Managing Risk & Exposure

If you are a relative newbie to the stock market then I’ve put this blog together to help you understand investing risks especially in the junior small cap stock market. If you are to succeed and not become one of the c.75% who lose money you must consider risk.

As I write this blog, many of us will be thrilled by the last six months on the stock market whether that be the main indices such as the FTSE, DOW etc or the small cap space such as the AIM London market.

As an experienced retail investor I have also seen what its like to be in the midst of a bear market or down-turn.

It’s not always ‘rockets’ and ‘baggers’ but even in this kind of market there is still opportunity.

Only in April 2020 as the pandemic struck did we see huge gains in some of the Pharma stocks whilst the rest of the market pretty much dropped off a cliff. So there is always opportunity in any market if you can spot it.

The purpose of this blog is to highlight five key risks I think you should consider when thinking about buying stocks, especially in the higher risk small cap space. I myself have seen a big influx of new followers on Twitter which I attribute to the lock-downs, people at home enticed perhaps by the buzz of a rampant market whether that be stocks, commodities or even Crypto!

These risks are focused on stocks but many apply to Crypto and other markets too, so here we go, here are five key risks you should consider before the adrenalin takes over and you can’t resist hitting the buy button!

Risk 1 – Market

The first risk to consider but not immediately obvious is what’s happening in the wider market ? Is the market in a ‘risk-on’ or ‘risk-off’ mood and more importantly where is it gravitating too? The market generally operates on a forward basis so known risks and future events become ‘priced-in’. Priced-in means stock valuations account for these risks and events and price them in ahead.

Back in 2019/2020 we saw political tensions between the US and China and this weighed on the market for a long period of time particularly resource stocks that would be impacted by tariffs. So during this period with tensions building you’d be forgiven for avoiding this sector at least if looking for shorter-term gains. Conversely, longer-term investors anticipating better times, would have seen this as the potential buy zone

Now with stimulus and a weakening dollar, resource stocks are beginning to shine hence why we have seen strong demand in this sector. Conversely during this period large tech stocks have reached record valuations versus earnings – are they a good buy now given those valuations and perhaps re-deployment of capital into higher growth sectors?

Another example, You want to invest in resources in Africa as the sector is set to grow – does that mean any stock is suitable ? What if there are political tensions building in a region, is it still good idea?

Or perhaps you fancy an oil company that has huge potential – ‘black gold’ has always been historically a great place to invest right? But what if money is starting to transition towards ‘green energy’ – will those oil companies still find it as easy to raise project funding on good terms for ‘dirty’ energy projects on a long-term basis and importantly attract investors?

In the context of the market it’s also worth considering the market applicable to the stock you are looking at. What is the market outlook for its product or service. Is there a clear demand driver? For a commodity stock it could be supply/demand balance for example, as we are seeing now, a copper deficit emerging. Or for say a company like Zoom a big drive towards home-working and on-line meetings. Try and establish, is there a positive back-drop for your stocks business? – if there isn’t or it isn’t clear then it’s another risk to consider.

These are all valid questions to be asking whether you are investing short or long-term and should be part of your consideration when weighing up the investment.

Risk 2 – Do you actually know what you are buying?

This sounds obvious right? You wouldn’t phone up a car dealership and say I want a nice new black sports car and just buy it! You’d want to look at the spec, the mileage and history, the condition of the car to make sure its going to meet your needs and not break down, leaving you with a huge bill!

It’s the same with stocks, even if you are just jumping in on a momentum-trade (a trade where a stock is seeing increased liquidity and strong sentiment you may be able to ride) at least do some basic research and for higher stake investments where you put more of your precious money in do more in depth research. Key things I consider are:

Management Team – Do they have a good track record and experience in the sector or if you can’t easily establish that at least check they don’t have a bad one! Quite often when I’m looking at a stock I’ll scan Social Media and BB’s to see if I can find anything negative that might put me off (red flags!). These people are essentially managing your money so find out a bit about them! Anything I go heavier into I tend to make contact with Management but I appreciate this isn’t practical for every one.

Value Proposition – Ultimately you want your investment to make money in the form of a share price rise. To this end, what is the value proposition? What is going to drive the share price higher? Will it be improved sentiment, certain catalysts that will add value to the stock, simply an increase in pricing of the business’ underlying product or service for example, a gold producer in a rising gold price environment?

