need to go back to the market to keep that business going. They have the wherewithal, the cash, the cash flow to operate their businesses independently. And the companies that don't are clearly, in my mind, I hope yours, riskier. When you have to go back out to the banks where you need an ongoing regular source of funding to keep the lights on and the money machines churning, clearly those are riskier businesses. And here too, between our two example companies, we do have a difference. It is profitable. We already talked about its cash flow. It has no problem running independently. However, Virgin America, a much heavier business to run with all of the aircraft, all of the maintenance, all of the, in some cases, union contracts, much more expensive proposition. And like so many airlines, Virgin America can't quite probably rely on no external funding. Now, I'm, I'm mincey, my words a little bit here because Virgin America among airlines is really one of the very most sustainable, most able to operate independently relative to so many others in that industry. So we're being especially conservative here when we give a no to Virgin America, because it's kind of borderline. But here again, we get into sort of a subjective question. It's how it looks to you. And it's how you kind of want to think through the risk of the company or spin the answer to a question and the number that you end up with might be slightly different from mine. But that's, that's how we've rated them here at the Motley Fool. Number eight, number eight is disclosure. Does the company maintain a high standard of disclosure consistent with SEC guidelines? This is an important question, disclosure, i.e., can you read the financial statements? Are they being asked by a regulatory entity on a regular basis to report their numbers? And now for a lot of us here in the United States of America, we kind of take this for granted. I'm happy to say we have a fairly high standard of disclosure. In some ways, it might even be the gold standard for 2016 globally. And so having the Securities and Exchange Commission require companies to report four times a year in their 10Qs and once a year with their 10K and release all of these numbers is really, really good for investors. It's been a wildly great benefit that particularly U.S. investors like me have appreciated, probably taken for granted over the decades, that we can largely believe what we're seeing. And we hear regularly enough that we can see data that helps us make investment decisions. There are not, not every country, not every area of the world we can say that of. So no's here often come from a, well, there are some companies in China that we have some questions about when we really look at their financial statements or just other companies or blocks of regions that just don't quite have the same standard of disclosure. And so this is an important question for us. It's a fairly easy one to answer, fairly wrote. Sometimes there can be a little nuance to it. But for both of our companies, both Virgin America and Carter's, I'm happy to say that we can say a yes. In fact, Virgin has always been a bit more naked in its approach to disclosure and Virgin America as part of Virgin Richard Branson's company has a really rich investor relations website. And that to me is another sign here. Can you go to the website of the company and really feel like you're able to look over and pour over the financials, read footnotes if you want, right there on the website. Does the company do a good job showing you the conference calls, transcripts, or can you listen online live? How investor friendly is that company's website? This is all the kind of thing that contributes to a yes versus a no. All right. Number nine, kind of related, transparency. Would an intermediate level investor find the company's financial statements and management ownership disclosures relatively easy to sift through and understand? Now if transparency sounds a lot like disclosure to you, there's definitely overlap, but let's be clear. There's a difference here. disclosure is about the standard being asked to the company. And it's reporting transparency is about once you get into those financial statements, can you figure out what the heck is going on? There are some really impressive people, people like John Malone in business of TCI fame whose statements are classically hard to read and understand. There are some businesses that are just more opaque. I find banks pretty hard to read when I look at their financial statements as a consequence. I tend to recommend and invest less in financial services companies than let's say, baby apparel companies. So, it's when you get into these statements and we're assuming again that you're an intermediate level investor. Now, as a listener of Rule Breaker Investing Podcast, you might not think you are. That's fine. We're not talking about you. We're talking about your friend who's an intermediate level investor. Can that person understand what the heck's going on in the financial statements yes or no? For both of these companies, Carter's and Virgin America, we say yes and yes, that makes them feel safer to us. Finally, this week, number 10, number 10 is well managed. Over the most recent fiscal year, did the company earn a return on equity of 15% or higher? So, this is again a financial term. We're running out of time so you can definitely look this one up on our website or on the internet, just Google return on equity, but you basically take the net income of a company, the amount of profit it makes in a year and you divide by the shareholders' equity, basically the value of the common stock that we all have. And that gives you a ratio and common rule of thumb is 15 to 20% is a good number. So, what we say here with our risk ratings is 15% or higher and we call that well managed. What return on equity basically tells you is basically how well does the company use investments, money that it takes in, in this case from shareholders, to generate earnings growth? Does it do so effectively and efficiently or not? 15% or higher, we like that, that's well managed. And for both of these companies, Virgin America and Carter's, they get a check. This is again another quantitative one, a number that you can look up. And now that you know our eyes having to guess. So there we go, I'm going to tie a ribbon around that for this week's podcast. We've just gone over 10 of the 25 binary questions, yes or no questions that we ask of every stock as we assess them. And so far, if you're keeping score at home or in your car as you're driving or as you're jogging, you're going to see that Carter's is perfect, zero, not a single no. Virgin America so far has two no's, so, so far it's plus two on the riskometer. You already know where we're headed, Carter's is going to end up with five, Virgin America is going to end up at 12. So there will be a lot more no's next week and the week after. And I'm looking forward to having you back next week as we go over questions 11 to 20, which will come under the rubrics competition, the stock looking at the stock and the management. These are some of the categories we'll be covering next week as we round out a greater understanding of risk. Thanks a lot for joining with me. I'm David Gardner, talk to you next week, Fool 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 Robaker Investing at rbi.fool.com [MUSIC] [BLANK_AUDIO]