All businesses face risks that could weaken the continuing success of their operations. There are a number of advantages in trying to understand these risks. For instance, when they are properly understood some attempt can be made to evaluate the board and senior management as to their abilities to manage such risks should they occur. Another advantage relates to the market reaction to the occurrence of these risks. Generally the market will overreact to the seriousness of the risk which often provides an excellent buying opportunity.
Examples of business risks are:
- departure of key management without proper succession planning
- failure of the company to maintain its competitive advantage
- loss of market share because of a new competitor or a change of consumer buying habits
- inflated payment for an ill-fitting acquisition
- reduction in export profits because of economic difficulties in other countries or adverse exchange rate movements
- damage to the brand name due to product failure
- changes in regulation impacting on the company’s business
- large expenditure to develop a new product or service which performs less well than expected
- general economic downturn
Most investors only give at most a passing consideration to determining if risks such as these are likely or relevant to their potential investments. However, Teaminvest believes that understanding the nature and significance of future risks is a vital part of successful investing. They have a well-defined process for studying future risks of business in terms of the type of risk, its likelihood of occurring in the next economic cycle, and the damage it would do if it occurred.
The likelihood of a particular risk occurring in the next economic cycle is scored from 0 to 3 as follows: 0: will not occur, 1: might occur, 2: likely to occur, 3: will definitely occur. Assuming a risk does occur, the severity of the damage is also scored from 0 to 3: 0: no damage, 1: some damage, 2: severe damage, 3: Capital Killer™. If a risk is deemed to be a Capital Killer™, then no further analysis needs to be done on the company. This is because a critical component of being regarded as a Wealth Winner® is that no risks identified as Capital Killer™ are identified in the next economic cycle.
The final Likelihood (L) and Damage (D) are combined to give a Rating (R) out of 10 with more weighting given to the Damage. The formula is:
R = ( L * D * D ) ^ ( 1 / 3 ) * 10 / 3.
As a guide, a final Rating in the range of 0 to 4 would generally indicate that the risk was unlikely to occur and if it did, the damage would be minimal. In contrast, a Score in the range of 7 to 10 would generally indicate that the risk was likely to occur in the next economic cycle and if it did, the damage would be severe. For most risks the final Score will be in the range of 4 to 7. This would generally be a combination of a risk that might occur and if it did, the damage would be mild. However, other possibilities are that the risk is unlikely to occur but would cause severe damage if it did, through to a risk that is likely to occur but with little damage if it did.