The 'Risk Factors' Faced By Corporate America

There is a lengthy list of "Risk Factors" that affect the business operations of public companies in their 10-Q and 10-K filings, the quarterly and annual financial reports that public companies are required to file with the Securities and Exchange Commission (SEC).

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Over the course of my career, I have thumbed through hundreds (if not thousands) of these. There is no particular order in which these risks are listed, but companies tend to start by identifying the risks on which their business operations are most likely to be affected. Some of the biggest companies have identified the following risks as the first of their risks:

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• “Global and regional economic conditions significantly affect the Company's operations and performance, and adverse economic conditions can adversely affect its business, results of operations, and financial condition.“ - Apple
• “Our business faces intense competition.” - Amazon.com
• “Our business and financial results are affected by complex and evolving global regulations.” - Visa
• “Economic conditions.” - Exxon Mobil
• “In highly competitive markets, the Company's businesses could be negatively affected by competitive pressures on earnings.“ - Johnson & Johnson
• “We may suffer a material adverse effect on our market position, net sales, and financial performance of our omnichannel strategy is not executed effectively and we overinvest in technology and eCommerce.“ - Walmart
• “Factors such as the general economy and geopolitics may negatively impact our financial results.“ - Coca-Cola
• “Our risk-based products and services could suffer from a decline in profitability if we fail to estimate, the price for and manage them adequately or set up benefit designs in an effective way. This could have a material and adverse impact on our results of operations, financial position, and cash flow if we do not take these steps. " - UnitedHealth Group
• “The current global economic conditions have the potential to adversely affect our business, operating results, and financial condition.“ - Nike

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It is clear from the above that there is often ambiguity in the language used. The risks associated with these companies are more specific to the industries in which they operate than others.

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The list of the top five priorities identified by Berkshire Hathaway in its 2022 annual report, which was released last week, caught my attention immediately. I was appalled at what the conglomerate placed at the top of their list. From the filing:

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Our operating businesses could be adversely affected by terrorist acts.

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Our worldwide operations could experience significant losses as a result of a cyber, biological, nuclear, or chemical terrorist attack. Such acts might adversely affect our business operations as a result of the loss of human resources and the destruction of production facilities and information systems as a result of such acts. All businesses share the risk associated with it.

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Cyber security risks

Our business relies heavily on technology in virtually every aspect of what we do. In common with many large companies, some of our information systems have been subjected to computer viruses, malicious code, unauthorized access, phishing attempts, and denial-of-service attacks, as well as other cyber-attacks like those of many large corporations. As such attacks become more sophisticated and frequent, we expect to be subject to similar attacks in the future as well. Our technology systems could be affected by significant disruptions or failures that could result in service interruptions, safety failures, security breaches, regulatory compliance failures, inability to protect information and assets, and other operational difficulties as a result of unauthorized access. There is a possibility that an attack on our systems could result in the loss of assets and critical information and that we could be exposed to substantial remediation costs and reputational damage...

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There are some risks in this list that are quite jarring compared to what you see at the top of most lists these days. Clearly, these are situations where bad actors are trying to cause harm and create chaos around the world.

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In all fairness, they are appropriate for a company like Berkshire Hathaway. With a global reach and a presence in most industries, it would be vulnerable to mass shock events like the ones outlined above, since it represents a well-diversified conglomerate. The fact that Berkshire Hathaway is a major player in the insurance and reinsurance business means that it might be forced to pay for the damages incurred by the companies they are covering as a result.

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In a sense, it is remarkable that Berkshire only got into the habit of ordering its list of risks in this way with its 2020 annual report. It was a no-brainer to lead Berkshire's 2019 report with: "We are dependent on a few key people for our major investment decisions and capital allocation." This made sense of course since Berkshire is led by Warren Buffet, perhaps the most successful investor in history.

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The fact that Buffett has made no secret of his concern about terrorism - particularly cyber-terrorism - is no secret to anyone who knows him.

