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Dear Daily Crux reader, Most people think investing is risky. In fact, after the roller-coaster ride the markets have been on over the past 10 years – and the countless frauds, bankruptcies, and bailouts that have destroyed billions of dollars of investor money – many people have sworn off traditional investing altogether. These folks would rather keep their money in bank CDs or bonds earning next to nothing than risk losing more in the markets. But what most people don't realize is the biggest investment risks fall into three basic types… And with a few simple strategies, you can almost always avoid them. To learn more, we sat down with Dan Ferris, editor of the income-focused 12% Letter. By following the advice below, Dan says even average investors can realize investment returns most people can only dream of. Good investing, Justin Brill Managing Editor, The Daily Crux www.thedailycrux.com |
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The three big risks you're taking every time The Daily Crux: In a recent issue of your 12% Letter, you wrote that there are three serious risks every investor needs to be aware of. What are they, and why are they so important? Dan Ferris: Well, I know just mentioning the word "risk" can cause many folks to run for the hills. But I hope your readers will give me just a minute to explain. This topic isn't nearly as complicated as most people think… and managing risk is literally one of the most important things you can do to ensure investing success. In fact, many of the world's most successful investors consider risk management to be the mostimportant factor in their success. As you mentioned, there are three major types of risk that all investors need to be aware of… and avoid at all costs if they want to be successful. The first is called valuation risk. This is simply the risk that you'll pay too much for your investments, causing you to earn less money – or even lose money – on them. This risk is probably the most important, because it's the only one of the three that an investor can totally control… after all, no one can force you to buy a particular stock at a particular price. ----------Advertisement--------- Why this "side income" secret could pay far more than your regular job A California man has figured out a way to earn more money in his spare time than he makes from his regular job each year. He's been so successful at collecting this extra income, he was able to pay cash for his 6,000-square-foot dream home. Click here to see how he did it. --------------------------------- Crux: What can an investor do to control or avoid this risk? Ferris: Well, it's less about what you can do, and more about what you can avoid doing. An investor can control valuation risk by refusing to pay too much when they make a new investment. Of course, buying low and selling high runs contrary to human nature, and is one of the most difficult things for the average investor to do. Rising stock prices feel good, but they're a major problem for investors who want to avoid valuation risk. Many investors are lured to believe there's less risk as stock prices rise. They feel more comfortable… which makes them think they're taking on less risk. But of course that's not true at all… The exact opposite is true. Stocks become riskier as valuations rise. When a stock's valuation rises too high – like the vast majority did in early 2000 and late 2007 – and risk hits an unsustainably high level, prices are certain to fall sooner or later. And when they finally do fall, it's usually a collapse. To think about it another way, suppose a particular company earns $1 per share. Would the stock be riskier when it sells for $13 or $23 a share? When asked that way, almost anyone could answer it correctly. The stock is riskier at the higher price and less risky at the lower price. In general, if the company is growing earnings at all, 13 times earnings – $13 a share in this example – is a cheap valuation, and unless it's one of my World Dominating Dividend Growers or another super-high-quality business, $23 a share is too expensive to buy safely. Determining how much to pay is not an exact science, however, and there are a number of different methods professional investors use. When I set the maximum buy prices for my 12% Letter recommendations, I mainly look at the amount of cash flow the business generates in a given year versus the share price, and come up with a conservative number. Sometimes the dividend yield can be a clue of a stock's cheapness, too. It's not complicated… But if you can consistently avoid paying too much for stocks and only buy them when they're cheap enough, you'll realize returns the vast majority of investors never see. One the other hand, if you consistently pay too much for stocks, nothing can save you. Crux: What's the second major risk investors face? Ferris: The second risk is business risk. This is the risk that something will go wrong with the business and hurt its ability to earn and grow profits. This risk could come from bad management decisions, increased competition, changes in the industry, or any number of other areas. Regardless of the cause, companies with high business risk are likely to earn less in the future. Because a stock is simply a claim to a company's future earnings, it's clear your returns are likely to be lower as well. Crux: How can investors avoid business risk? Ferris: The easy way to avoid this risk is to buy only high-quality businesses... companies that beat their competition year after year, have excellent management teams and grow earnings like clockwork almost every year. One of the key traits of the highest-quality businesses is they're much more likely to grow and much less likely to shrink than most businesses. An easy way to find these companies is to look at their dividends. Companies that earn more year after year also tend to pay higher dividends year after year. So companies with a long history of consistent dividend growth tend to have very low business risk. Two other clues to identify high-quality businesses include consistent profit margins and plenty of free cash flow. Companies that have all three traits in spades – like my World Dominating Dividend Growers – are likely to be among the highest-quality, lowest-business-risk companies in the world. Crux: And finally, what's the third investment risk? Ferris: The third investment risk is known as balance sheet risk. This is the risk that a business will fail or get in trouble because it can't pay its debts. This is probably the simplest type of risk to understand and avoid… One easy way to do this is to find companies with much more cash than they'll ever need to pay their debts. For example, if a company has $63 billion in cash and less than $12 billion in debt – which one of our World Dominating Dividend Growers does – the whole company could shut down tomorrow, and it could easily pay off all its debt and still have tens of billions of dollars left to distribute to shareholders. There's practically no balance sheet risk in a business like this. But a company doesn't have to have that kind of cash hoard to have low balance sheet risk. I also like to look at the amount of interest the company pays compared to how much it earns. If a company can earn many times more each year than they pay out in interest payments, balance sheet risk is often low. The best part is, it takes a just a few minutes to take a look at a company's balance sheet to see if it has more cash than debt and/or earns many times its interest expense. This makes it very easy to find companies with low balance sheet risk. Crux: Sounds great… Any parting thoughts? Ferris: As I mentioned to my readers, learning how to assess these three types of risk will take a little time. But it's guaranteed to be time well spent. Avoiding these risks will do more to guarantee your investment success than almost anything else out there… and it's accessible to the professional and amateur investor alike. Of course, if any readers don't have the time or inclination to master these techniques themselves, I encourage them to try The 12% Letter. I never make a recommendation without checking off each of these three risks. Crux: Thanks for talking with us, Dan. Ferris: My pleasure. |
Editor's Note: Dan recently reported on a little-known investment that has beaten every other asset class over the last 15 years… producing incredible 16.6% annualized returns. To get all the details on this opportunity, and gain instant access to Dan's elite list of World Dominating Dividend Growers – four of which are currently trading under his maximum buy price – click here to join The 12% Letter. |
Sunday, 13 January 2013
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