Part 3 – Lesson 13
When investing in a stock, you should always consider the scenarios or factors that may contribute to your investment thesis proving to be incorrect. If you are drafting an investment write-up, it is prudent to write down the main risk factors and periodically refresh yourself on whether these risk factors have worsened or alleviated and whether new risk factors have emerged.
Risk factors come primarily in two different forms: 1) company specific (idiosyncratic risk) and 2) market or macro risk (systematic risk). Company specific risks are risks that are unique to the company itself. These could include losing a key member of management or losing a key customer. Systematic risks are risks that affect the entire industry or economy and are not particular to the company itself.
Not every risk is knowable, so part of investing is dealing with new risks that emerge over-time. However, prior to making an investment, every investor should spend considerable time listing out all the major risks that can affect your investment.
What types of risk make an investment unattractive?
Every investment comes with risk, but there are certain types of risk that we like to avoid taking, which we list below. As you develop your investment style, you must determine for yourself your risk tolerance.
Risks that result in binary outcomes – Single product biotech companies, whose value depends on the outcome of a single drug trial, is a great example of the type of company we avoid investing in. In many of these types of situations, the stock is so dependent on the outcome of the trial that the stock can drop by 50%+ if the trial fails. The upside for these companies is also substantial if the trial is a success. However, this type of risk is beyond our risk tolerance.
Extremely high valuations or very high expectations – Very high valuation, in and of itself, is a considerable risk because the downside can be enormous if the investment thesis proves to be incorrect. The Internet bubble and subsequent crash is a great example of this. In 1998-1999, many Internet companies traded at 50-100x earnings (if the company had any earnings at all) because investors had very high expectations for these companies. When these expectations proved to be incorrect, many of these stocks crashed 90%+. We would much rather be invested in a company at a 10x-20x P/E since the downside is more manageable when there is valuation support.
Highly competitive industries with no pricing power – We generally like to avoid industries in which the underlying companies are experiencing downward pricing pressure or where competition is dramatically worsening.
One product companies – Many consumer retail companies have been built around the success of one product, and then, these companies try to diversify their revenue sources as the company matures. We prefer to avoid companies that are reliant on a single product or very few products, particularly when those products are subject to changing consumer preferences or tastes.
Highly concentrated customer sources – There are companies whose revenues streams are dependent on a handful of very large customers. For example, some IT services companies have large government contracts that make up a large percentage of the business. While we would not necessarily avoid companies just because of high customer concentration, we do believe a lower valuation multiple is warranted for companies with high customer concentration.
As you build experience as an investor, you will come up with your own list of risks that you are unwilling to take. Additionally, it is also important to not scare yourself out of every investment. Invariably, you will be wrong on a certain percentage of your investments. The goal is not to avoid taking all risks, but to take risk when the reward is worth it.
Charter (CHTR) Risk Factors – Investment Write-up
Building on our previous lessons, let’s draft the risk factors section for our CHTR write-up:
Charter (CHTR) Risk Factors
Increased competition from wireless providers – CHTR is facing potential new entrants into the broadband space as wireless providers (Verizon, AT&T, T-Mobile) build out their 5G networks. Verizon intends to offer fixed wireless 5G internet service, which Verizon believes will provide similar or better speed and throughput vs. fixed broadband (cable). While we certainly view fixed wireless 5G broadband as an incremental risk, we believe that 1) fixed infrastructure such as cable is more likely to provide faster and more reliable service than wireless and 2) the economics for over-building cable networks with fixed wireless may prove to be uneconomic. For example, Verizon tried to over-build cable in the mid-2000s with FiOS (and AT&T tried to overbuild cable with U-verse), but ultimately gave up on these efforts because the cost of building new fiber proved to be uneconomic. It is not yet clear whether fixed 5G broadband can be implemented cost effectively.
Long-term capex needs are higher than anticipated – One of the tenets of the bull case for CHTR is that capex needs will come down over time, particularly as cable box spending is reduced or eliminated. There is risk that cable box spending may persist longer than investors currently expect, or increased network capex needs may arise due to increased competition or unanticipated growth in data consumption (although growth in data consumption would ultimately be positive as consumers place greater value on their broadband connection).
Consumer preferences for higher internet speeds subsides – Today, the greatest use of data over fixed networks is video. If consumption of streaming video slows, CHTR may lose some pricing power on their broadband product.
Higher interest rates – CHTR is a highly leveraged company (4.5x EBITDA), so higher interest rates may place pressure on the company’s interest expense. We believe this risk is manageable over time as CHTR can use cash flow to paydown debt.
Loss of Tom Rutledge as CEO or Liberty Media as an investor – Tom Rutledge is considered one of the best CEOs in the telecom and media sector and is credited with implementing the turnaround and integration strategy for their Time Warner Cable integration. Additionally, Liberty Media (CHTR’s largest shareholder) is considered one of the best telecom and media investors in the industry. A loss of either of these parties will likely hurt investor confidence in the company.