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• “There is, however, one clear, present, and enduring danger to Berkshire against which Charlie and I are powerless. That threat to Berkshire is also the major threat our citizenry faces: a “successful” cyber, biological, nuclear or chemical attack on the United States.“ - Buffett in 2016
• "I don't know that much about cyber, but I do think that's the number one problem with mankind." - Buffett in 2017
• “Cyber is uncharted territory. It’s going to get worse, not better.” - Buffett in 2018
• “I think cyber poses real risks to humanity.” - Buffett in 2019

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Buffett and Berkshire have the option to do the same thing as Apple and Exxon Mobil and to start with a generic statement about "economic conditions," which could be viewed as encompassing the effects of terrorism and cyber-attacks. However, they did not do so.

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What is the purpose of this discussion?

There is no way for me to know if a crippling cyber attack is imminent.

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The risk should not be totally ignored, however.

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You may have heard a lot about inflation, monetary policy, fiscal policy, recession risks, and the effects of the war in Ukraine if you have been following business news.

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There is, however, a tendency for markets to at least partially price in known risks that are at the top of minds.

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Furthermore, TKer Truth No. 8 asserts that the most destabilizing risks are the ones that people are not talking about.

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Buffett may be referring to cyber threats. So is the White House. But it is rarely identified as a top concern among investors.

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Thus, the very fact that cyber current garners so little attention may be a reason to be concerned as an investor.

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When investing, managing risk involves finding a balance between “hoping for the best” and “preparing for the worst.” Of course, it is up to you and your financial advisor to decide how to position your portfolios in this context.

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Taking a look at the macro crosscurrents

The following are some notable data points from last week:

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The business sector is investing

An all-time high of $75.2 billion was reached in January for orders for nondefense capital goods, excluding aircraft, which is more commonly known as core capex or business investment.

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January's backlog of unfilled core capex orders stood at $267.2 billion.

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There are rosy estimates for GDP growth

In Q1, real GDP growth is expected to increase by 2.3%, according to the Atlanta Fed's GDPNow model for Q1. There has been a substantial increase in growth from its initial estimate of 0.7% on January 27.

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Survey says services are hot

ISM's Services PMI fell slightly to 55.1 in February from 55.2 in January. Sector expansion is indicated by a reading above 50.

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There was a significant increase in hiring in February, as the employment subindex jumped from 50 to 54.0.

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But the survey says manufacturing is cooling

Manufacturing PMI for February rose from 47.3 in January to 47.7 according to the ISM. If the reading is below 50, then it indicates contraction, suggesting manufacturing activity is continuing to deteriorate but at a slower pace than in previous months.

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The price of gas is declining

According to the EIA, the average price for regular gasoline in the United States on February 27, 2023, was $3.342/gallon, down 3.7 cents/gallon from 2/20/23 and down 26.6 cents/gallon from [a] year ago.

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Costs of shipping have decreased

Apollo's Torsten Slok says that transportation costs between China and the US are basically back to pre-pandemic levels, boosting manufacturing and driving goods inflation downward.

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Price declines in the housing market

It comes as no surprise that home prices fell 0.8% in December compared to the same month last year, marking the sixth consecutive month of declines according to the S&P CoreLogic Case-Shiller index. A year-over-year comparison of the prices showed a rise of 5.8%, compared to a rise of 7.6% in the month before. Craig Lazzara, a senior economist at S&P DJI, concludes that the prospect of stable, or higher, interest rates is likely to hamper home prices as a result of mortgage financing restrictions, while weakness in the economy, including the possibility of a recession, may also hamper potential homebuyers. The macroeconomic environment is likely to remain challenging, and as a result, home prices are likely to continue to decline.

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Rates for mortgages have gone up

The average 30-year fixed-rate mortgage rose to 6.65% last week, according to Freddie Mac: “With lower economic growth, inflation, and loosening monetary policy, 30-year fixed-rate mortgages decreased at the beginning of the year. However, since economic growth has been sustained and inflation has been continuing, mortgage rates have surged and are inching up toward seven percent as a result. There has been a surge in buyer activity since January of this year due to lower mortgage rates. Because of the rising interest rates, potential buyers are finding it more difficult to make an informed decision, especially repeat buyers who have existing mortgages with rates at less than half of what they are paying now.”

