In 1974, French artist Philippe Petit walked between the Twin Towers in New York using a high wire. Petit maintained complete control during the entire act; nevertheless, he took on a huge risk. In my neighborhood park, amateur tight rope walkers perform a similar act except they walk across a rope that is only three feet above the ground. Despite their lack of experience, they are engaging in less risky behavior than Petit, as they would always survive a fall, but Petit would not.
The Dow recently hit an all-time high, even adjusting for inflation. As stock prices rise, the risk of many stocks increases due to a lack of a corresponding rise in asset values. Of course Monsieur Petit would love this situation of balancing high above safe zones, but many of us investors are more like the park rope-walkers who enjoy the comfort of knowing that their fall is quite limited. This article will focus solely on security risk as an entity isolated from performance. I will argue that many investors, academics and Wall Street professionals measure risk irrationally and therefore take on more risk than intended or desired.
In this article, I propose a new way of assessing risk and concentrate on three companies: Amazon (AMZN), Fuel Systems Solutions (FSYS), and Tesla (TSLA). These three companies are not competitors and have nothing to do with each other. The reason I selected them for comparison reasons is that the three nicely demonstrate my point about investment risk assessment. By conventional standards, as I will show below, Amazon and Tesla are considered to be "safe" investments. Fuel Systems Solutions, a much smaller company by market capitalization, is considered to be much riskier by conventional standards. Using my proposed risk assessment measures I show that in reality Amazon and Tesla are much riskier than Fuel Systems Solutions.
Volatility as Risk
Academics have published hundreds of articles analyzing risk. It is widely believed that by calculating a standard deviation of a security's historical returns one gets at risk. For example, a stock that is highly volatile is riskier than one whose price does not fluctuate much. Intuitively, one can argue that this is appropriate since an investor who buys a stock of a company that is stable can hope to sell it someday without taking a huge loss. The problem with that reasoning is that historical volatility is a poor predictor of future prices. An investor may mistakenly assume that the price of a low-volatility stock will not decrease a year from now, which could be far from reality.
To be sure, volatility may lead to emotional reactions that can be detrimental to an investor, but volatility by itself should not be confused with risk. The true risk is the investor's own emotions and not volatility. As Ben Graham said, "The investor's chief problem and even his worst enemy is likely to be himself." Equating volatility with risk falsely legitimizes the emotions that cause the most harm to investors during manias and panics. Many investors sold stocks in early 2009 because they thought that the market was too risky due to increased volatility. In fact, as I will argue below, the risk of equity investing was diminishing due to falling prices. Similarly, I am astonished when I hear investors today say that they feel more comfortable with investing in stocks again since we have not had any big drops in prices for a while.
Popular Numeric Measures of "Risk"
In Yahoo Finance or MSN Money, investors can find the "beta" of various stocks. Beta is a measure of the volatility of the stock relative to the market, and it is meant to give investors an idea of how risky the stock is. A beta of less than one means that the stock is less volatile than the market, whereas a beta of 1.6 implies that the stock is 60% more volatile than the market. However, investors who use beta to measure risk do so at their own peril, as discussed above.
Another common measure of volatility as a substitute for risk is VIX, the ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index. It is constructed by measuring the prices of calls and puts and is supposed to capture the expected volatility of the S&P 500 index. It is often referred to as the fear index. According to this measure during the financial crisis in 2008-2009, risk reached an all-time high since 1987. During that time stock prices were hitting new lows, yet many investors and academics viewed them as becoming riskier. In reality the tight-rope had just been lowered to inches above the ground. Of course decreasing price alone does not necessarily indicate less risk since oftentimes there is a legitimate reason for why the price drops. Enron did not become less risky as its stock price tumbled.
So, How Should Risk Be Measured?
As Ben Graham said, "You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right." Beta and VIX represent prices and, thus, are measures of how much the crowd agrees or disagrees with you. The crowd will influence price in the short term but in the long term intrinsic value (or as Graham would say a "weighing machine") determines prices. To get at the right "data and reasoning" for risk assessment, investors must look at a company's balance sheet. A balance sheet indicates potentially how much a stock can drop in case the company loses all its business overnight; it is a measure of how far the ground is from the tight rope walker and thus the degree of injury from a fall.
