How to mitigate risks when investing

Did you find a wonderful company? Isn’t it an awesome company – it’s got it all! Well, now you have to build a case to why your new love isn’t as perfect as you had thought...

”You must force yourself to consider opposing arguments. Especially when they challenge your best-loved ideas.”

Charlie Munger

This is a very difficult exercise because you’ve probably already spent a lot of time studying your company. Most people do not like to have spent a lot of time on something and then drop it. It’s perfectly human to not like this exercise, but if you don’t want to lose money, now is the time to be brutally honest about why this business is not so wonderful.

The most important question you can ask here is: What are the risks of the key performance indicators (KPIs) in this industry?

A key performance indicator is a company’s defined goals that every employee in the organization work towards and different industries have their own key performance indicators. For example, for social media networks it can be user acquisition, revenue per user and engagement rates. For fast moving consumer goods, it can be product demand, net promotor score (NPS) and active share, for ecommerce cost per order, repeat customer rate and cart abandonment rate. It’s all performance indicators that keeps the business alive.

Because we only invest in business, we understand it’s critical to know the key performance indicators. Unfortunately, only few companies share them in the annual report, but sometimes, it’s possible to read between the lines and other times there are articles or research online that will help you.

Back to the point. What you must do now is to identify risks for each KPI. Users abandon the social network because a new functionality makes it difficult to navigate, consumers don’t buy the product because it’s not trendy anymore and users abandon their carts because there’s not a clear virtual isle to checkout. These are just examples but use your common sense and think about what would cause this company to go under.

One exercise you can do, is to track back and see if the stock price of your wonderful business has fallen like an elevator in the past and what caused the stock price to fall? Try to not look at overall crashes of the market (though sometimes that does certainly leave clues). Some examples of stock prices falling is Chipotle, a fast-food chain selling organic Mexican food. Years ago, on two separate occasions their customers got sick from e-coli. The company came back stronger with new and improved processes. Another example is the oil company BP, which had a horrible oil spill in the Gulf of Mexico as many of us probably remember. The company stock fell like a rock off a cliff, though the intrinsic value was the same. Whether or not you want to buy into an oil company it’s an example of an event that causes shareholders to sell, while the value of the business is not impacted.

Last question: Which companies in the same industry has gone down in the past and what was the cause. Sometimes there’s gold to be found learning from other’s mistakes.

Study the case for your wonderful business, and what the company did to bounce back.

Try to find the top three reasons the company will fail, as well as the reasons why this failure will be mitigated.