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Confidence among consumers slips

According to The Conference Board, “consumer confidence decreased again in February, especially among households with incomes of $35,000 and higher... In addition, while consumer expectations for 12-month inflation improved—falling from 6.7% last month to 6.3%—consumers may be beginning to pull back spending as a result of high prices and rising interest rates. The number of consumers who plan to purchase homes or autos has declined, and they also appear to be scaling back their plans to buy major appliances. February saw a decline in vacation intentions as well.”

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Improvements in labor market confidence

“Among consumers, 17.8% rated business conditions as 'good,' down from 19.9%. The percentage of consumers rating business conditions as 'bad' declined from 19.0% to 17.7%,” the Conference Board reported.

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The unemployment rate remains low

The number of initial unemployment claims declined to 190,000 during the week ending Feb. 25 compared to 192,000 during the week prior. Despite the fact that the number of unemployment benefits has increased from its six-decade low of 166,000 in March 2022, it remains near the levels seen during periods of economic expansion in recent years.

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Refunds from tax returns are up but lower than they were before the pandemic

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“The average February refunds between 2016 and 2019 ranged from $111 billion to $125 billion in terms of volatility, with the average being $118 billion. In a similar fashion to 2022, the number of refunds that were paid in February this year was below the pre-pandemic average of $84 billion ($85 billion in 2022)," according to UBS.

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Sales of cars are on the rise

The number of light vehicles sold in February was 14.9 million units on an annualized basis. “While there has been some volatility in the monthly readings, it seems like sales have been trending higher in recent months, with improving inventory dynamics likely facilitating car purchases. Autos are clearly subject to sector-specific issues that are not indicative of broader economic conditions. However, several economic indicators have shown similar patterns in activity in recent months to auto sales data, with moderate increases in February following strong increases in January," as per JPMorgan.

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Empty offices still abound

From Kastle Systems: “Office occupancy was above 50% last week for just the second time since the start of the pandemic when occupancy levels exceeded 50%. It is estimated that occupancy rose by three-tenths of a point to 50.1%, according to the Back to Work Barometer, released today. Despite the fact that the data for the survey only covered four days due to the Presidents Day holiday, seven of the 10 tracked cities experienced moderate increases, while only three cities - New York, San Francisco, and San Jose, Calif. - experienced minor decreases. There was a high occupancy of 57.2% on Tuesday, and a low occupancy of 32.4% on Friday, which made up the week's daily high and low.”

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Putting it all together

Clearly, we are seeing a lot of evidence that we may be able to have a soft landing under the bullish "Goldilocks" scenario, where inflation cools to manageable levels without causing the economy to fall into recession.

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Fed President Ben Bernanke recently adopted a less hawkish tone, acknowledging that "disinflationary processes have started.“

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Yet, the Fed is still not comfortable with the price levels due to the fact that inflation still needs to come down more. We should expect that the central bank will continue to tighten monetary policy, which implies that we should be prepared for tighter financial conditions (e.g. higher interest rates, tighter lending standards, and lower stock valuations) in the future. In light of all of this, it is likely that the market beatings may continue and that there is a higher risk that the economy will sink into a recession than in the past.

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S&P 500 (^GSPC)

There's no denying the fact that recession risks are elevated, but consumers are coming from a very strong position financially, so it's important to remember that. Unemployed people are getting jobs as a result of the economic downturn. There have been increases in salaries for those who have jobs. Many people still have excess savings that they can use to supplement their income. This financial resilience is confirmed by strong spending data. Therefore, we shouldn't sound the alarm at this point from the standpoint of consumption.

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Given the strong financial health of consumers and businesses, any downturn is unlikely to turn into an economic catastrophe.

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The best course of action for long-term investors is to never lose sight of the fact that recessions and bear markets are something you will have to deal with when you enter the stock market in order to generate long-term returns. Even though stock markets have had a terrible year, long-term prospects remain positive.