To assume worst-case scenario, that a business will cease to earn money and has to liquidate its assets, is a stringent and conservative test and not a perfect measure of risk. Yet it is a far better measure of risk than the current conventional way of using volatility as a proxy for it. Investors who are risk averse will be far safer investing in companies whose value can be justified by their assets. Many investors may object to this and profess that most companies derive their true value from their potential to earn money for years into the future. Unlike a discounted cash flow analysis, examining a balance sheet does not rely on assumptions or projections that often prove to be inaccurate. The balance sheet will offer a more objective way of quantifying investment risk.
Beta Vs. Balance Sheet
Now let us evaluate the risk of Amazon, Fuel Systems Solutions and Tesla using each of the two techniques, beta and balance sheet. From Yahoo Finance we can quickly find the betas of the three companies. Sorted from least "risky" to most we obtain:
Fuel Systems Solutions
Now let us examine the balance sheets of the three companies.
Fuel Systems Solutions
1. Current Assets
2. Total Liabilities
3. Shares Outstanding
4. Share price
5. Book Value per share
6. CA minus TL (NCAV) per share
7. NCAV per share/price
8. BV per share/price
9. Potential Drop based on NCAV
10. Potential Drop based on BV
Source: Rows 1 to 5 from MSN Money ; Rows 6 to 8 calculated; Row 9 = 1 - Row 7; Row 10 = 1 - Row 8.
I have used two separate methods in assessing risk in the table above. The first and more conservative measure is net current asset value (NCAV, row 9). The second is book value (BV, row 10). Neither method is perfect nor an accurate measure of risk, but they are both superior to the conventional measure, volatility. The drawback of using book value is that frequently it overstates the true liquidation value of a company since many companies have intangible assets that are nearly worthless. The drawback in using NCAV is that it understates the true liquidation value of the company since many companies have valuable assets like property, plant and equipment. Sometimes NCAV may not even be conservative enough since some companies with liberal accounting policies overstate the value of some of their current assets like inventories.
Rows 7 and 8 demonstrate the amount of support the companies' assets provide. For example, Tesla's book value is only 3% of the stock price. If Tesla ceased to make any more sales, presumably investors would recover 3% of their current investment.
For easy analysis, we can summarize the two tables above as follows:
Fuel Systems Solutions
Risk based on Beta
Risk based on NCAV
Risk based on BV
According to the conventional volatility measurements (beta), Fuel Systems is the riskiest investment. However, the company trades at just 30% above its NCAV and 23% below its BV. Tesla and Amazon, however, have betas below one, implying less riskiness than the market, yet their assets are far below their stock prices. Both companies' NCAV per share is negative. Amazon's BV is only 5% of its stock price while Tesla's is only 3%. The ground is far below Amazon and Tesla and only inches below Fuel Systems.
Another major advantage of using assets as a way to measure risk is its influence on psychology. Investors will become less prone to panic or irrational exuberance by relying on a tangible metric. For example, during the financial crisis investors would have correctly realized that the value of companies' assets were providing a great support for the companies' stock prices, thereby making those investments less risky. During that time many companies reported lower earnings, yet their tangible assets were not going anywhere. Many advisors wisely warn against panics and manias. When investors utilize the balance sheet model of assessing risk, they become more immune to the market moods. In contrast, using volatility as a proxy for risk can reinforce investors' fear and greed.
Limitations of Risk Assessment Using the Balance Sheet
Many companies have fantastic cash generating businesses with a wide moat. It is unfair to base their riskiness based on their assets alone. Companies like Coca-Cola (KO), Google (GOOG), and Amazon derive their value not by their assets but by their power to mint money through their extraordinary businesses. The future, however, is uncertain. Cash generation in the future relies on projections. Investors never know what havoc creative destruction can bring onto industries and companies. For example, war, politics, and natural disasters can have permanent effects on these businesses.
The above analysis makes no judgment of whether Amazon and Tesla are good investments. Amazon has a decisive moat in web retailing. No other retailer even comes close to Amazon with regard to web sales. Bezos, appropriately paranoid, as all managers should be, constantly thinks of new ways to widen and defend its moat. The analysis does, however, make a judgment as to the riskiness of these investments.
There is no perfect method of assessing investment risk. By its nature, risk is uncertain and unpredictable. Many investors and academics assess risk by analyzing the volatility of an investment. A more rational and accurate way is by examining a company's balance sheet. Using this approach, investors will find that despite decreased betas and declines in VIX, stocks may actually be riskier today than during the financial crisis. Amazon and Tesla are two companies with increasing risk. Even in this frothy environment, relatively safe investments such as Fuel Systems Solutions can still be found. The balance sheet model of risk assessment prepares investors better to withstand market panics and manias.