Catastrophe risk

Catastrophe risk

The rewards in the stock market can be vast – why else would we spend so much time on it? But the risks can often go overlooked as we dream of retiring down at the beach tomorrow. One risk we would like to highlight is catastrophe risk.

Catastrophe risk quite simply is the risk that the company you’re analysing will encounter a circumstance in the future that will drastically reduce its value. Examples of this include large impairments in profitability, bankruptcy, regulatory disruption or even a loss in competitive advantage. Understanding both ‘what you know’ and ‘what you don’t know’, goes a very long way to mitigating catastrophe risk.

Take, for example, the mining sector – whose revenue from operations is simply the ore price multiplied by volume. Perhaps through an analysis of the company and its capacity you can estimate the firm’s potential output and costs at a later date; however can you definitively estimate the future ore price? I know we at Montgomery can’t and hence we will largely stay away from this sector, avoiding catastrophes one at a time.

Companies we do take an interest in are those where catastrophe risk is minimised through a dominant market position, predictable recurring revenues, an unleveraged balance sheet or some set of other variables. REA Group Limited (ASX: REA) is one stock that springs to mind, due to its market leading position, as does iSentia Group Limited (ASX: ISD), who have close to a monopoly on media monitoring and intelligence in Australia. Normal business risks apply to these stocks, but it becomes difficult to see their intrinsic values decline substantially in the near future.

The Montgomery funds hold positions in REA and iSentia.

Scott Shuttleworth is an analyst at Montgomery Investment Management. To invest with Montgomery domestically and globally, find out more.