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Rule Breakers risk rating

The Rule Breakers risk rating is a collaborative effort by the Rule Breakers team to build an effective guide for our members to identify risk among our stocks. It's intended to replace (improve) the present Risk rating ("high" or "medium" or "low") in our Buyer's Guide.

Below is a list of questions. Apply each question to the stock you're researching, and every "no" adds +1 to the stock's risk rating.

The higher the risk rating, the higher the risk.

Because this is a wiki, you're highly encouraged to edit/tweak/improve/add to the below. Please tend not to delete ideas, however, as we're in the gathering process at this stage -- our team will do the culling later on.

Also, we've now put these into categories -- so try to fit additional ideas into existing categories... or invent new ones. Thanks. --The Management (okay, it's just David) :)


Contents

The Risk Questions

Again, questions need to be written so that: "yes = safer"


Business Basics

  • Is the company profitable?
  • If not profitable, is the company cash flow positive? (BreakerForce)
  • Does the company derive no more than 20% of revenue from one customer?
  • Is our investment thesis based mostly on a continuation of existing business?
  • Is the company subject to heavy government regulation? (E.g. FDA approval, foreign government interventions, etc.)

>Discussion: It's not clear enough to me that this equals "more risk" -- often, government regulation can serve to keep out competition.
  • Does the company have, or is in the process of creating, a wide economic moat? This can come from intellectual property, network effect, high switching costs, regulatory or geographic barriers to entry, or economy of scale.
  • Is the company past any binary events (eg, government approval, product launch, rocket launch, customer wins, etc.) that would affect more than 10% of revenue?

>Discussion: I'd suggest that it get 1 point for every 10% of revenue impacted...eg, a biotech company waiting to get its one and only product approved would get a full 10 risk points.

Finances

  • Does this company have than $100+ million cash on the balance sheet?

>Discussion: Perhaps this should be a relative metric, maybe: 'Does this company have cash >= 75% of its annual operating expenses?'
  • Is this company's debt-to-equity ratio (making up the number here) below .3?
  • Are most financial metrics like earnings quality, growth, margins, and returns on capital either stable or improving?
  • Does this company file 10-Q's, 10-K's, and Form 4's with the SEC?

>Discussion: Basically I'm getting at that there's less information for foreign companies which might only file a yearly 20-F, and no Form 4's or other disclosures. But this obviously applies to pinks and otc. I'm sure wording could be different. And OTEX files a 10-Q, but for insider trading you have to deal with Canada's SEDAR. I think risk is higher when it's harder to learn everything you can in the US - even with a giant company like BIDU.
  • Does the company have a market cap greater than $500 million?

>Discussion: The thinking here is that larger = safer -- yes, of course it's not always true, but it's generally true that larger companies have greater stability for a whole host of reasons -- and the aim here is to help investors, especially new investors who often think penny stocks are the way to go -- to understand market cap and to realize that small/micro-cap companies have, on the whole, more risk built into them.
  • Is the company able to avoid large cyclical swings in its earnings?
  • Is it clear how this business makes money?

Competition

  • Would new competitors face high economic, technological, or regulatory barriers to entry?
  • Does this company have one or more direct competitors with substantially (2x+) greater financial resources?
  • Is this company vulnerable to business model challenges from any disruptive upstarts?

>Discussion: This is an important question, but it may be too subjective if the goal is to have consistent risk ratings. One can argue that most -- if not all -- companies are vulnerable to disruptive threats.[RAM]
  • Is there no substantially equivalent alternative to the company's product or service?

The Stock

  • Is this company's stock beta rating over the past 12 months less than 1.2?
  • Is the stock's forward P/E higher than its projected earnings per share growth rate?
  • Is the P/E below 30?


People

  • Is the founding CEO/manager/team still leading the company?
  • Of the top three officers, do they have more than 15 years of a combined leadership record at the company?
  • Does management own shares in the stock? If so, what %? (BreakerForce)
  • Are bonuses for executives based upon clear metrics tied to creating value for shareholders?

>Discussion: This is a nice idea but how easy is it really to understand and quantify, company by company? I suspect this is at the very least complex, and for many companies there probably isn't documentation even to answer this question. So I think it's heart is in the right place, but I think it's not nearly as uniformly doable as is necessary for our risk index. [DG]

Rule Breakers

  • Does this company meet a majority of our Rule Breaker attributes?
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