A Risk Management 101 for Professionals

What is risk management? Why do professionals need to know about risk management? These are great questions to ask as a professional – whether you’re a consultant, a lawyer, a financial advisor, etc. Risk management will look different for every profession and every industry, but this risk management 101 provides tips for professionals all across the board.

It is critical to manage your risk as a working professional, not just as a business owner. Professionals face a different level of risk than your average worker does and, without properly addressing the issue or taking the necessary steps to mitigating your risk, your business may be severely impacted by a loss which could threaten to put you out of work for good.

Professional liability insurance is just one piece of the puzzle. Here’s the rest:

First of all, what is risk management?

Risk management is the practice of evaluating risks which could potentially harm your business’ operations – as well as its profitability – and taking the necessary action to mitigate the devastation of these risks or avoiding them altogether.

Risk management can look like:

  • Mitigation – When you avidly reduce the impact of the potential risk
  • Acceptance – Accepting that the risk may occur and creating an emergency preparedness response for if it does happen
  • Avoidance – Taking away the risk altogether by avoiding taking on certain clients/working in a certain location/etc.
  • Transference – Transferring all or a portion of the risk to a third-party, like through the purchase of insurance.

Risk management may take the form of the following steps:

  1. Acknowledging or identifying a risk that exists
  2. Determining the severity that the risk could cause to your business
  3. Identifying the source of the risk
  4. Navigating a process to mitigate or avoid the risk
  5. Navigating a process to recover from the risk.

Not every risk can be mitigated, avoided, or even managed. Some risks may simply need to be accepted (which is, in fact, a part of the risk management process!) As such, it is imperative that you focus only on the risks that are the most impactful to your business.

How does risk management help my business?

As a hard-working professional, you love what you do. You excel at what you do. You want to better your business, and risk management is one of many ways to do just that. Here are just a few of the ways that risk management can help better your business:

  • Allows your business to be adaptable to change
  • Boosts your teams’ communication skills
  • Hels aid in project/contract negotiations
  • Allows you to meet deadlines with success
  • Keeps long-term costs affordable
  • Allows your business to operate smoothly without a hitch

There are plenty more benefits than just those that we have listed here. Working with your team is imperative to acknowledging, weighing, and managing your risk. It just depends on your company’s individual risk and how seriously you take the process of risk management.

Not all risks can be mitigated

Part of risk management is accepting that some things may just happen, no matter the precautions we take and no matter the measures we instill to avoid them. Planning for risks can be a difficult endeavour, but there are some risks that we may simply have to accept. Part of our risk management plan can then be a “risk response plan,” for how we get back to normal following an emergency or incident.

For any business, the following scenarios can be significantly impactful:

  • Cyberattack/data breach
  • Medical emergencies
  • Storm damage
  • Fire damage

For your emergency response plan, you should consider orienting your team members on how best to handle the threat of a natural disaster. Include an evacuation plan, a muster point, and give each employee corresponding roles for if an emergency does occur.

Technology and data can be vulnerable spots when it comes to risk management as cyber-attacks become an ever-increasing issue for Canadian businesses. You need to be aware of these risks and how to handle your business accordingly if something does occur (such as a breach.)

Professional liability insurance may not be able to prevent a risk from occurring, but it can be a huge aid if something does happen. Professional liability insurance is designed for businesses and individuals of a professional nature and can cover you for legal defense costs if a client should ever sue for alleged, perceived, or actual negligence resulting in their financial loss.

Eternal Technologies (ETLT.OB)

I received an email earlier today from a reader suggesting a micro-cap value company, Eternal Technologies, Inc. (ETLT.OB). Operating in China and incorporated in Nevada, the company offers embryo-transfer services, large-scale improvement of livestock quality, and the development of agricultural and medical  products. If you know exactly what any of that means, shoot me an email. I’d love to know.

But all joking aside, the company seems compelling due to its attractive valuation.  Its price to tangible book value, coupled with boatloads of marketable securities and cash on hand, give the company around a 40-50% discount to realizable asset value. All the while, the company has virtually no debt, a profitable income statement, and is cash flow positive. It also expects much of the same in the coming year(s).  So with all that going for the stock, it’s a no-brainer, right?Tech

Not so quick. Before getting too giddy about the opportunity, I wanted to share my email response to the suggestion. Forgive me again for allowing my cynical side to run amuck, but I believe their are several risk factors in the company that are tempering my greedy side. Here goes:

“I’ve checked out ETLT before and went back to take another look. The cash in the bank is tempting, but I’m a bit    hesitant to buy any shares. I see the company as having several material risks offsetting its net asset value.

