It feels like there has been a wave of surprise profit downgrades recently.
This week it was shares in GBST Holdings Limited (ASX:GBT) and OFX Group Ltd (ASX:OFX) which plunged after disappointing pre-earnings season updates.
Many of the companies are blaming the impact of Brexit and the weakening UK pound, a risk that few people predicted. But it raises an important point I think a lot of investors miss: stop focusing on how much a company could go up, and put your energy into understanding what could go wrong.
Legendary investor Howard Marks even uses this view of risk as the mantra of his investment company Oaktree Capital:
'If we avoid the losers the winners take care of themselves'.
Because many of the risks we face when investing are outside of our control, Ian Schapiro, one of Oaktree Capital's portfolio managers, says there are five risks he won't go near:
1. Commodity risk
Companies involved in producing and selling commodities have far less control over the price they receive for their products, so risk is a much larger part of the investment.
Pricing can be hedged somewhat with contracts and derivative options, but even then companies get caught out. Energy producer Santos Ltd (ASX: STO) is a classic example, getting caught out by falling oil prices.
2. Turnaround risk
They may look cheap, but companies that need 'turning around' are likely to have already suffered brand damage and lost customer good will. These companies can underperform for years.
I think Bellamy's Australia Ltd (ASX: BAL) could be at risk of this as the company publicly brawls with its shareholders.
Focus instead on successful companies with leading market positions, says Schapiro.
3. Technology/start-up risk
Start-ups are exciting and often have big potential. Many start-ups prey on that hype to list on the stock market to help them grow.
But burning cash to achieve revenue growth automatically reduces room for error and makes valuation harder, so risks are much higher.
4. Returns based on financial leverage
It's much cheaper for a company to borrow money as debt than issuing equity to investors who demand higher returns. Debt is also a great way to amplify returns to shareholders.
However the illusion can be quickly shattered if market conditions change, and large volumes of debt leaves a company vulnerable and inflexible.
5. Public policy risk
Diagnostic imaging company Capitol Health Ltd (ASX: CAJ) relied extensively on government rebates to drive revenue, while operating with a high proportion of fixed costs. Profitability came crashing down when Medicare got put under review and shares plummeted almost 90% from their highs in 2015.
Foolish takeaway
Beyond these risks, Ian Schapiro points to three easy ways to improve your odds of success: understand the company; understand the management; and seek opinions which conflict with your own.
Once you've got your head around the risk, the strong economic engine underlying great companies will take care of the upside for years to come.
If you learn only one thing about investing today, make it this.
