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Course 210
Operating Risk versus Price Risk

Introduction

In investing, as in life, risk comes in many forms. When it comes to stocks, two particularly important types of risk are operating risk and price risk. Operating risk is the risk to the company as a business. That includes anything that might adversely affect the company's market or its profitability, such as volatile raw-materials costs or rising labor costs. A debt load that is high compared with industry or market averages would also make for higher operating risk because it would magnify the bottom-line effects of a drop in demand. Basically, anything about the business that makes its earnings less certain or more unstable qualifies as operating risk. Price risk has more to do with the stock than with the business. There are different ways to look for price risk, but probably the most common is comparing a stock's valuation measures, such as its price/earnings or price/book ratio, against that of the industry, the market, or any other index that will yield a meaningful comparison. A stock with comparatively high multiples carries more price risk than one with lower multiples. When looking at a stock, it is a good idea to figure out how its operating risk balances its price risk. To see why that might be important, imagine a company in a turnaround situation--that is, one that carries a fair amount of operating risk. If the stock is expensive, you may not be interested because much of the potential improvement in earnings is already figured into the price. And if those earnings don't materialize, chances are good that the stock will tank. But if the stock is cheap, you might be inclined to take a chance on those theoretical and risky future earnings. The upside potential is great if the company comes through, and the downside risk--or price risk--is comparatively limited. It is helpful to visualize the balance between operating risk and price risk as a four-box matrix, with stocks fitting into one of four categories: low operating risk and high price risk, high operating risk and low price risk, low operating risk and low price risk, and high operating risk and high price risk.

Low Operating Risk and High Price Risk

Most of the leading stocks in today's market fit into this box. These are stocks like Cisco Systems CSCO, Wal-Mart WMT, and Johnson & Johnson JNJ--in other words, companies that have advantages, such as leading market position, brand-name franchises, and superior profitability, that allow them to post reliable earnings and growth year in and year out, quarter after quarter. Smaller or less well-known companies with good managements or strong market niches can also end up here. These companies--though they occasionally post lower-than-expected growth or weak earnings--have delivered over the long haul. And the market has noticed. For example, as of November 1999, Clorox CLX commanded 47 times its trailing earnings, a P/E ratio 50% higher than its average P/E over the past five years. The market raised the premium on Clorox's future earnings in large part because the company has been so reliable in the past. If the companies in this group don't meet or exceed the market's high expectations, their stocks could be in for a long period of subpar returns until earnings catch up with the prices. And any glitch in earnings--and every company has glitches, no matter how steady it is overall--can send these stocks into a tailspin.

High Operating Risk and Low Price Risk

Cyclicals, with their reliably unreliable earnings, tend to crowd into this corner, though companies with less-than-ideal markets or mediocre managements fit as well. In large part, these stocks can make up for their lack of earnings stability--as in the turnaround example previously mentioned--or their choppy growth, with their low price risk.

Low Operating Risk and Low Price Risk

These stocks are the Holy Grail. Warren Buffett's stocks fit into this category when he bought them, before their valuations increased, pushing them into the low-operating-risk-and-high-price-risk box. The big problem with this box is finding stocks that fit into it. As you've probably realized by now, most stocks tend to congregate in the low-operating-risk-and-high-price-risk box or the high-operating-risk-and-low-price-risk box. The market is more or less efficient, and it tends to exact a higher price for higher quality and a lower price for lower quality.

High Operating Risk and High Price Risk

This playground is pretty much off limits to all but speculators and aggressive-growth investors. Most often, hot startups and small technology plays end up here. These are companies whose businesses are new or are so small that they carry a lot of operating risk. But they are also usually in popular or glamorous industries, which means that the market has put high price tags on those uncertain earnings. In order for their high-priced stocks to do well, these companies need to present some convincing evidence that they could be the next Microsoft MSFT. It is important to recognize the riskiness of any investment, and it's even more important to recognize that there are different types of risk to consider. A stock that's risky because its operations are unstable is a different kind of investment than one that's risky because it is expensive. How much of each kind of risk you're willing to tolerate depends on both your temperament and your time horizon. If every drop in a stock's price makes your stomach churn, you probably don't want a lot of price risk. And if you're about to retire, you probably want a predictable stock without a lot of operational risk. Balancing the two is not always easy, but it always makes for better investing in the long term.

Quiz 210
There is only one correct answer to each question.

1 Price risk refers to:
a. The risk that a company may have to lower the price of its products in order to keep up demand.
b. The risk that the goods that a company needs to manufacture its products will increase in price, resulting in lowering operating profits.
c. The downside risk associated with a stock that already has a high relative or absolute valuation.
2 The stocks of which types of companies are most likely to have high price risk?
a. Cyclical companies.
b. Companies with valuations that are already high.
c. Companies with low operating risk.
3 Which types of stocks are least likely to keep you awake at night?
a. High operating risk and low price risk.
b. Low price risk and low operating risk.
c. Low operating risk and high price risk.
4 Why is it so difficult to find stocks that fit in the low-price-risk-and-low-operating-risk category?
a. Warren Buffett already owns most of them.
b. The market is generally efficient, and stocks with low operating risk are typically rewarded with higher valuations, putting them at higher price risk.
c. Investors crave excitement.
5 High-price-risk stocks are most likely to appeal to:
a. Retirees.
b. Investors who are within 10 years of retirement.
c. Investors with long investment horizons.
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