First, the company is a Chinese operation with ‘government backing.’ Truth be told, I have no idea what that means, and, for that matter, I don’t know if I like the Chinese government backing anything I have my money in right now. I know little to nothing about China, and I believe investors face substantial risks investing there, and should be prepared to heavily discount any investments there.

Second, the company may have that cash stash, and you may be right that their acquisitions are good. But I just don’t have the ability to say one way or another. And generally speaking, when I can’t tell for sure that an acquistion is good, I assume it’s bad. That said, I’d love to see [more of] your research on this.

Third, the business is inherently complex, and given the high tech area in which it operates, I have no special knowledge that can give me an edge. Tell me that management planned to distribute what they have in the bank or allow it to earn returns in a much simpler business then that’s a different story. I have no idea what they plan to do with the assets, and because they’re investing in (other) high tech businesses, I’m especially afraid that whatever they do, it’ll be stupid.

Fourth, be careful not to fall into the trap of looking at the total asset value and not the diluted per share values. The company has been issuing equity at a rapid pace, and has 2.5 million shares worth of in-the-money options waiting to be exercised. Running a quick calculation reveals a ‘true’ per share value of about $1.11 in book, not $1.30.

And last but not least, I always worry about these very small operations having materially significant deficiencies in accounting and control procedures. Though their auditors (whom I’ve never heard of) issued a clean opinion, they also reported at least two material deficiencies [in the past few years, including 2005]. And, on a completely different note, their somewhat sketchy website doesn’t ease my worries. I’m not saying they’re fraudulent, but you never know what ugly practices lurk behind the scenes.

Again, I’d love to see or hear more research. If my aforementioned fears could be eased, I’d be very interested in purchasing shares…”

I’ve seen a fair bit of bullishness on the stock on message boards, other posts, etc. The enthusiasm is understandable. Give any investor a profitable and growing company trading for less than liquid assets, and they well should be excited. But I believe ETLT is a different can of worms, with a set of unique risk factors that must be taken into account and fully realized before any investment is made.

Over-Stimulation

It’s hardly a problem when it comes to sex, but it’s a big problem when it comes to investing. What, was that too forward?

Okay, fine. I apologize. But seriously…Over Stimulation

When investing, it’s easy to become caught up in hype and activity surrounding the stock market. We have a natural tendency to want to just do something when everybody else is doing something. Red and green tickers flashing every few seconds, streaming news stories, hyper-active Wall Street types screaming their buy orders, and a host of other signals all tell us, often without our conscious awareness, that we are being left behind and that, to keep up, we must partake in the festivities. After all, who wants to miss that quick buck promise from a screaming Jim Cramer? And who wants to sit idly while someone (on TV, nonetheless!) tells them their favorite stock is a dud?

So what’s the problem with this? Well, to put it in plain English, intelligent investing often requires you to sit quietly on your ass. Active trading does several harms to your portfolio.

First, it fails more often than not. Those who believe they know where a stock is headed in the next day, week, or month often have no clue and are merely speculating. Second, it takes away valuable time for thorough research. Time spent sitting and staring at your tickers does nothing to give you great ideas, presents an opportunity cost since you could be reading a 10-K and getting to understand a company instead, and often results in anxiety because you’re so damn worried what the stock will do next. But who cares? If you’re right about it, it’ll go up eventually. Give it time and leave it the hell alone. Third, active trading increases transactions costs. Granted that with extremely low online commission expenses one trade is not that big of a deal, but if you’ve actively traded for an entire year, you’re looking at hundreds, if not thousands, of dollars in excess commissions by year’s end. For most people with portfolios of a small size, this can represent a large percentage of the portfolio. And finally, it ups the value of taxes you have to pay. With short-term capital gains taxed at income levels, trading gives you an extra hoop to jump through in order to beat the market.

How is one to deal with over-stimulation? I, for one, force myself not to look at my portfolio more than once a day (if that), and I never keep any sort of streaming quotes on my computer screen. I avoid reading anything having to do with a short-term trading idea (some say this is ignorant. If so, I say ignorance is bliss. And lucrative). I limit the amount of time per day I spend syphoning through blog posts, message boards, or any other potentially stimulating activities that don’t give much in the way of researched ideas or sound advice (do me a favor and please tell me if my own blog diverges from this). Finally, every time I’m tempted to check quotes or start buying and selling things on a whim, I walk away, take a break, come back and read a 10-K instead.

Conquering the desire to stay active and do something is no easy task. It often requires boring substitutes like reading SEC filings. But I believe avoiding the devastating tendency and conquering over-stimulation is necessary for prolonged success. After all, some things are better saved for the bedroom.

