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Chapter 5. Fundamental Volatility > Expanding the Definition of Risk

Expanding the Definition of Risk

We contend that price is not a valid exclusive test of risk for the purpose of fundamental analysis. As a strictly short-term and technical indicator, price cannot be used to identify long-term investments nor to compare long-term value between two or more different companies. Price volatility implies varying degrees of market risk, and in that sense, a high-volatility stock provides us with one of many warning signs. However, market risk based solely on recent price trends has to be viewed not only as short-term in nature, but more appropriately, as a symptom of potential problems in other areas. For example, when a stock's price is highly volatile and core earnings adjustments are high as well, the combined indicators may lead us to a more detailed examination of fundamental indicators.

Can we equate high volatility and core earnings adjustments with higher than average risk in the fundamentals? While we cannot say with certainty that there is always a connection, the process of checking this possibility is worthwhile. In many cases involving these two symptoms, you are going to discover underlying fundamental causes for high price volatility. Our detailed examination of Sears began with an observation that total revenues were rising; on closer examination, we found that retail revenues declined over a three-year period, accompanied by a reduction in the number of stores. Exceptionally high debt ratio trends and other negative fundamental indicators explained much of the price volatility; we confirmed the apparent trend by also observing that core earnings adjustments were high.


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