Heads-Up: Upswing Resilient Investor Guide - Min(Risk) Control
Credit ratings of companies and countries are most popular universal tools for helping investors to gain insight into different investment environments and to understand the risks and advantages these environments pose [1]. Globally, there are three main ratings agencies that provide credit ratings: Moody’s, S&P, and Fitch. Figure 1 gives an idea of the different rating symbols that Moody's and Standard & Poor's issue [1]. These ratings are considered to be investment grades consistent with the TLS Red “Junk”, Amber BBB and Green (A, AA and AAA) scores. For completeness, it is worth mentioning the monthly Zacks Stock Rank [18] that will help you find the best mutual funds to outperform the market. The Zacks Industry Rank is the average Zacks Rank for all companies within a specific industry group.
Most risk ratings determine the enterprise risk which consists of the business risk (volatility of cash flows) and the financial risk of the capital structure. A firm with higher risk should reward investors with higher returns. A technology company might have high business risk, whereas a utility or a property company may have low business risk.
The analysis of a company's financial risk begins after all possible risk events have been identified. Generally, there are seven types of business risk: economic, compliance, security, financial, reputation, operational, and competition risks. the Risk Ratio (0<RR<1) can be calculated as
RR=Nr/NR,
where NR=7 is the total number of risks and Nr is the number of known risks. As a result, the percentage of risk is as follows: 14-28% (Green), 48-57% (Amber) and 75-85% (Red).
As a realistic example, let’s analyze how much of the risk of a 60/40 stock/bond portfolio comes from each of its components [17]. Risk assumptions are based on the 42Y historical data: volatility of stocks/bonds is 15/5% and stocks/bonds correlation is 20% (according to the rule of sum for mutually exclusive events). Assuming that the risk of stocks is 15%, the risk of stocks alone is given by the squared value (0.6*0.15)**2=0.0081. Assuming that the risk of bonds is 5%, the risk of bonds alone is given by the squared value (0.4*0.05)**2=0.0004. The “co-risk” of stocks/bonds and bonds/stocks is given by the product (0.6*0.15)* (0.4*0.05)*0.2=0.00036. Adding up the four numbers 0.0081, 0.0004 and 2*0.00036, we get 0.00922. Thus, the volatility of the 60/40 stock/bond portfolio is the square root 0.00922**1/2 *100%=9.6%. Here, we see the contribution of each component: stocks contribute almost 92% of the portfolio’s risk, while bonds contribute the remaining 8.2%! Figure 2 extends this observation to other stock/bond portfolios. For an all-stock portfolio, all of its total risk of 15%. If we diversify into an 80/20 stock-bond portfolio, total risk falls to 12.2%.
Referring to drawbacks of probability calculations, it is well known that neglect of probability is one of 10 strong cognitive biases that can lead to investment mistakes [6]. Indeed, we often over- or underestimate probability in decision making. To circumvent these biases, let’s turn our attention to best industry practices by invoking some common business/financial risk ratios and metrics [1] such as such as the standard deviation (STDEV) or volatility of returns, the Alpha/Beta coefficient, the Treynor/Sharpe ratio, Value at Risk (VaR), Conditional VaR (CVaR), R-squared, Debt-to-Capital Ratio (DCR), Debt-to-Equity Ratio (DER), Interest Coverage Ratio (ICR), and Degree of Combined Leverage (DCL). These ratios and metrics are the main indicators of business/financial risk used by credit rating agencies mentioned above, but by no means the only ones [19]. You might want to use them in combination with other TLS metrics to arrive at an accurate decision.
Let’s begin with STDEV that measures the variation from annual performance. If all else is equal, we would select stocks with lower STDEV. For example, relatively high STDEV values of most top penny stocks [20] (red score) create opportunity in barring their shares from being purchased (that can make sense for beginners!).
