The Harbour Pilot

An investor is considering making an investment. They have considered the systemic risks involved – the question of which stock market is most stable, has the best reporting, has strong investor protections, and is based in an economy or country with good legal infrastructure, and best-in-class currency and monetary policy management. They understand the potential systemic risks they are exposed to in the alternative investments.

They have also reviewed the systematic risks, the stage of the business cycle in the domestic economy that hosts the stock exchange, the strength of its regional trading relationships, its competitive and productive position within the world economy. They have investigated the political stability of the host country, and its dominant demographic and cultural trends. The systematic risk profile is understood.

Great – so what then?

The investments available include the 2,748 corporate entities listed on the stock exchange, the various bond and debenture issues offered by corporations, governments of various levels, and an assortment of financial entities including banks, and capital groups. There are also a number of mutual funds that could be attractive. In addition to all of these publicly offered and traded vehicles for investment, there are also a number of independent operating companies, ranging from private managed investment funds, to operating companies, all the way to various venture capital opportunities.

How does one decide? This is the level of specific risk – it is the set of risks that are particular to one investment opportunity as opposed to any other. The risk is specific to the investment.

In evaluating the risk of a specific investment, the process varies. Taking the simplest process, the assessment of risk associated with government debt issues (bonds and T-Bills for example) is pretty simple. The risk of any well established developed countries government defaulting on its obligations are pretty remote. However, the attractiveness of any specific debt vehicle will vary with the debt markets as a whole. For instance if you hold a bond issue with two years remaining to its maturity date and an interest rate of 4% p.a., but interest rates are expected to rise in the next six months to 6%, then your bond issue is less attractive. As a result the immediate cash value of the bond on the secondary market decreases. This however, is a systematic risk – not a specific risk. If the terms of the debt issue are unusual however, there can be specific risk elements in addition to the systematic risk. In general, government debt issues are considered to be risk-free, meaning that there is no specific risk in their instruments. As a result, the rates on their instruments tend to be viewed as a benchmark against other investments that do have specific risk.

Perhaps your investment is a corporate debt issue, perhaps a convertible bond or debenture, In this case, a portion of the value of the investment is the potential upside opportunity to convert the instrument into another form of investment, possibly either preferred shares, or even common equity. Now things are a little more interesting. The easiest approach to this problem is to establish what portion of the investment is paid for the straight debt issue, and what consideration is attributable to the conversion option. You may now treat them as two somewhat distinct parcels for evaluation, before recombining them for an overall decision. The straight debt component must carry element of specific risk that the corporation will be unable to meet the interest schedule on the debt, plus the chance of outright default on the debt, and the percentage of debt not recoverable in a liquidity situation. This is a fairly straightforward matter, particularly with the assistance of debt raters such as Dun and Brad. The conversion option is much more complicated to address, requiring the use of option pricing techniques. We will talk about this in a few days. As a simple guide, the specific risks include the potential that the corporation’s market valuation will deteriorate, reducing the value of the converted options. No one will convert if the resulting priced value of the new security is well above realizable market value. In that scenario, the conversion option has lost all of its value. This is a risk specific to the imputed investment in the options.

Leaving the debt markets behind, lets continue with our options big brothers – common equity in a publicly traded corporation. Here the risk is that the value of the stock will fall. This form of specific risk varies with each corporation. While the hi-tech sector of micro-processors may rise strongly over the next year, Podunk Undivided Neoprocessors Korporation, or PUNK, has recently lost its chief technologist to the competition – Winners Integrated Neoprocessors Korporation or WINK. In addition, PUNK has lost its accreditation as an International Standards Organization validated ship manufacturer. This means they have also lost the ability to sell product to the defense industry of West Dudialand, a major buyer. Lost revenue means lost profit, means lost R & D investment funds, means decreased market respect, means higher debt interest rates on their bonds, means a higher cost of capital, means fewer funded projects. PUNK has a higher specific risk than WINK does. Accordingly, the value of their common shares is likely to fall because there needs to be greater rewards for the higher risk profile specific to their corporation.

We have spent several hundred words revisiting the question of specific risk from an investment point of view. Independent businesses, as we define them, do not grapple with these problems on their own account. Nevertheless, the issues are relevant.

The independent business person is the investor in their business- and more, they are the investors in each of their own projects.

That new product line you would like to take on to distribute to the existing customer base? It requires an investment in inventory to fulfill orders, it requires, warehousing space, it requires the owner’s time, it may require marketing collateral, there are added credit risks with a new line, and possibly product liabilities. These risks are specific to the new product line.

That new plant expansion that is needed to service new geographic markets that you have been able to access? There is the investment in the new plant real estate and buildings, improvements, moving costs, hiring of new staff and training. There are possible long term commitments to overheads for infrastructure such as capital leases that reduce your flexibility to reduce costs and preserve cash flow. There is the risk that you may lose access to the new market, or even worse confront new competition who may then decide to attack your home base market as well.

That new contract you have negotiated that is expected to absorb more than 50% of your production capacity for the next two years? There is the risk that the new customer becomes too influential to your organization, and negotiates so aggressively that the business is no longer profitable – and yet, you have foreclosed other options by servicing this single major contract.

Every major investment you make in your business carries specific risks. The discipline of risk management can teach a great deal on the identification, analysis, and survival of risks of this nature. In future, we will examine some of these issues very closely, with an eye to adopting a risk analysis approach to your decision process.

Above all, as always, the issue is NOT that risk is bad – it is often very good. Taking risks without being fully aware of them so that they can be managed profitably is very, very bad.