Today when we speak about risk – the first risk comes to our mind is the valuation risk measured by traditional metrics like PE , PB ratio and the premium we are paying today to their historical averages. But, there are a few other risks which are rising in listed securities and need nuanced thinking to reduce the effect in a portfolio . These are collectively called 4C Risk – Beyond Valuation Risk.

Competition risk

One of major risks referred to by the Porter 5 Force model is how much is the entry barrier to any particular industry. We saw how Bharti Airtel delivered almost 0% return for a 12-year period (2007 to 2019) due to competition and weak operating environment. Today, even as most of the corporate balance sheets is in the best of position – we see new, large competitors attacking the profit pool of the industry. We don’t have to look any further than the paint industry, considered as one well managed in terms of industry structure, ROE and growth metrics for the last 10 years .

The average ROE profile of top 3 listed paint firms is in the range of 20%, signifying value creation across time cycle. With the entry of Grasim – the disruption is for real and we are seeing the first all-round effect in terms of every player raising capex and stock prices underperforming the broader market. Asian Paints outperformed market by 12% CAGR in the last 20 years but in the last 3-4 years, the situation is reversing where the firm has been underperforming the market by 13% for the last five years likely on expectation of lower growth and ROE given competition.

Competitor listing risk

In the past, if we had to play passenger vehicle (PV) industry, one best way was to buy Maruti Suzuki shares to capture PV growth. But, in the last 5-6 years, investor choice had widened with a lot more PV firms either listing or going to get listed. Hyundai had filed DHRP already, Tata Motors is going to demerge PV unit and list in some time and there is potential listing of JSW MG Motor in some time. We are seeing a similar story in the banking sector where non-lending financial institutions got listed in the last five years

Cash out risk by promoters

The third major risk to the market is the cashing out of long and largest shareholder of the company which is probably the promoter or PE investor. Promoter PE selling steadily increased from ₹30,000 crore to ₹60,000 crore between 2019 to 2022. FY23 and FY24 saw a record ₹1.4-₹2 lakh crore selling which is continuing in FY25 as well

We have seen the incidence of large sell-down by promoters in ITC, Whirlpool, ITD Cementation , Happiest Minds and Hyundai, reflecting the fact the more informed owner is using the high-liquidity phase to reduce ownership which is fine as still we have high retail flow. But, any change in macro scenario and fund-flow reduction, firms with higher free float can bring higher price volatility till loose shareholding gets consolidated into stronger hands.

Capital allocation risk

Capital allocation risk is one where the corporate takes more risk than needed given the balance sheet size. During the last investment bull cycle (2006-08), we saw large capital allocation issues happening in metals and industries with global exposure which did not help either the market or the firm for the next few years as the organisation had to recover from heavy investment and delayed benefit on slower economic recovery .

As long term investor, we need to take cognisance of these risks and build a margin of safety in terms of valuations we pay for buying shares and build a very high quality portfolio which can withstand adverse macro situation and keep compounding wealth for longest period of time .

(The author is head of research and co-fund manager at ithought PMS. All views are personal)

Published on September 16, 2024