ReplyDeleteNext, Beta is a measure of the systematic risk of an individual stock R compared to the market M as a whole. Systematic risk is related to the crash of the whole market, and Beta indicates how much companies will fail during this period. Beta is expressed as
Beta = Cov(R,M)/Var(M),
where Cov and Var are covariance and variance, respectively [1]. By utilizing Beta, we can study the stock reaction to unprecedented changes in the market conditions such as black swan events (Covid-19, the financial crisis of 2007-2008, etc.). For example, the value Beta>1 indicates a stock’s price swings more wildly than the overall market (this is typical for most tech companies); the value Beta<1 means that a stock’s price is less volatile than the overall market; the value Beta=1 indicates that the stock moves identically to the overall market (e.g. the S&P 500 index); the negative values Beta<0 signifies an unlikely inverse relation to the market; cash has the zero value Beta=0; the value Beta=1 means that the stock mirrors the volatility of the market; the great values Beta>4 represent either statistical errors or a fatal price swing. To put it in a nutshell, high-beta stocks are supposed to be riskier but provide higher return potential; low-beta stocks pose less risk but also lower returns. Beta indicates how volatile a stock's price has been in comparison to the market as a whole. A high Beta may be preferred by an assertive investor in growth stocks but shunned by conservative investors who seek steady returns and lower risk.
Alpha shows how well (or badly) a stock has performed in comparison to a benchmark index (most commonly the S&P 500). The Jensen’s Alpha coefficient [1]
ReplyDeleteAlpha = Return(R) - (Return(F) + Beta x (Return(M) - Return(F)))
is expressed in terms of the realized returns of the portfolio R and the appropriate market index M, Return(R) and Return(M). Other input parameters are Beta and Return(F) - the risk-free rate of return for the time period [15]. Alpha is represented as a single number, like 2 or -3. In fact, Alfa indicates the percentage above or below a benchmark index that the stock price achieved. In this case, the stock did 2% better and 3% worse, respectively, than the index. Alpha helps reveal how a stock or fund might perform in relation to its peers or to the market as a whole. But it can't tell you how the stock will do tomorrow. You may want to generate a higher Alpha by diversifying your portfolios to balance risk (see Figure 2). A high Alpha is always good. The baseline number for Alpha is zero, which indicates that the portfolio is tracking perfectly with the benchmark index. In this case, you have neither added or lost any value. Both Alpha and Beta are historical measures of past performances.
The Treynor Ratio (TR), also known as the reward-to-volatility ratio, is a form of RRR that adjusts for systematic risk mentioned above. It is a performance metric for determining how much excess return was generated for each unit of risk taken on by a portfolio. Excess return in this sense refers to the return earned above the return that could have been earned in a risk-free investment. The Treynor Ratio can be calculated by using the following formula [1]:
ReplyDeleteTR=(R-R0)/Beta,
where R is the return generated by your portfolio, where R0 is the risk-free rate that carries virtually no risk of default [15] (e.g. U.S. government 3-month Treasury bills and 10-year bonds). For example, the value TR=2 implies that the fund gave two units of return for every additional unit of market risk assumed. TR can identify the best performing investment within a subset of the broader portfolio. However, it is calculated based on the historical data. Therefore, it does not reflect the future potential of a portfolio.
Another form of RRR is the Sharpe Ratio (SR). The SR helps you understand your investment's return compared to its risk while the TR explores the excess return generated for each unit of risk in your portfolio. The explicit SR formula is as follows [1]:
ReplyDeleteSR=(R-R0)/STDEV,
where the numerator is the familiar Jensen’s Alpha that is useful to quantify the investment’s return over the market return. To put it simply, the greater the value of SR, the more attractive the risk-adjusted return [21]. In practice, the range SR<1.0 is considered bad (red score); the SR interval [1.0,1.99] (including SR=1) is considered adequate (amber score); the range SR>3 is considered excellent (green score). The particular case SR<0 often means that the expected return is likely to be negative (red score). The main drawback of the SR is that it does not account for return fluctuations (since STDEV=const) during the reference period, especially when analyzing stocks that have a negative return [29].
