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Thursday, February 2, 2012

How to pick lower risk stocks

Investing strategy
Due diligence and investment vision are important aspects of financial plannng

Picking lower risk stocks involves finding good returns on investment with less downward price volatility. Ideally well chosen low-risk stocks are comparable to a savings account insured by the Federal Deposit Insurance Corporation (FDIC). A good starting point in knowing how to pick low-risk stocks is understanding how much stock to invest in, and for how long as even invested money in conservative stocks becomes risky if that investment may be needed in the short-term.

Protect against risk

Stock  that maintains or grows value during most parts of an economic cycle doesn’t necessarily mean it's conservative during a recession; this possibility makes the whole concept of conservative stock somewhat fallacious. That is to say, since market and economic conditions can change relatively quickly, unless one has picked conservative stocks able to withstand share price volatility, then the value of those shares can drop. One method of risk management is value investing, which seeks low risk investments that yield positive return on investment. This concept is further illustrated in the video below:
Value investing

Identify low-risk

If there is such a thing as a conservative stock, one’s chances of picking the right one might be somewhere between finding the holy grail and spotting a $1 bill in a parking lot. In other words, be prepared to do some research. An important step in performing due diligence on investments is defining low-risk. This could mean a number of things; high dividend, low beta, and consistent profit margin are what some might look for. Moreover, according to Investopedia, low beta measures the risk of volatility a stock's price experiences relative to movements in the broader market. Large cap, blue chip stocks that weather cyclical and seasonal downturns while continuing to provide dividends also provide an opportunity for growth without as much risk as small-cap stocks.

Forecast future risk

Just because a company is low risk in the present doesn’t mean it will be a conservative stock in the future. It is not impossible for a large, stable blue chip stock to take a turn for the worse. To illustrate how a blue chip stock can decline, according to Yahoo Finance.com, Merck & Co,. Inc. (MRK), the large pharmaceutical firm, dropped from an all time high over $80.00 per share in the early 2000’s, to the low $30s in 2011. A part of the risk for Merck might of included expiration of drug patents and not enough high demand patent protected drugs to grow revenue.

Assess capital gains

To pick a conservative stock, the value of the company’s shares, or total investment in the stock, should also rise over time. The conditions for long-term capital gains are quite diverse and vary by industry, economy, and market conditions. An investor can increase the  chance of capital gains by locating a well managed company with strong financial statements. Companies that have a high percentage of market share and consistent product or service demand  have a potentially increased chance of consistent capital gains.

Evaluate capital structure

The capital asset management of a business is also an indicator of how 'conservative' a stock is. This is because use of capital in part indicates how a company plans to grow, maintain revenue stream, and improve profit margin. Companies that invest in projects with high internal rates of return, and operate with low costs and efficient  cash conversion cycles are examples of potentially good capital structure.

Selecting conservative stocks is not really a fool proof endeavor as stocks themselves do not provide guaranteed returns nor are they insured financial instruments. For this reason, picking conservative stocks is more akin to choosing lower risk stocks. Lower risk stocks sometimes share a few characteristics, some of which include profitability under adverse conditions, strong and proven business models, and legacies of success that help ensure at least medium-term investment stability.

Image attribution: 1000ThangLong. CC BY 3.0