A R.I.S.K Framework

Personal insight in evaluating various risks associated with public market investment

Disclaimer: The information contained within this website and article is not financial advice and reflects my opinion in a strictly personal capacity. I am an engineer by training and profession; I do not possess formal qualifications in finance or investment. I may hold positions in the stocks mentioned and hence probably biased. This website and article aren’t written to give you advice. I am just using it as my online journal to share knowledge and insights and to get feedback - I can’t guarantee the complete accuracy of all content so don’t rely on it. Please conduct your own research or consult a professional financial advisor - I am not the one.

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Previously, I've shared how I evaluate businesses using two main frameworks:

• The S.I.M.P.L.E Framework for Qualitative Assessments – Read about it here.

• The S.O.L.I.D Framework for Quantitative Evaluations – Read about it here.

I've also outlined my straightforward methods for valuing businesses to understand the potential upside of investments. - Read about it here

Once I determine that a company is fundamentally solid and available at a fair price, I've essentially figured out the potential reward. But what about the risks? Understanding the risks is crucial.

The first question I ask myself is why the market is offering this business at such a price. What might the market see that I don't? Is there any merit to the market's perspective, and how does my view differ? Remember, it's not enough to simply take a contrarian stance; you need to be right. As Charlie Munger wisely puts it, you should understand the bear case for your investment better than the bears themselves.

As a stock market investor, I've come to realize the importance of numerous known and unknown variables that can affect our investments. Today, I want to introduce a framework I've developed, which I call the R.I.S.K framework. This is a tool I use to journal my thoughts and keep track of the various risks that could impact my holdings. Like all my frameworks, it’s a live document — always evolving and improving as I learn more and gain new insights. I don't claim to know everything ( actually far from it), but this framework helps me think about risks in a structured way.

If you have any thoughts or insights that could enhance this framework, please share them in the comments below. I'm on a public learning journey, and every piece of feedback helps.

Here’s a breakdown of the R.I.S.K framework:

• R - Regulatory Risks: These risks come from changes in laws, government policies, compliance requirements, and other legal aspects that might impact the investment environment.

• I - Inherent Risks: These are risks directly related to the characteristics and behaviors of the investments themselves.

• S - Systemic Risks: These risks arise from broader economic and sector-wide phenomena that influence the entire investment landscape.

• K - Key Internal Risks: These risks originate within companies, including their internal operations and management practices, potentially affecting their performance and stability.

Let’s delve deeper into each of them

R - Regulatory Risks

• Changes in Laws and Regulation: Changes in regulations that directly affect company operations or industry standards.

• International Compliance: For companies operating across national borders, compliance becomes even more complex due to the need to adhere to the regulatory frameworks of each country - eg. labor laws, consumer protection laws, Workplace safety standards, etc

• Compliance with Existing Regulation: Failure to comply with regulations can lead to investigations and enforcement actions by regulatory bodies. This can result in penalties, fines, or other legal consequences, which can be costly and harm a company’s reputation.

• Licensing/Permitting/Approval: Certain industries require specific licenses or permits to operate. Obtaining and maintaining these licenses often involves rigorous regulatory scrutiny and adherence to strict standards.

• Sector-specific Regulations: Certain sectors have additional compliance requirements. For example, the pharmaceutical industry must comply with health and safety standards that govern drug testing and approval processes, while the financial sector must adhere to stringent risk management and reporting standards

• Environmental Compliance: Environmental regulations require companies to manage their operations to minimize their impact on the environment. This can include waste management, emissions control, and the use of certain chemicals.

I- Inherent Risks

• Liquidity Risk: Liquidity risk refers to the difficulty an investor might face when trying to buy or sell shares without causing a significant impact on the stock's price. Some stocks, especially those of smaller companies, maybe traded less frequently, making them harder to sell quickly without accepting a lower price

• Volatility Risk: Volatility refers to the frequency and magnitude of the stock price’s fluctuations. High volatility means the stock price moves significantly within a short period, which can increase the potential for large gains or losses. Investing in highly volatile stocks can be risky if the market moves unfavorably

• Sector Risk: Sector risk involves adverse developments that specifically affect an industry or sector. For example, regulatory changes, technological advancements, or changes in consumer preferences can significantly impact specific sectors differently than others

S - Systemic Risks

• Economic Recession: Economic downturns affect virtually all sectors of the economy. During recessions, corporate earnings generally decline, and stock prices can drop significantly as investors anticipate lower profits and heightened risks

• Interest Rate Fluctuations: Significant changes in interest rates set by central banks can affect the valuation of stocks. Rising interest rates generally lead to lower stock prices due to higher borrowing costs for companies and more attractive yields on alternative investments such as bonds

• Geopolitical Instability: Conflicts, wars, or political unrest in key regions of the world can create uncertainty that affects global markets. Investors tend to move away from stocks to safer assets in such times, impacting equity markets globally

• Global Pandemics: As seen with COVID-19, pandemics can lead to widespread economic disruption. Lockdowns, changes in consumer behavior, and disruptions to supply chains can negatively impact business operations and financial markets.

• Systematic Financial Crises: Issues like the 2008 financial crisis, where the collapse of major financial institutions led to a global banking crisis, illustrate systemic financial risks. Such crises can result in severe liquidity shortages and loss of confidence, leading to broad market declines.

• Currency Devaluation: Significant devaluation of major currencies can lead to financial turmoil. This impacts multinational companies by affecting their repatriated profits and altering competitive balances in global markets.

K - Key Internal Risks

• Poor Capital Allocation Risk: Poor capital allocation occurs when a company's leadership fails to invest its financial resources in profitable projects or spends excessively in areas that do not yield adequate returns

• Poor acquisition decisions: Spending large sums on acquisitions that are not strategically sound, fail to integrate well, or do not achieve anticipated synergies (same as capital allocation - but this needs to be listed separately so I don’t forget to think through about it)

• Operational Risk: This includes risks from the failure of internal processes, people, systems, or external events that could disrupt a company’s operations. Examples include supply chain disruptions, manufacturing failures, or IT system outages that can lead to operational downtime and financial loss

• Execution Risk: The dangers associated with a company's inability to effectively implement business strategies, plans, or projects due to internal inefficiencies, external pressures, or a combination of both

• Financial mismanagement: Poor financial control can lead to issues such as inadequate liquidity, excessive leverage, or poorly managed expenditures. These issues can compromise a company’s ability to invest in growth opportunities or survive adverse economic conditions

• Fraud Risk: Internal fraud risk includes activities such as embezzlement, misrepresentation of financial information, or other deceptive practices ( like running away with the company’s funds) that can damage a company’s reputation and financial standing

• Human Resources Risk: Challenges related to human resources, such as the inability to attract or retain key talent, labor disputes, or poor workplace culture, can affect productivity and innovation

• Major Customer/Vendor risk: potential financial and operational vulnerabilities that arise when a company relies heavily on a single customer for a significant portion of its revenue, or on a single vendor for crucial supplies or services. This concentration increases the risk because the business becomes overly dependent on the financial health and decisions of that customer or vendor.

• Succession Risk: This involves risks related to a lack of preparedness for replacing senior leadership. If a company does not have a clear succession plan, it could face instability or strategic uncertainty should a key leader leave abruptly. This risk is very high for founder-led/family-run businesses.

• Intellectual Property Risks: Risks related to the protection and management of intellectual property, including patents, trademarks, and copyrights. Mismanagement or theft of intellectual property can impair a company’s competitive position and revenue streams