The Sortino Ratio (SR-) is similar to the SR but with a twist. The SR- is calculated by taking the difference (R-R0) and dividing this by STDEV- of the negative returns witnessed over the time period [1]:
ReplyDeleteSR-=(R-R0)/STDEV-.
Since upside volatility is not considered to be negative, the SR- is a better measure of risk-adjusted returns than the SR itself [30]. A higher SR- is better than a lower one as it indicates that the portfolio is operating efficiently by not taking on unnecessary risk that is not being rewarded in the form of higher returns (green/amber score). A low, or negative, SR- may suggest that the investor is not being rewarded for taking on additional risk (red score).
In addition to above ratios, let’s dive deeper into the risk of loss for your investments by analysing VAR and CVAR [1]. It estimates how much a set of investments might lose in a set time period. Statistically, VAR is calculated as a function of mean and variance of the returns with the confidence r=95%, assuming normal distribution beyond swan events [31]. For example, if the 95% one-month VAR is $1, there is 95% confidence that over the next month the portfolio will not lose more than $1 [31]. Conventionally, CVAR is derived from the value at risk for a portfolio [1].The use of CVAR as opposed to just VAR tends to lead to a more conservative approach suitable for beginners in terms of risk exposure (e.g. investing into dividend stocks [32]).
ReplyDeleteAnother popular statistical measure is the R-squared (R2) defined as follows [1]:
ReplyDeleteR2=1-(Unexplained Variation)/(Total Variation).
An R-squared of 100% means that all movements of a stock are completely explained by movements in the reference index. a high R-squared, between 85% and 100%, indicates the stock's performance moves relatively in line with the index. A stock with a low R-squared, at 70% or less, indicates the stock does not generally follow the movements of the index. A higher R-squared value will indicate a more useful Beta. For example, if a stock has an R2 value of close to 100%, but Beta<1, it is most likely offering higher risk-adjusted returns (green/amber score).
Finally, let’s discuss the following metrics related to risk: Debt-to-Capital Ratio (DCR), Debt-to-Equity Ratio (DER), Interest Coverage Ratio (ICR), and Degree of Combined Leverage (DCL). The DCR ratio is calculated by taking the company's interest-bearing debt, liabilities and dividing it by the total capital [1,35]
DCR=Debt/(Debt + Shareholder’s Equity).
According to HubSpot, a good DCR range is 1-1.5, indicating that a company has a pretty even mix of debt and equity. The values DCR>0.6 usually mean that a business has significantly more debt than equity.
The formula for calculating the DER is to take a company's total liabilities and divide them by its total shareholders' equity [1]
DER = Total liabilities / Total shareholders' equity
Generally, a good DER is around 1 to 1.5. An acceptable range is DER<2.0 for most companies and industries.
The ICR is a debt and profitability ratio used to determine how easily a company can pay interest on its outstanding debt. The ICR is calculated by dividing a company's earnings before interest and taxes (EBIT) by its interest expense during a given period [1]
ICR = EBIT / Interest Expense.
The lower the ratio, the more the company is burdened by debt. When ICR<1.5, the company’s ability to meet interest expenses may be questionable (red flag).
The degree of financial leverage is calculated by dividing the percentage change in a company's EPS by its percentage change in EBIT [35]
DCL = (% of change in EPS)/ (% of change in Sales) = DOL * DFL,
DOL = Contribution Margin / EBIT,
DFL = EBIT/(EBIT-Interest)
The ratio indicates how a company's EPS is affected by percentage changes in its EBIT. A high DCL shows the risk involved in the company, while a low DCL would mean better for the company.
In the above expression, earnings per share (EPS), also called net income per share, is a market prospect ratio that measures the amount of net income earned per share of stock outstanding [1,49]. The EPS formula is
ReplyDeleteEPS = (Net Income – Preferred Dividend)/(Weighted Average Common Shares Outstanding)
And the EPS growth rate is
EPS Growth Rate = 100%*(EPS(Y)-EPS(Y-))/EPS(Y-),
where Y = the current year and Y-=Y-1 is the previous year.