People, people, people.

In his Common Stocks and Uncommon Profits, Philip Fisher pointed out that the force that creates “an outstanding investment vehicle…is essentially people.

Warren Buffett says that one of his main tasks in evaluating a company is to look the management in the eye and see if they are truly passionate about their work.

Peter Lynch points out that he loves managements who love their companies and that pass up the fancy corporate offices for garage-style digs to save money.

Eddie Lampert says he places more emphasis on the people who put together a track record rather than the track record itself.People

Still yet, Marty Whitman told me that he’s been fortunate enough to “go to bed with great managements” and will look for the same in future investments.

Catching the trend?

Clearly, one of the most important jobs for investors is to evaluate the management of the companies in which they invest. Managements have the power to create gold mines or destroy castles, and with the way proxy machinery really works in corporate America (with managements typically choosing boards of directors rather than shareholders), it is absolutely essential that the “little guy” know what kind of people he is dealing with.

Not surprisingly, many investors will talk about how much they care about evaluating managements or how good they are at picking up talent. And who can blame them? No one would admit that they haven’t really looked at the people behind the scenes. No one would admit that they are simply not good at picking out talent and weeding out incompetence. And further still, no one thinks they are not a “people person” who can read others like a book.

But few – I argue very few – actually walk the walk. They think they know the management and how great (or bad) it is, but they’re often mistaken. Yet, one cannot really blame them for this. As the huge majority of investors are outside, passive, minority holders, getting access to management is not the easiest thing and often makes little sense given the size of the investment. So what is the average investor to do?

I propose a few easy steps to gain insight into the passion, competence, and shareholder friendliness of the people behind your investments. These are steps that any investor can take by making use of public documents, the written word, and some common sense. Some you’ve probably thought of or heard of before, but I hope you gain something from at least a few of them.

  1. Check the salaries. Managements of publicly traded companies must disclose their salaries in 10-K’s filed with the SEC. Take note of how generously the management is paid. Naturally, smaller companies should have managements that are paid less (a $20 million company shouldn’t have a CEO getting paid $1 million+). Larger companies generally display the reverse. But overall, the most important thing is to determine whether management deserves those salaries. Just because a company is large or has “potential” does not mean management has truly earned its paycheck. How long has top management been with the company? How well have they used shareholder money to gain high returns?
  2. Check the bonuses. Beware of managements that are awarded generous stock options, pension plans, perks, etc. This information is also disclosed in public documents, and you can easily find how many stock options management has been granted, what the exercise price and date of those options are, etc. The general theory behind options are that they align interest with the shareholders by giving management incentive to perform well for more pay. But keep this in mind – generous options packages can promote risky behavior since there exists unlimited upside and little to no downside for management if things fail. Also, more commonly, they can lead to practices that lift share price without creating real value (unnecessarily high dividends, unnecessary share buybacks, practices that show more earnings even though more tax effective methods are available, or, at its extreme worst, fraud). In short, be generally wary of managements that are willing to waste or dilute shareholder value to stuff their own pockets.
  3. Check the ownership. I prefer managements that have heavy ownership in the company and a large fraction of their net worth tied up in the company. It shows that they will have a greater tendency to think and act like you as an investor. I’m suspicious when I see executives sell-off a ton of shares, and I like to see when executives are putting their money where their work is and buying shares on the open market.
  4. Listen to conference calls. It’s probably the best way small shareholders have to get acquainted with management and hear them talk about the company, its goals, its attitudes, its triumphs and failures. Most importantly, focus on their discussion of the failures. The most honest and competent management will have no shame in and will not try to hide their mistakes. When management comes forward and says “we did this wrong, we need to improve here,” you can generally bet that your dealing with honest and competent people. When you hear them always blaming circumstances, customers, or other people, proceed with extreme caution. [Note: A great resource for analyzing conference calls can be found atSeeking Alpha, where transcripts are available free of charge]
  5. Note the tone in the 10-K section dedicated to Management’s Discussion and Analysis. This is similar to listening to conference calls – how does management discuss its failures and shortcomings? Are they confident? Over-confident? Honest? Suspicious? This is generally tougher since the section is obviously written before hand (unlike a conference call) and remains largely objective, but you can always be on the lookout for warning signs.
  6. Pay attention to the employees and rankings. I love to read Fortune’s list of the best places to work. When a company treats its employees with dignity and respect and pays them well for their hard work, I become a bigger fan of the company as an investment. Companies that make great places to work are usually so because people from the top have made it that way. I believe that, in general, a company that treats its employees well will be more likely to treat its shareholders well. Not to mention the improved productivity of the workforce whose hard work makes owners money.
  7. Pay attention to customers. Managements that stress superior customer service are people-conscious, and, as with #6, usually shareholder conscious. If customers complain about a company’s inferior service, nasty employees, and terrible value, you can bet on an inferior stock, with nasty management, and, well, terrible value.
  8. Fib a bit. If you have the guts and time, do what Peter Lynch recommends – fib a bit, call the company, tell them you hold a bunch of shares in street name, and that you wish to speak with management. While doing so, remember this: a company that refuses to talk with you, the “big shareholder,” is not worthy of investment for obvious reasons. And, if they do speak with you, make the most of it and ask away. Pepper them with questions and try to get a feel for their abilities.
  9. Trust your gut. If you have a sneaking suspicion that the CEO of the company you’re researching is some slick fast-talker who’s just looking for a quick buck, do yourself a favor and don’t invest. Even if you’re wrong, there are no called strikes in investing and you save yourself the headache.

