Defense Wins Championships: Risk Management For Your Stock Portfolio

by: Jeremy Blum
Summary

When investing in stocks, defense is as important as offense.

Knowing the risks with individual stocks, their industry and your portfolio is important and often critical.

This article lays out some of the major risks to look for.

OK, so Progressive recently lampooned the phrase “defense wins championships” in a funny commercial about becoming our fathers. But quite often, dad was right.

Back in the late 1980s when I lived in St. Petersburg, Florida, there was a series of commercials for a local tire chain. The pitchman’s line was “Tars aint purty! For you Northerners the translation is “Tires aren't pretty”. Well, risk management aint pretty or exciting either, but very necessary if you manage a portfolio of stocks. In most team sports such as football, soccer, basketball, hockey and baseball, defense is as important as offense. Good offensive players often get little playing time if they are unable or unwilling to play D.

Investors when they analyze stocks generally are offensive minded. They tend to look primarily at the upside potential. My point is, you have to look at both upside potential and downside risk equally. In this article we will look at ways to reduce or mitigate the risks of large losses in your stock portfolio. These actions have been particularly important to me as I invest primarily in deep value and/or small cap stocks. These stocks tend to be higher individual risk so I have had to find ways to reduce risk. As a result, my portfolio usually has an average volatility despite apparent higher risk stocks.

For your portfolio as a whole

1. Diversify

A. By Industry

Limit the amount of stocks you own in a particular industry. If the industry has a downturn you will likely get hit several times as hard if you are concentrated there.

B. By Position Size

The position size you use will depend on your risk tolerance, age, and amount of discretionary money you have. For example, if you have a large portfolio that has more than you need to retire on, you can take some large positions. If you are young, you can also take more risk and bigger positions. For the rest of us, I recommend no more than 10% initially in any investment. I personally limit it to 6%. If you don’t have the time to find and analyze enough stocks to fill out a portfolio, consider putting the rest of your money in a few broad mutual funds or ETFs. I personally sweep whatever I don’t have invested in stocks into an S&P 500 ETF leaving enough cash to add one or two positions. Holding a lot cash will likely reduce your returns over time but could improve your piece of mind.

C. By Geography

Historically American investors have had most of their investments in U.S. based companies. However, opportunities for foreign exposure have significantly increased in recent years. There are hundreds of foreign based companies now traded on our exchanges and filing 10-K’s and 10-Q’s with the SEC. There are hundreds of mutual funds and ETF’s focused on foreign stocks. Many brokers now allow stock purchases on foreign exchanges. Also, many large American companies get over half their revenues outside the U.S.

2. Watch your stocks betas

Companies with betas over 1.0 move more than the stock market. For example, if the company has a beta of 1.5, when the market goes up 1.0%, that stock on average has been going up 1.5%. Same thing to the downside. Avoid having a lot high beta stocks if you can't handle a lot of volatility. I personally usually have some as I buy a lot of small cap and deep value but limit them.

3. Be very careful with buying options

Buying options, whether puts or calls, is like walking into a casino. The odds are against you because you have to make up for the premium you pay before you can make money. Out of the money options in particular are very risky. I do occasionally use options, but only on my best ideas. My options position is about 1/10th of my stock position if it is out of money. If it is in the money, then it is a higher fraction of my average stock position. Selling options (uncovered) is extremely risky if you do not own the stock. I never do it because the downside risk is unlimited. Selling options on stocks you own is called covered options. They are less risky than the others I have mentioned, but also don’t provide enough return on average to interest me. What you are doing is limiting your upside, and there is still downside if the stock drops more than the premium you collected.

4. Stop losses – These automatically sell your stock if it falls to a preset level. I recommend it if you aren't constantly monitoring your portfolio. Since I am constantly monitoring my stocks I don’t use them as they can also be problematic. Sometimes stocks have sudden drops with quick recoveries.

5. Hedging – You can hedge positions in certain industries. For example, if you own a mining company you can buy futures on the commodity they mine. You can do the same thing for oil and gas companies. For companies that have options, you can buy out of the money puts to hedge against too large of a stock price decline. Those options are not as risky as most as it is usually done to lock in a profit. As a general rule I don’t recommend hedging as it can be expensive. But if you are overexposed in an area it should be considered.

6. Margin– Margin is borrowing in order to buy stocks once you run out of cash. A portfolio with margin magnifies your gains and losses. A little margin probably won’t hurt, but a lot can be devastating in a market downturn. I generally don’t use it or use it just temporarily.

For individual companies

1. Red flags

A. High Inventory– If inventory is growing significantly faster than sales it may indicate trouble selling inventory. This may lead to big discounts and write-offs.

B. High accounts receivable– This could indicate trouble collecting from customers and may lead to write-offs. As a general rule if receivables are higher than the last quarter’s sales, it’s high.

C. Lots of affiliate transactions– Insiders may be taking advantage of their position at your expense.

D. Lots of insider sales– If the insiders don’t believe, why should you?

E. Lots of lawsuits– This indicates loose or poor management.

F. Lots of employee or executive turnover– This indicates poor management or prospects. If management or employees are unhappy, problems arise more easily. Employee comments can be found on glassdoor.com. Also watch for independent auditor turnover.