You’d be surprised just how many stocks increase in value because they have become under-valued and/or over-sold. This is trickier for new investors to figure out especially as valuation, particularly on AIM is very subjective. But as an example, if you are scratching your head thinking a company that is valued at £10m and generating £5m of EBITDA pa with a strong market back-drop is undervalued, you are probably right and this can simply be down to a consistent seller of the stock who may be a distressed seller. A distressed seller is someone who is being forced to sell either because they need the capital out or are mandated too.

Once that seller clears i.e. has finished selling the stock, it can rapidly turn to the upside. This can be one of the best ways to make money in small cap stocks. That leads me onto entry:

Risk 3 – Entry

This is so important and something I never really understood when I started investing.

Again entry is somewhat subjective as a stock (especially small or micro-cap) that has moved 100% could still move another 400% due to a re-rating event but if this isn’t obvious then fall back to technicals.

The first thing I do if a stock comes onto my radar is look at the chart. I want to know where I am in the pecking order am I early or late. Again late can still be ok but it increases your risk, earlier is better !

Take the following Ferrexpo (LSE:FXPO) chart as an example:

You can see from the chart that the share price bobbed around the 170p level for a good few months after suffering a big dip in April due to the Pandemic sell-off. At that point when it dipped, no one really knew what was going to happen, fear gripped the market as a vaccine could be years away. So at that point there was risk of the ‘unknown’.

As we emerged from the first wave and vaccine developments looked promising Iron-Ore prices started rocketing lead by huge Chinese buying pressure. The market was still cautious and hence the price settled around 170p

As share-price support developed, iron-ore prices continued to rocket and earnings were clearly running at an incredibly low PE (Price/Earnings) ratio this was well and truly the buy-zone!

I missed this thinking I’d get a second chance sub 150p but with all of the information in front of me I knew it was a buy – silly boy !

Inevitably the share price continued to rally with a little tussle at 200p (that was the second buy signal) – it kept attacking 200p and eventually broke.

But since this is about entry would you buy now at 330p? There is a bull case too, commodities strong and PE is still attractive so it could well continue to run hence my comments earlier about higher entry isn’t always bad – but the point is the risk is higher now.

So for me I would leave it as I have ‘missed my entry’, for now. The risk is Iron-ore prices decrease after a good run, and the market moves to risk-off i.e. people that have seen a 200% profit gain take profits. That risk was minimal at 170p because other investors profits were nowhere near that and the share price had developed a lot of support.

At 330p we see no support (yet) so we could see a run back to 300p as an example.

My point is, entry is important if you miss something, you miss it, there are thousands of stocks where the same scenario could play out find one where the same sequence of events could un-fold for example some Uranium stocks are now coming off lows in anticipation of a Uranium bull market – Uranium has not moved anything like Iron-ore.

Risk 4 – Funding & Liquidity

This applies mostly to small and micro-cap stocks and is also very important. You should consider it for all stocks though, take for example Tullow Oil. Its share price crashed as Oil hit historic lows due to its debt burden versus reduced revenues. If Tullow had to go back to the market and roll-over it’s debt, could it get funding if it was losing money or couldn’t service (repay) that debt?

The risk to you as an investor in small an micro-cap stocks is two-fold:

Funding – Small and Micro Cap stocks in their earlier existence regularly require funding by way of debt funding or more commonly equity placings if they are not revenue/profit generating – this is normal.

Particularly on AIM, if a company cannot raise funds to satisfy its working capital requirements (keep the lights on) it can be suspended from trading and even de-listed. When this happens your stock is locked-up for an in-determinate period and could result in 100% loss.

When non revenue generating companies raise they usually go for a placing (issuance of new stock) but can use other methods such as Convertible Loan Notes (CLN). Both of these pose risk to investors as typically they are struck to incentivise the entity injecting cash.

So for a placing you normally see shares issued at a discount to the current share price and a CLN often convertible into equity at a discount to the Share price (a series of mini discounted placings if you like. You may have heard the phrase ‘death-spiral’ – this applies to certain (but not all) CLN’s – the holder can continuously convert the loan they have given to the company into equity by receiving stock on request at say 9p when the stock is trading at 10p – they can instantly sell the stock and book the 10% profit . What does this do? It puts consistent downward pressure on the share price until they have finished converting the loan to equity.

