Overview – Not All Risk Factors are Worth Your Attention
If you’ve ever gone over the “Risk Factors” section of an annual report or similar documents, then you’re probably aware of how long this section can become. Anything that presents even the slightest chance of being detrimental to a business or business-related activity is listed as a risk factor.
Not only that, but some factors are so broad that the explanation behind them can go on seemingly forever. For example, an emerging risk factor is technology/cybersecurity risks which, due to its relatively new nature, is usually accompanied by a lengthy explanation.
While it’s understandable that a company wants to prove to investors they are being thorough when assessing potential risks, intelligent investors understand that just because something is listed as a risk factor doesn’t necessarily mean it’s worth ruminating about.
Why is that? Because not all risk factors will put an investor’s capital in jeopardy, nor will the investment merit of a given company always be adversely affected by them.
A Quick Reminder of What Investment Risk Entails
“Risk” is thrown around rather carelessly in most investment discourse. As a result, sometimes it’s easy to forget what exactly it entails, specifically how it affects investors.
We’ve previously discussed what investment risk is. To review, investment risk is simply defined as the probability of losing money and how much money could potentially be lost.
Investment risk could therefore be visualized by a risk matrix, as shown below:
By definition, there are only two ways to affect investment risk: increase/decrease the probability of potentially losing your money, or increase/decrease the amount of money you stand to lose. That’s it.
So just because a company discloses dozens of risks accompanied by mini-essays to explain them doesn’t mean all of them need to be worried about. A company could face a variety of different risks, but not all of them may result in investors losing their capital.
To illustrate this point, in the next section, we will go over a case study of when risks needed to be considered before a transaction took place, but not all of the “risks” in question were necessarily worth worrying about.
Case Study: Brookfield Property Partners Transaction
On January 4, 2021, Brookfield Asset Management (BAM) announced that it would buy all outstanding shares of Brookfield Property Partners (BPY), essentially purchasing the entire business.
In preparation for this purchase, BAM released a document to BPY unitholders, giving them three options on what they could do with their units: they could elect to receive BAM stock, a cash payout, preferred shares of a BPY spinoff, or some combination of the three.
Within this document was a Risk Factors section regarding the proposed deal: it was 20 pages long. The risks that were discussed included risks from the transaction, risks associated with the three options unitholders were presented with, and even tax consideration risks.
Most of the risks that were talked about were extremely nitpicky, and some of them were arguably a stretch.
One of the risks was, verbatim: “Current BPY Unitholders will generally have a reduced economic ownership interest in BAM than they have now in BPY, after the Transaction.”
Going back to our definition of risk from earlier, how is having a reduced ownership stake in another company a risk factor? Going back to our definition of risk from earlier, just because you have a reduced equity stake doesn’t mean your capital is now in danger.
There were several other “risks” detailed in the document that were mild inconveniences at best, and fixable problems at worst.
This is what we mean by not all risks being a potential threat to an investor’s capital. Most of the risks disclosed in the document were likely for legal purposes and the sake of completion. But when looking solely for sources of investment risk, there were arguably only a few in that section that would be classified as such.
Risk Factors Affect Different Parties to Different Extents
When going through a Risk Factors section, it’s easy to believe that all of the risks being discussed are of equal merit. However, not all of them will have the same “weight”.
First, it’s important to understand that different risk factors will affect different parties. Most of the risk factors that a company talks about will most likely affect them, but there’s also the possibility of others being affected such as sub-contractors, creditors, subsidiaries, and investors, to name a few.
For example, some risk factors may be of great interest to a company’s investors, while others may not affect investors much, if at all.
Second, even if a given risk factor affects multiple parties, not all of them will be affected to the same extent. Certain parties can be heavily affected while at the same time, others may not feel much impact at all.
An example would be an increase in interest rates. If rates become too high, and companies struggle to make payments on time, this increases the chances of them defaulting on their loans.
Due to this, a company’s creditors are the ones who will be most affected by this risk, while other parties who aren’t directly involved with a company’s loans, such as their investors and sub-contractors, may not need to worry as much.
Now, this isn’t to say the Risk Factors section can be taken lightly. Almost everything that’s listed is there for a purpose, and investors will still want to go through each of them, even if just giving them a quick skim, to understand exactly what each entails.
Underestimating certain risks can lead to an investor’s demise, but overestimating them and giving them more attention than needed can also prove to be harmful.
Risk Factors That Affect Businesses Don’t Necessarily Affect Its Investors
Building off the previous section, many investors mistakenly believe that the risks that could affect a company can also affect them. While that may be true in some instances, this won’t always be the case.
Knowing how to distinguish between “risks that affect the company” and “risks that affect my portfolio” is something investors must be cognizant of.
Take, for example, reputational risk. Many companies cite this as a risk factor, stating that a damaged reputation/image could adversely impact their ability to do business. While this may be true, this doesn’t necessarily mean investors need to start worrying.
There are many companies around the world, such as the members of Big Tech, Big Oil, and aerospace/defense that have controversial public images, yet for the most part, carry on with their day-to-day business activities and continue to provide value that their investors seek, despite how they’re perceived.
Another risk factor that’s frequently cited is political/geopolitical risk. Many companies cite this factor, and rightfully so: political climates and/or strict regulatory environments have the potential to affect a business’ operations for better or for worse (for more on politics and investing, we’ve talked about it here).
However, just because political developments can affect companies doesn’t mean its investors are automatically in the line of fire. Again, it’s not unheard of for companies to face political/regulatory pressures without having to sacrifice investor value. Companies can, and in many cases do, adapt to political changes.
Most risk factors have the potential to affect businesses, otherwise they wouldn’t be listed in the first place. However, many investors conflate “risks that affect a business” and “risks that affect my investment portfolio” which isn’t necessarily the case.
Wrapping Up
Publicly-traded companies face all kinds of risks in their operations, and are dutifully reported in their publicly available documents. Although these companies face all sorts of risks, not all of them may be a cause of concern for investors.
Risk factors can affect multiple parties, and to various extents. Sometimes, investors are one of those affected parties, and other times, they aren’t.
Now, this isn’t to say that investors can disregard the risk factors that a company faces, but when analyzing them, investors need to ask if they are affected, and if so, ascertain if their capital is in jeopardy. If not, then investors don’t really have any reason to stress.
