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Markets: Assessing risk...

Jun 12, 2006

Prudent investing in equities requires an investor to assess the risks and rewards of a particular stock before arriving at an investment decision. Both risks and rewards are inseparable in the sense that one cannot exist without the other. While it is obvious that rewards easily capture the attention of an investor, proper assessment of risks is imperative as it provides a perspective on the likely 'downside' while investing in stocks.Risk is different from uncertainty, which cannot be quantified. Return is the reward you get for bearing risk. Risk is of two types viz., unsystemic risk and systemic risk. Unsystemic risk is the risk that is company specific like a strike or fire in a particular company. Systemic risk on the other hand is the risk that is associated with all the companies and sectors.

Natural risks: Natural calamities can be summed up in a single word - 'unpredictable'. To cite an example, the SARS epidemic, the recent avian flu scare or the 9/11 terrorist attack were events, which affected nations across the globe. While these events did impact the economies of certain countries, they could not be foreseen and therefore 'factored' in. For example, in India itself, the floods in Mumbai (July 2005) affected the pharmaceutical sector as inventories were damaged leading to a dip in revenues. Also, these events generally tend to have a negative impact on the hotels and tourism sector.

Economic and market risks: These risks are at the macroeconomic level such as inflation and interest rates. In recent times, inflationary concerns have led to a hike in interest rates as has been demonstrated by major central banks in the US, Europe and India. As far as the Indian stock markets are concerned, the Fed rate hike is likely to impact Foreign Institutional Investors (FIIs) inflows in the medium term. This means that companies, which have high levels of FII holdings, are likely to be impacted when there is an outflow of money. Similarly, with the rate hike by the Reserve Bank of India (RBI), manufacturing sectors like metals, auto, capital goods, textile and pharma that have acquired considerable debt in the recent past, will see a rise in their interest costs going forward. This might have an impact on their bottomline, which means that investors will have to tone down their earnings growth expectations.

Political risks: Government policies affect the economy and financial markets in a big way. This was largely reflected in the energy sector wherein products such as kerosene, petrol and LPG were subsidised despite rising crude prices, consequently causing oil marketing companies to bleed. Similarly, the impending DPCO policy (for price control of drugs) looms like a dark cloud over the pharma sector.

Sectoral risks: Every sector has risks, which are unique to that particular sector only. This is termed as unsystemic risk. For example, pharma companies competing in the global generics space face the risk of lower realisations due to fierce competition. Similarly, in the software sector, which is people-intensive, attrition and availability of skilled people assumes significant importance. Also forex risks are prevalent in companies, which focus largely on exports such as software, pharma and textiles and imports such as energy.

To sum up...
While systemic risks cannot be avoided, unsystemic or sectoral risks can be reduced by diversifying one's equity portfolio. This means that besides investing in different companies within the same sector, investors need to invest in stocks across sectors. At the end of the day, it is important to understand one's risk appetite and invest in companies with strong fundamentals from a long-term perspective.

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