Four Classes of Long-Term Security Investment Risk

Below are four classes of risk to keep in mind when analyzing securities for long-term investment.

1. Risks Inherent to the Underlying Essential Assets

An underlying essential asset is one that is necessary to the operation or purpose of the company, its raison d’etre (cars for Hertz or properties for a REIT). Almost all assets carry some degree of risk, even if seemingly infinitesimal.

Is the underlying essential asset tangible or intangible? How tightly does the perceived value correlate to a fixed variable? How fungible are the underlying essential assets? How strong is the IP protection?

2. Risks Inherent to the Form of Security

The form of security, or how it is held, could also create risk exposure. Whether the security will be secured/unsecured debt, common/preferred stock, or voting/non-voting shares, will involve a balance of risk. Debt securities can be secured or unsecured, if secured the debt is “secured by” (think “tied to”) a company asset for purposes of repayment in case of a bankruptcy event. Equity securities are commonly in the form of private or public stocks, common or preferred, with voting or non-voting rights. Each set has its own risk profile.

3. Third Party Risks

The third class of risks are appropriately reserved for those associated with third parties. Most securities will require the involvement of third parties to achieve its purpose or even function. Risks include third party contractual agreements not being reached or timely, unequal bargaining power, non-payment, ineptitude, bad faith and all related litigation risks.

4. Unique Risks

Unique risks are those that are unique to the investment. These include soft factors such as the quality of leadership, experience of management and sometimes corporate goodwill. Unique risks will likely be discovered during a thorough corporate analysis, with particular attention paid to the strength of corporate governance, market position and financial statements.