What is company-specific risk?
Share risk can be thought of in two parts. One is market risk: the economy, interest rates or the mood of the whole market, which moves almost every share together. The other is company-specific risk, also called unsystematic or idiosyncratic risk: events inside or around one particular company that have nothing to do with the market as a whole.
As part-owner of a company you share in the results of all its decisions. If management gets things wrong, the factory catches fire, a big customer leaves or the accounts turn out to be wrong, that company’s share price falls, whatever the rest of the market does.
Say the whole market is having a good year and most share prices are rising. Meanwhile, a made-up juice company is found to have adulterated its product, sales are halted and customers turn away. Its income drops suddenly and its share price halves. None of this has anything to do with the market; that is company-specific risk. The company and the events are made up.
Why it matters to an investor
- To avoid a big loss on one share: the whole market going to zero is rare, but one company failing and its shares becoming nearly worthless is not unusual.
- To see which risk can be reduced: diversification cuts much of this risk, because the same trouble rarely hits every company at once. Market risk does not shrink this way.
- To separate a “good story” from a good investment: however strong a company’s reputation, problems inside are not always visible from outside.
- To know what to read: annual reports, the auditor’s opinion and price-sensitive announcements are the main news about this risk.
Where the risk comes from
- Business risk: falling demand, new competitors, rising raw-material costs, relying too much on one big customer.
- Financial risk: heavy borrowing boosts profits in good times, but in bad times the interest swallows the profit and leaves nothing for shareholders.
- Governance and fraud risk: misstated accounts, doubtful dealings with sponsors or related parties, small shareholders’ interests being ignored.
- Event risk: a fire, a flood, a lawsuit, a cancelled licence, or a new rule or tax that hits only that industry.
- Trading risk: shares in small companies trade thinly, so when bad news hits there may be no buyer when you want to sell.
How widely single shares’ results vary
Professor Hendrik Bessembinder of Arizona State University studied nearly 26,000 US shares from 1926 to 2016 and found that about 58% returned less over their lifetimes than short-term government Treasury bills. All of the wealth created above Treasury bills came from just over 4% of shares. In other words, while the market as a whole did well, most individual shares did not.
A good reputation is no protection. Wirecard, a German payments company, was a member of the country’s main share index, the DAX, and was once worth about $28 billion. In June 2020 it emerged that €1.9 billion of cash shown in its accounts probably did not exist. Within about a week of its auditor refusing to sign off the accounts, the share price had fallen about 98%, and the company filed for insolvency. Nothing like that happened to the German market as a whole at the time.
Source: Bessembinder, Arizona State University, 2018
See the numbers as a table
| Worse than Treasury bills | Better | |
|---|---|---|
| All shares | 58 | 42 |
Signs that should raise questions
- An auditor’s “qualified” opinion or an “emphasis of matter”: the auditor has spotted a problem or uncertainty in the accounts.
- Skipped AGMs or dividends: in Bangladesh this can move a company into the Z category.
- Profits rising while no cash comes in, or debt growing fast.
- Prices and trading volume jumping suddenly with no business news behind them, or rumour-driven “tips”.
Common mistakes
- Thinking a familiar or well-known company carries no company-specific risk.
- Assuming every share you own will do well because the market is doing well.
- Buying more of a share again and again because “how much lower can it go?”, without knowing why it is falling.
- Deciding on price and rumour alone without reading the annual report and the auditor’s opinion.
One company can fall much further than the market, even to zero; this risk cannot be avoided, but its effect can be greatly reduced by spreading across many different companies.