LEVEL: BEGINNER
Company risk which is also known as unsystematic risk is risks that an investor faces that are directly related to the performance of a specific company. Company risks can stem from debt, sales of a product or even the management of the company. There are a number of ways to hedge this type of risk exposure which include direct derivative hedges or diversification.
Business Interruption
Business interruption is an operation risk, in which companies can no longer produce a product or a service based on an interruption. This could come from a natural disaster man made interruption that impedes a company from standard operations.
Many companies will purchase business interruption risk from an insurance company which will in turn protect an investor from this type of risk. When a loss from an insured risk forces a business to close temporarily, business interruption insurance pays for the salaries, rent, taxes and benefits that would be due while the business is unable to operate.
Reputational Risk
Reputational risk can create business interruption risk in that other business no longer wants to transact or do business with counterparty. An example of this situation is the fall of Lehman brothers. The reputation of the company was quickly damaged by traders who refused to lend money to the company on a daily basis which in turn created a situation where the company could no longer fund its daily operation and therefore had to declare bankruptcy. When a company’s reputation is damaged, it is difficult to restore and it is usually specific to a company rather than an industry.
Management Risk
Many companies have strong top management but fail to put together a succession plan that wills a smooth transition when the top dog leaves. The head of a company can retire, fall sick to an illness or commit an immoral act that can leave a company in limbo. When a company is heavily relying on a chief executive officer to drive a company’s performance they are subject to management risk.
Product Risk
Companies that produce one or two products that drive the lion’s share of their revenues face product revenue risk. For example, if a drug company generates the majority of its revenue from one type of drug, they face the risk that a competitor might move into the market. The pharmaceutical company could also face the risk that their drug has side effects which in turn generates law suits that hurt their bottom line. Companies that do not have a diverse revenue stream face product revenue risk which is difficult to hedge.
Stock Performance Risk
Investors can face the backlash of other investors who are not pleased with the stock performance or leadership of a company. Subsequently, there is a potential threat from shareholders who obtain large ownership stakes in companies as these individuals or institutions can influence the way that a business is run. Activist investor risk can hold a management hostage to change their style which might initially damage the stock price.
Debt
The ability for a company to borrow money is a key attribute to their success. Companies can borrow money through banks or the capital markets, which is generally based on their credit quality. The inability for an investor to borrow risk can create significant company risk, as daily operational funding could be curtailed if a company cannot borrow effectively.
Internal Controls
Internal controls of a company include their accounting, auditing, systems and risk management. All these functions have a management structure in which investors rely on to handle specific internal controls. The investor community relies on these areas to product the most accurate assessment of the health of a company. Unfortunately this is not always the case. Accountant or auditor will make mistakes, which in turn will project a distorted reality of a company’s financial health.
Fraud is another issue relative to a company’s internal controls. Compliance and regulation areas of a company are higher to fight fraudulent activity, but they are not always successful which can undermine the ability of a firm to operate properly. An excellent example of this situation was former energy giant Enron. Fraudulent activity was prevalent throughout the accounting and management functions of the company which eventually saw the financial erode and the company move into bankruptcy.
Hedging Company Risk
Hedging the risk of a single company can be accomplished by either using derivatives or diversification. The derivative approach is similar to purchasing insurance on an adverse movement on the company’s stock price. An example of a derivative that would hedge against downside price action is a put option. A put on a company’s stock price is the right but not the obligation to sell a stock on or before a certain date at a specific price. The price is known as the strike price, while the date of the option expiration is called the expiration date. If the price of a stock falls, the put buyer can sell the stock to the put seller at the strike price, hedging some of the downside risk associated with the stock.
A second technique which can be used to hedge a single stock is to diversify a portfolio and hold a number of stocks within the same sector. For example, if an investor owned five pharmaceutical companies the change that all five had a company risk that led to an adverse move is less than the chance of just one company facing unsystematic risk. Diversification of a portfolio amongst multiple stock sectors is also a way an investor can mitigate the exposure he has to company risk.