Smart Investing

It's time to talk about redefining risk, and I'm not talking about the typical blah blah blah asset allocation.

I'm talking about the risks and perceived risks of investing in the right equities. Many won't talk about this because it is too complex to understand, and that doesn't just mean the average investor; it also applies to many financial advisers who are nothing more than salesmen trying to sell you some plan or investment or whatever they can get you to buy.

One problem I have when talking with people is that they impose the same risk on all stocks. They will say such things as, "Well, I better be cautious and only put 50 percent of my money in stocks," and my question is, why? Yes, I understand that stocks are more volatile than bonds or money markets, but all stocks are not created equal, so why talk as if they are?

Let me explain: If you invest in a company that has a PE of 30, price to sales of five, a price to tangible book of 10 and trades at 22 times cash flow, does that company carry more risk than a company that trades at 10 times earnings, one times sales, a price to tangible book of 1.5 and trades at six times cash flow? All being equal, is the risk the same? No, of course not. Company one has a higher degree of risk then company two.

Let's also look at the financial strength of a company. Company one has a quick ratio of 0.2, a current ratio of 0.6 and total debt to equity of 150 percent. Company two has a quick ratio of 2.0, a current ratio of 3.5 and debt to equity of 0.40. Which company has less risk? Company two, of course.

Company two could pay off its next two years of current liabilities with its cash and account receivable. Company two could pay the next four years of its current liabilities with its current assets of cash, account receivable and inventory. Company one also owes to its creditors 50 percent more than it is worth, yet company two only owes 40 percent of what it is worth. Are these two companies equally safe? No, they are not. Company two has a higher degree of safety.

What if company one has a short-term peg of 3.0 and company two has a short-term peg of 1.0? A peg ratio reveals how much an investor is paying for the future growth of a company. In my portfolios I look at the peg ratio a little differently then the norm. I use the most recently reported past two quarterly earnings per share and add to that the next two estimated quarterly earnings. I will deduct this number from the full-year estimate of the next year. This will give an earnings growth number in a percent going forward. I then simply divide this number into the most recent price to earnings ratio for the trailing 12 months. You now have a number to measure what one is paying for the earnings going forward into the next year -- the lower the number, the better.

Lastly, while there are many other things I look at as well, I perform this action every single Monday on all the companies that I hold in my portfolio. This keeps me informed of changing risk factors. While this is a labor of love, it is a very important component in deducting increasing risk factors. Keep in mind, throughout the year prices are changing, estimates are moving and numbers are being modified. If you or your investment adviser is not on top of the companies you hold, your risk could be higher then you thought.

I will acknowledge that on the short term, my portfolio will move up and down more than a bond portfolio or other types of investments. I often say what I do doesn't work every day, but historically, it has worked over the longer term -- and I'm not talking about 10 years out, I'm talking about investing of three to five years.

So the next time someone says to you, "Well, my return was lower because I was more conservative and didn't have that much in stocks," dig a little deeper; find out what the valuation ratios were or the financial strength of the companies that they hold, and be sure to check the peg ratio. Then compare it to your own portfolio, and you may find that while you hold more in stocks than they do, your portfolio may have less risk.