MAT 444 Module 4 Risk and Return Example

Eighty-Five Percent in One Basket: The Risk a Family Carries by Owning Its Fabricator and What Diversifying Would Change

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Business Administration Program, Aspen University

MAT 444: Finance for Managers

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Month Day, Year

Eighty-Five Percent in One Basket: The Risk a Family Carries by Owning Its Fabricator and What Diversifying Would Change

Module 3 valued Haverstock Fabrication's equity at about $13.1 million. For the family that owns it, that stake is most of what they have: the eleven shareholders together hold about $15.4 million of wealth, and roughly 85% of it is in one company, in one industry, in one city. The family has always thought of Haverstock as safe, because it has never lost money in a year. This paper measures how risky the stake actually is, what diversification would change and what return the market would require for Haverstock's risk. Every person and number, and the company itself, are invented for teaching.

What Risk Means Here

Risk in finance is the spread of possible outcomes around what is expected, measured by the standard deviation of returns. A company that has never posted an annual loss can still be risky to own, because the value of the business can swing widely with orders, steel prices and the health of its few large customers. Haverstock's three biggest customers account for 46% of sales, and a single agricultural equipment downturn cut its earnings by 40% in 2016.

Estimating Haverstock's Risk

Haverstock has no traded share price, so its return characteristics are estimated from small public metal fabricators and industrial parts makers. Their shares have shown standard deviations of annual returns between 28% and 38%. This analysis uses a 32% standard deviation and a 14% expected return for Haverstock, consistent with the required return used in Module 3. A broad stock index fund is assumed to offer an 8.5% expected return with a 16% standard deviation, and the analysis sets the correlation between Haverstock and the index at 0.55.

How Holdings Combine

Markowitz (1952) showed that an investor choosing a portfolio should look at the expected return and the variance of the whole, and that the variance of the whole depends on how each pair of holdings moves together, not only on each holding's own variance. As long as holdings are less than perfectly correlated, combining them produces a portfolio whose risk is less than the weighted average of their risks. For two holdings with weights w1 and w2, standard deviations s1 and s2 and correlation c, portfolio variance equals w1 squared times s1 squared, plus w2 squared times s2 squared, plus 2 times w1 times w2 times c times s1 times s2.

What a Bad Year Would Look Like

With a 32% standard deviation, a year in which Haverstock's value fell by 18% or more, one standard deviation below its expected 14%, would be expected roughly one year in six. For the family's current holdings, that is a loss of $2.4 million or more. At a 50% mix, a one-standard-deviation bad year would cost about 10% of the family's wealth, against roughly 15% under today's mix, in which the other 15% of wealth sits mostly in cash and local property.

Which Risk Earns a Reward

Sharpe (1964) developed the capital asset pricing model from Markowitz's ideas. If investors hold diversified portfolios, the only risk that bears on any single asset's price is its tendency to rise and fall alongside the broad market, which beta captures. Firm-specific risk, such as losing a major customer, can be diversified away and therefore earns no extra expected return in equilibrium. In the model, a holding's required return is the risk-free rate with beta multiplied by the market risk premium added on top.

Three public peers have betas of 1.10, 1.25 and 1.40, an average of 1.25. Using 4.3% for the risk-free rate and 5.5% for the market risk premium, the model gives Haverstock's required return as 4.3% + 1.25 × 5.5% = 11.2%. Haverstock's 32% total risk is far larger than its market-related risk, which means most of what makes the family's stake volatile is firm-specific, the kind diversified investors are not paid to carry.

How Far to Trust the Model

Fama and French (2004) reviewed the evidence on the capital asset pricing model and concluded that its empirical record was poor. Average returns on low-beta stocks were higher, and on high-beta stocks lower, than the model predicts, and other characteristics, such as size and how cheaply a stock was priced relative to its book value, helped explain returns where beta did not. They cautioned that applications built on the model, including estimates of the cost of equity, are likely to be inaccurate. For Haverstock, the 11.2% figure is a starting point, not a precise answer, and a range of roughly 10% to 13% is more honest. Module 5 adds an adjustment for size and private ownership.

Why the Family Should Care

The capital asset pricing model assumes owners are diversified. Haverstock's family is not, so it bears all of the firm-specific risk with no extra reward for it. A family that holds 85% of its wealth in one company is, in effect, accepting the volatility of a single stock in exchange for the comfort of control and the pride of a family business. Those are real values, but they should be chosen knowingly.

Recommendation

Selling a large part of the company is not the family's wish and would not be necessary. Three steps would reduce concentration gradually. First, the shareholder retiring this year should invest the buyback proceeds in broad index funds, as her advisor already suggests. Second, each shareholder should invest at least half of yearly dividends in a diversified portfolio instead of holding cash or buying more property in Fort Wayne, which adds to local risk. Third, the board should review customer concentration, the largest source of firm-specific risk, and set a goal of no single customer above 15% of sales within five years. At a dividend of $1.4 million a year, the second step alone would move roughly $700,000 a year into diversified holdings, reducing the Haverstock share of family wealth to under 70% within about five years.

Conclusion

Haverstock's owners carry far more risk than its history of profits suggests, because most of their wealth rides on one firm with concentrated customers. Markowitz explains why combining holdings reduces risk, Sharpe explains why the market pays only for the market-related part, and Fama and French explain why the model's estimate should be treated as a range. Investing dividends and buyback proceeds broadly lets the family keep control while lowering the risk it bears.

References

Fama, E. F., & French, K. R. (2004). The capital asset pricing model: Theory and evidence. Journal of Economic Perspectives, 18(3), 25-46. https://doi.org/10.1257/0895330042162430

Markowitz, H. (1952). Portfolio selection. The Journal of Finance, 7(1), 77-91. https://doi.org/10.1111/j.1540-6261.1952.tb01525.x

Sharpe, W. F. (1964). Capital asset prices: A theory of market equilibrium under conditions of risk. The Journal of Finance, 19(3), 425-442. https://doi.org/10.1111/j.1540-6261.1964.tb02865.x