Types of Investment and Market Risk Factors in Equity Research Report

In this article I will explain the importance of providing risk factors and their probable effect in the equity research report.

These risk factors provide the reader a perspective of the risk in investing in the equity stock of the company.

Equity risk is the danger that one's investments will denigrate because of stock market dynamics, affecting one to lose money. In other words, equity investment risk refers to the risk of negative deviations in the value of listed equity shares.

Equity research analysts, though they do make risk assessments, or build risk into their company analyses reports, have conventionally been seen as a supplier of first-hand information about the level of organization’s future cash flows, rather than the riskiness of these cash flows.

Even in academic readings that examine the influence of equity analysts’ intelligence, the possibility that equity analysts notify the readers of the correct equity risk has not yet been considered.

Equity research analysts study the ‘fundamentals’ of an organization and issue their evaluation of how well the organization’s shares could perform in future.

Credit rating companies assess credit risk, analyzing organization’s financial health and creditworthiness.

By considering and bearing in mind these various sources of information, investors can get a sense of the probable upsides and downsides of investing in shares.

So it is inevitable that as an equity research analyst you provide a proper risk assessment of investing in the organization’s shares on which you are writing the equity research report.

If you look carefully, there are some key risk areas to any organization:

Equity Research Report Risks

1. Performance of the economy / industry in which the organization performs

The performance of any organization depends on the growth of an economy.

An economy which is growing, ensures that organizations functioning in it profit from its growth. But, an equity shareholder also faces the risk of any recession in the economy disturbing the performance of his organization.

Economic or macro related risks are typically reflected in the dynamics such as inflation, GDP growth, interest rates, balance of payment positions and credit growth.

2. Market risk

Market risk refers to what happens when the market turns against or ignores your investment.

This could happen when the market goes off chasing the “next big thing” and ignores many good, but unexciting companies behind.

It can also happen when the market collapses, good stocks as well as bad stocks suffer as equity investors exit the market.

Some investors find this a good thing and view it as an opportunity to load up on great stocks at a time when the market isn't bidding down the price.

On the other hand, it doesn't advance your cause to watch your investment flat-line month after month while other parts of the market are going up.

3. Performance of the organization

Performance of the organization means how the organization has been performing historically and how the organization is expected to perform in the near future.

Past performance can be gauged from the financial performance over the past few years which can be got from historical financial statements.

Future performance would be based on future strategies, new investments, new product launches, new markets entered, new management, new acquisitions, etc.

Also important is the organization’s performance as compared to the performance of its competitors.

Another thing to consider is whether there are any legal cases registered against the organization which could end up in huge financial losses for the organization.

4. Financial strength of the organization

What is an organization’s financial strength and position?

It is important to gauge carefully to make sure that the company will be functioning tomorrow.

Financial strength ratios go by many names (liquidity, solvency, financial leverage), but they all point to the same thing. It is important to convey to the reader how leveraged the organization is as more the debt, more risky the investment is.

If you see the below example, here, the equity research analyst has put down some risk factors for the company in contention.

Types of Investment Risks

If you read carefully, notice how the analyst has talked about different risks, starting from industrial performance of the domestic formulations segment and ending with macroeconomic factors such as currency fluctuation.

He has also written about the legal cases that the organization is facing and the financial health of the organization.

Below is another example of risks for the same company:

Key Investment Risks

Again if you see in this example, the analyst has covered risks such as uncertain government policies which could affect the industry adversely, new investments made by the company which could be risky and also financial risk of NPPA (National Pharmaceutical Pricing Authority) liabilities.

Let’s take another example. This one is from the IT industry. See the example below for Oracle.

Company specific risk Oracle

Now if you see the above example, you’ll understand how the analyst has given a lot of stress on performance of Oracle’s competition. He has tried to evaluate Oracle in comparison to its nearest peers like SAP.

As explained earlier, performance of the competitors can directly affect the performance of the organization’s share prices. So it’s very important to not only study the performance of the organization in contention but also the performance of its competitors.

Also look at the below example now:

Oracle Security Risks

Here if you see now, the analyst has talked about the relative security weakness of the Oracle database. This could be a risk going ahead and it’s important that the analyst brings this to the notice of the readers. In fact he has provided statistics to prove his point with a bar chart which shows the number of security flaws in the product.

Risk from Competition

In the above image, you can see that the analyst has written about the eroding profit margins of the organization. He has supported this statement with a line chart showing reducing margins for the last five years.

Key Takeaway

I hope that you have understood the importance of providing risk factors in your equity research report.

Please study the organization carefully, look at the macroeconomic factors, the industry performance, changes in government regulations, competition and try to come up with appropriate risk factors which will give the reader a proper perspective of the investment risks he would have, if he invests in the equity stock of the organization.

Types of Investment and Market Risk Factors in Equity Research Report 1
Types of Investment and Market Risk Factors in Equity Research Report 2

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