G. A competitor introducing a superior product– This can be devastating in some cases. Remember Blackberry and Nokia? You need to know how much potential impact to sales and earnings.

H. A change in management’s tone– In poker this is called a tell. Analysts often call it reading between the lines. If the CEO changes his tone from upbeat to cautionary, look out. If the CEO is upbeat but uses a lot of puffery and little specifics, sell immediately.

I. Adverse government regulations– Changes in regulation can have a big impact on companies. Examples in recent years was President Obama rolling out regulations that did significant harm to for profit prisons and payday lenders. Both are now recovering as those regulations got reversed.

H. Concentrations– If a company gets a large amount of business from one customer, it can get badly hurt if they lose that business. Watch in particular large contracts that are coming up for renewal or ending. Even losing 10% of revenues can sometimes cut a stock in half.

I. Constant non-recurring items– Like many investors I routinely factor out non-recurring items to get a truer picture of the company’s core earnings. However, if non-recurring items are constant that generally means two things. One is they are not non-recurring. Two, management is not running a tight ship.

J. Read the risk factors in the 10-K– Most companies list the risks they face in their 10-K filing. The majority are written for CYA reasons and can be quickly disregarded. However, there are often some that are very real and you need to be aware of. It is a good place to find some of the risks mentioned above.

2. Understand the downside risk before you invest

Even stocks considered blue chips like say GE can get hit hard. This means understand the downside risk potential for each investment, before you invest. One way I use is to look at historical charts going back 3 months to 5 years. Also look at what known potential negative events can have on future earnings.

3. Don’t short beaten down stocks

I do occasionally short stocks. But I NEVER short an already beaten down stock, because the upside risk can be huge. A great example is Arch Coal. During 2015, this stock rallied from $1.00 to $10.00 in a few weeks on the rumors of well-known investors buying the stock. Six months later it was bankrupt. If you shorted it at or near $1.00 you got steamrolled and possibly wiped out, even though you were right. The point is, it doesn’t matter had bad the prospects are, if the stock is already way down, rallies can happen on any good news. I am about 95% certain Sears will be bankrupt by the end of next year. But it is so beaten down, I don’t even look at it.

4. Stock liquidity

If you plan to buy and hold for many years, this one may not be an issue. For the rest of us, it’s best to avoid companies that have low daily trading in its shares. What is low depends entirely on the size of your portfolio. You should be able to exit your position if you have to within a day or two. Compare the average daily dollar volume to the size position you want to take.

5. Loans

There are several things to look for in the loan footnote of a 10-K or 10-Q. First of all, look at the interest rate they are paying. If the rate is low and the company is solidly profitable, you probably don’t need to look further. If the company is struggling then this section becomes very important. Look at the covenants to see if they have violations or about to violate. Also look at the restrictions the covenants place. Look at upcoming maturities. Maturities in the next 18 months that significantly exceed cash can be a real problem.

6. Impact of outside factors

A. Interest rates – If rates are rising and the company has a lot of adjustable rate loans or upcoming maturities, their interest expense is likely to rise.

B. Rising commodity prices – If the company uses a lot of a certain commodity it is vulnerable to rapid price increases. This can be mitigated by hedging. Home builders would be making a lot more money right now if lumber prices weren’t soaring.

C. Need pay up for labor – With the current low unemployment rate, businesses are starting to pay up for labor. This has already impacted some industries such as construction, trucking and oil & gas exploration.

D. Increased regulations – Democrats love regulations, Republicans hate them. Reality is we need regulations but sometimes they go too far. Banks, payday lenders, and coal miners are benefitting from less regulations in their industries.

E. Tariffs – A current hot button and suddenly real important. You need to know the impact of tariffs on the company’s industry.

F. Economic cycle – Certain industries have historically been very tied to the economic cycle such as auto makers, steel, discretionary products, certain real estate and travel. Some have their own cycles such as semiconductors. Others such as utilities and consumer staples are less impacted and may even see increased stock prices as investors see them as a safe haven.

G. Secular Declines– There are several industries in secular decline. That means the whole industry appears to be permanently declining due to disruptions from other industries. These include newspapers, radio stations, office supply stores and coal. This doesn’t mean they are uninvestable. I have made good money on some of these when they fall too far.

H. Competition - New products or lower pricing by competitors can have a devastating effect. Airlines suffered from a price war that went for decades until they consolidated enough a few years ago to stop. Most tech companies are constantly facing the need to improve their products or lose the business. Apple in particular gets most of its profits from one product (smart phones) where technology is moving very fast. They have to come up with major upgrades annually to stay on top.

I. Size advantage – Larger businesses if managed right have the advantage of scale. This puts smaller competitors at a disadvantage.

Conclusion

As any team sports coach will tell you, defense is as important as offense. In fact, coaches are adamant about it because most players want to score. The same applies to stocks. Risk management helps protect your downside risk. It is a lot of work but is important if you are going to personally manage a stock portfolio. If you want to avoid the work, put most of your money in broad mutual funds or ETFs.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.