Risk is more important than returns. When investors focus primarily on returns they’re likely to get sucked into whatever has done well recently and to ignore the central importance of risk management. That is, until a major risk crystalises and whacks them around the back of the head.
That’s exactly what we’ve seen with FirstGroup.
If you look just at the returns from FirstGroup then they’re pretty impressive. Dividends have gone from around 11p in 2004 to almost 24p in 2012, and they went up every year. Ditto for revenues. And it was going that way for earnings too until the financial crisis.
Investors thought this was a safe, defensive company with a bright future of reliable growth stretching out into the distant future.
In reality it was anything but.
The problem with risks is that they can often be ignored until they can’t. They can sit dormant for many years and the longer they sit there doing nothing, the easier they are to ignore. Paradoxically, this risk ignorance will usually increase the size of the risk and therefore its impact when it does eventually turn from probability to reality.
One popular measure of debt manageability is interest cover. Through most of the last decade FirstGroup’s interest cover was around 4, and since 2009 it had been consistently below 3.
That means anything from 25% to more than 33% of operating profits were going straight out the window to lenders rather than shareholders.
Not only is that offensive to me as a shareholder (although thankfully, not a shareholder of FirstGroup), it’s also incredibly risky to have such massive obligations to lenders.
Investors should have known better. The debts were not hidden; they were in plain sight for all to see. Investors who bought into this company at more than 700p (while today the shares sit closer to 120p), with a dividend yield of just 2.5% and a PE ratio of almost 20, were taking on huge risks for very little potential return.
Those risks have now become real events, but for many it is too late.
Investing is about taking on risk. There is no other way to achieve rates of return above the “risk free” rate, or above what you can get in a cash savings account. But if investing is about taking risk then investors must understand the risks they are taking, and for the most part that begins with looking at a company’s financial obligations and most obviously, its debt levels.
Most investment errors stem from a lack of understanding of risk; whether its operational risk from the underlying companies or price risk from elevated share prices. In all cases a close attention to and deliberate management of risk is a must if an investor is to do consistently well over the long-term.