The stock may have a great investment case but the CLN holder doesn’t and never cared! – all he ever intended to do was return the capital of his loan with a nice consistent profit.

I’ll never buy a stock personally that has a death-spiral CLN in play (unless it’s coming to an end and as a consequence has been over-sold) as I’d see my money as dead money until the loan holder has finished selling.

A final note on placings, look out for companies that repeatedly raise money at steep discounts and burn through that money without progressing the value of the businesss. Many of these companies are known as ‘life-style’ companies – what’s that? Basically, a company that pays the boards wages with high cash-burn for little or no progress on what you were actually investing in. You can spot these companies they raise regularly and do a lot of PR!

Liquidity – liquidity in a stock is essentially the ability to buy or more importantly sell that stock. A low liquidity stock wont have much trading volume and as a result the spread (difference between buy and sell price) will be much wider.

The key take-away here and risk to be aware of is that small and micro-cap stocks pose higher liquidity risk so for example if you have just bought a stock as you think some positive news is coming and something goes wrong you may not be ale to sell or sell anywhere near a price you bought.

As an example if you bought a stock like EasyJet listed on the FTSE say for 1000p it’s bid and offer price may be 990p (sell) / 1010p (buy). If they announced some negative news the stock might drop say 3% so you could still sell say at 970p.

Now compare this to small cap stock say an oil company that is drilling a new potential target. You bought the stock at 10p prior to the drill and the price is currently at 12p – you are 20% up. The bad news arrives, they didn’t hit commercial oil but they have identified another interesting target but they used all their funds for the drill so will need to raise money again soon. On open the market makers could drop that stock to 6p bid a 50% instant loss and a 40% loss on your initial capital.

Even worse is that to get back to your 12p you need a 100% gain now.

Basically EasyJet has many fundamentals backing its valuation and plenty of liquidity (buyers and sellers) so wouldn’t typically see a move of over 5% in a day either way and that’s a significant move.

The oil stock however has had a big chunk of its recent value generation removed hence the crushing 50% drop.

One last point on liquidity, as a consequence of the Oil stock example above the price of a stock can move 50% or more during the day – initial panic on open (with the help of the market makers!) making the stock oversold to then bounce and end the day say 20% down as investors emerge saying well there is another target all is not lost.

If you had set a stop loss around 9p (10% max loss) that would have had no effect – the stock would most likely have been sold at 6p on open only then to see actually by the end of the day you are actually only 20% down. If you hadn’t put a stop loss in then you would just have a 20% paper loss currently.

I don’t use stop losses on high-risk small cap stocks for this reason – the swings are too great due to liquidity and you never have control over the execution price. I invest in these plays on the basis I may lose 100%.

I do set stop losses on Large Cap companies like in the Easyjet example as I know my actual loss on that trade will be close to where I set the stop loss most of the time.

I’m not saying don’t use stop losses as it is a risk management tool what I am saying here is don’t think on small cap high risk stocks it’s going to necessarily protect you and at worse could work against you as per my example.

Risk 5 – The good old Twitterati and Bulletin Board brigade

The last risk I want to highlight to you which mostly applies to newbies is social media influence.

If you were in the pub and some guy came up to you and said this designer watch is worth £1000 but you can have it for £500 you’d probably laugh and walk away. It’s the same with stocks and social media platforms. Most of those saying that a stock is worth more, going to ‘explode’ or going to the ‘moon’ are in the stock already and wanting you to buy.

Now there may be very good reasons why that stock is worth more and they may be right but are you going to believe that on just what they have said or are you going to dig a bit ?

My simple advice is if you are going to use social media platforms to help with making decisions, perhaps because you don’t have much time to do research, try and find the influencers/commentators that can back-up their statements with facts or good reasoning. There are plenty of good guys out there that do this.

Summary

So in this blog, I’ve highlighted five key risks I think you should consider when investing. When you first start out you are likely to take higher risks (I did!) but as you build capital it becomes more important as you want to protect your gains.

Building a portfolio in a steady well risk-managed fashion has worked for me. Don’t let FOMO and greed take over, there is always another opportunity if something doesn’t feel right. Trust your research, get your entry right and be patient. Continuously challenge your investment and assess risks and you’ll be on the right path hopefully to financial freedom!