Introducing New Risk Ratings
April 10, 2021
7investing defines risk as the probability of permanently losing capital or significantly underperforming the market over the next decade. A company’s risk categorization is assigned by the Lead Advisor who recommends the company and might be given different categorizations if recommended multiple times by other advisors. Risk can stem from various factors, including;
- Failure to develop a competitive advantage
- Failure to maintain an existing competitive advantage
- A premium valuation that can cause a company’s stock price to lag even if the company executes well.
As long-term investors, we will no longer define risk as to how much a company’s stock price might fluctuate each year. We believe this is better defined as volatility, which various factors can cause outside of a company’s control (e.g., the onset of the COVID-19 pandemic in March 2020 is a perfect example of this). All stock prices will eventually see volatility and often represent buying opportunities rather than signals to sell. Long-term investors have the luxury of tuning out short-term noise and focus on returns compounded over many years.
While these are loose definitions, we believe they best characterize how we think about our assigned risk ratings:
- Low risk – Strong competitive advantages exist, giving the company a strong chance of at least matching the market’s returns over the long term. It is unlikely that investors will permanently lose capital in this investment.
- Moderate risk – Strong competitive advantages exist, giving the company a strong chance of at least matching the market’s returns over the long term. There are foreseeable risks, however, making it a possibility that investors permanently lose capital.
- High risk – Competitive advantages might exist or are still in the process of being developed, but real and present threats to these companies’ business models exist. Permanent loss of capital is a real possibility.
- Very high risk – Permanent loss of capital is a high possibility. Several known threats to the company’s business model exist.
Of course, while not always the case, the most significant potential rewards can come from the stocks with the greatest risk. Investors should choose stocks based on their risk tolerance, financial goals, time frame, and personal conviction in each recommendation.