There are clearly plenty more great ways to get to understand management, but I believe these are nine useful and generally easy ways to get to know the people behind your investments, even if you’re not a big shareholder. In short, look for passion, honesty, aligned interest, and people-consciousness. As Warren Buffett says, it’s simple, but not easy. Hopefully I’ve made is a bit easier.

Apple iPhone Hype – But how ’bout the long term?

Hype is by definition a short-term phenomenon. And Apple’s iPhone has epitomized it.

Of course hype, short-term results, and pumped up demand for product often blind market participants to long-term business ramifications and actual shareholder value creation. But on the other hand, world-changing innovations which started as hypes and were derided as fads have gone on to make fortunes for owners. So what’s the deal on the heels of the iPhone’s much-awaited debut — is AAPL overbought or underestimated?iphone hype

Well, first a few qualitative thoughts. As much as I may not be able to tell you with certainty where AAPL will be in ten years, I can say this: they are the reigning kings of what I’d call synergistic marketing and demand creation. In other words, whether or not they are actually innovative (that’s up for debate — iPod was not the first MP3 player, for instance), they are better than anyone at convincing customers that there product is the coolest, hippest, and best must-have invention on the face of the planet. And their success has bred only more success and greater cross-selling revenue (Paul Carton has a great discussion of Apple’s halo-effecthere).

Think of it this way — that Apple has been so successful and hip with the iPod has made computer buyers more interested in their other, largely unrelated product, the Mac. This should come as no big surprise — simple psychology informs us that, well, people love winners. This is at the heart of what I believe is Apple’s true competitive advantage. Apple has been and should continue for the foreseeable future to be a winner.

From a quantitative perspective, the added revenue if the company meets sales prediction for the next twelve months should be around $5-7 billion (or about 20% of TTM revenue). That’s assuming sales of 10 million iPhones. My quick and dirty estimate might put incremental net income from iPhone sales at around $0.60/share. So it’s not an insubstantial short-term factor. But in the long-term things become more interesting. Who’s to say the iPhone won’t flop in a couple of years and that the shares that have been so heavily bid up will topple?

Certainly not me, which is just part of the reason I won’t take a position in any shares (I generally don’t short, and almost universally avoid stocks with such rich multiples as AAPL unless exponential growth is a no-brainer). But I can at least speculate on what I think the future of the iPhone or iPhone-like products will be. For what it’s worth (and that’s probably not much coming from me), I’ll attempt to prophesy the future. I’ll keep it brief, but bold:

1) 1-4 years. The iPhone sees significant demand, but competing products (likely from shops like Research in Motion) begin to cut into market share and drive down prices as quality and functionality also increases.

2) 5-10 years. Hand-held, all-in-one personal devices will ultimately become nearly as good, affordable and universal as personal computers. They’ll steal share from the desktop and laptop markets, but those devices will never entirely disappear, though they may change forms. We enter new tech era.

3) 11-15 years. Owners of said devices begin to realize that it is too risky to carry their whole life in tablet form, so devices come equipped with a body-encapsulating bubble and a life-insurance policy.

4) 16-17 years. Given the slight inconvenience of personal bubbles, the iPhone as physical device is replaced by implanted brain chip with telepathic email functionality, trance-inducing sedatives that allow you to watch YouTube videos in your mind.

5) 18-20 years. YouTube, Apple, and Google merge to form You-Google-Appletube, with combined market cap (adjusted for inflation) of $17 trillion and a PE of 245.

6) 21-24 years. All human interaction is replaced by electronic communication.

7) 25-26 years. World peace.