You’d think established measures of risk would meet a basic rule of investment prudence…
But they don’t.
The indicators are based on data showing how volatile a stock was in the past. So as a result, they only work if you assume that past performance guarantees future results.
That’s a bad assumption… I detailed why yesterday, using the popular beta measure.
Another flaw comes from defining risk simply as “volatility”…
You see, volatility isn’t always bad. Investors like big gains after all… That’s considered “upside volatility.”
Instead, let’s start fresh today…
I’ll define risk as the “potential for disappointment.”
I’m not talking about ordinary stock-price declines that we see all the time, though. I’m talking about significant disappointments – the types of disappointments that interfere with your investment goals.
And like we do when thinking about returns, we must consider how the future differs from the past. In other words, as I mentioned yesterday, risk consideration requires full-blown security analysis.
Now, here’s some good news…
Our proprietary “Power Gauge” system can relieve you of the grunt work. This is the 20-factor, fundamental-technical model developed by Wall Street veteran and Chaikin Analytics founder Marc Chaikin. It’s based on his 50-plus years of Wall Street experience.
Let’s analyze risk using the Power Gauge today…
We’ll look at the separate ratings that the model supplies for each of its individual factors. And as we do this, we’ll consider how much confidence we have in the predictability of each factor.
High scores for “here and now” factors suggest less risk. Emphasis on lower-confidence, expectations-oriented factors suggests more room for big disappointments – or higher risk.
This framework draws from research papers by Dr. Robert Shiller, a Nobel laureate, and Stanford University’s Dr. Charles M.C. Lee. It divides a stock price into two parts…
- Visible
- Expected
Today, we’ll apply this framework to drugstore chain CVS Health (CVS) and chipmaker Lattice Semiconductor (LSCC). They’re two different companies in two different industries… So that will allow us to clearly see everything we need to as part of this process.
The “Visible” factors within our Power Gauge system are price-to-book (P/B) ratio, price-to-sales (P/S) ratio, free cash flow, projected price-to-earnings (P/E) ratio, return on equity, the ratio of the company’s long-term debt to its equity, and earnings consistency. They’re the metrics we can see “here and now.”
All the other factors are “Expected” items. They reflect future expectations that various members of the investment community have about the company.
The table below shows how CVS Health and Lattice Semiconductor differ across the Visible and Expected factors within the Power Gauge… Don’t worry about the specifics of each individual factor today. The main takeaway is what they collectively show us…
You’ll notice that both stocks fare well among the Expected factors – with mostly “bullish” or “very bullish” (green) or “neutral” (yellow) scores in that part of our analysis. But as you can see, CVS Health scores much higher in the Visible factors…
In the end, as I said, we can see that the Visible factors favor CVS Health… The company receives top marks from the Power Gauge for P/B ratio, P/S ratio, and earnings consistency. And it gets “bullish” ratings for free cash flow and projected P/E ratio.
Lattice Semiconductor receives a “very bullish” rating for earnings consistency. But it scores poorly across the rest of the Visible factors – with mostly “bearish” or “very bearish” (red) grades.
That means the company’s investment merits are more tied to potentially lucrative but much less certain Expected items. There’s more room for big, unexpected disappointments.
That’s why Lattice Semiconductor is the higher-risk investment. And it’s consistent with what we would expect when comparing a drugstore chain to a semiconductor company.
Having said that, using a model like the Power Gauge can help you take your analysis further in three important ways…
First, it can alert you if a stock is likely to be harmed by developments that are atypical for that line of business. For example, the recent semiconductor supply-chain problems are likely adding to Lattice Semiconductor’s risk today.
Second, it can help you differentiate among companies in the same business… Right now, drugstore chain Rite Aid (RAD), one of CVS Health’s peers, is “neutral” in the Power Gauge.
Third, it can help you evaluate companies with which you aren’t already familiar… Among other things, the Power Gauge allows users to search for peers among various industry groups.
In short, as we’ve learned over the past two days, it’s critical to attack risk much like you do anything else in investing… You must be ready to do full-blown security analysis.
Fortunately, the Power Gauge makes this analysis much easier for investors. It does all the grunt work for you… You only need to click a few buttons and read the ratings it spits out.
Good investing,
Marc Gerstein
Editor’s note: Now that you’ve seen the Power Gauge in action, we’d love to give you a full demonstration… Chaikin Analytics founder Marc Chaikin recently put together a special presentation in which he does just that – and also makes the biggest prediction of his five-decade career. Just for tuning in, you’ll get a free recommendation. Learn more here.
