The question on everyone’s minds is whether those caught by the lack of liquidity and dropping values for asset-backed commercial paper in the second half of 2007 could have foreseen the problem and avoided it.

The answer is: “Maybe, but probably not.” So, how do you evaluate — and avoid — risk in today’s marketplace?

Getting a handle on the ABCP problem has been tough. If you’d been really smart, you might have realized that the spreads offered for non-bank ABCP did not reflect the risk of holding a basket of assets that could include some very risky products. But bond-rating agencies rated the ABCP highly and reputable institutions, including the big banks, sold the paper. You would assume that anything accompanied by these credentials is of good quality.

Unfortunately, that wasn’t the case — and that’s a lesson for everyone. But the fact is that you have to do your own due diligence, says Charlie Kim, head of Canadian securities at HSBC Securities (Canada) Inc. in Vancouver. When it comes to products such as ABCP, you need to know who the ultimate counterparties are — who is responsible for paying?

Kim views the ABCP crisis as a symptom of the mispricing of risk that has occurred during the past five years. The risk premium in all markets — equities, corporate bonds and commercial paper — shrank as a result of tremendous economic growth and a tremendous increase in liquidity. People forgot that there are business cycles. In addition, the increase in wealth that came with strong growth caused retail and institutional investors to bid up risky assets as they tried to find incremental returns.

What investors could have done, and should have done, was make sure they didn’t hold too much ABCP. That’s not because the securities turned out to be risky but because of the rules of diversification: you should never have too much of any one type of asset.

Of course, you can’t entirely avoid risk, say Clancy Ethans, Richardson Partners Financial Ltd.’ s chief investment officer in Winnipeg, and Andy MacLean, RPFL’s director of private investing in Toronto. What you have to do is minimize risk by having a portfolio that’s properly diversified, both by country and sector for equities and by assets class, which can include fixed-income, alternative investments, real estate, private equity and commodities.

That’s the main lesson from the ABCP crisis. But the issue also brings up the question of evaluating risk for all asset classes. Here are some pointers:

> Understand The Asset. One of the problems with ABCP was that it was difficult to determine what assets were backing the paper. Those issuing the paper were, in many cases, not backing it with assets they owned but with securitizations purchased from other financial institutions. Furthermore, if investors were rolling over their ABCP holdings — which is likely, given its short duration — the composition of the ABCP in which they invested kept changing.

Understanding the asset comes back to due diligence. Investors and advisors alike need to ask questions and more questions. Ask about assumptions and make sure you understand how products are structured and what’s involved in getting the return they offer.

The issue of understanding what you recommend to your clients extends to every kind of asset. If it’s the stock of a company, make sure you understand the company’s business. Money manager John Arnold, managing director and CIO with AGF International Advisor Co. Ltd. in Dublin, likes to be able to see and feel a business. If he’s investing in a retailer or a bank, he wants to visit a store or branch. His advice: know the companies you are investing in intimately and monitor them closely.

Actually seeing a company’s business in operation isn’t always feasible; indeed, it’s next to impossible with foreign companies. But you can apply common sense to a company’s strategy. If a firm says it expects strong growth because it is launching a new product, make sure you agree that the product is likely to appeal to large numbers in its target market.

And make sure you understand what a company does. Enron Corp. is an extreme example of a business that was incomprehensible to outsiders. It involved all kinds of special-purpose entities that Enron controlled, but whoses results it did not report. That meant that losses were not reported in its financial statements.

@page_break@Other examples include the derivative operations of many financial services institutions. You need to figure out exactly what they are doing and how much risk they are running — or take them off the list of companies you recommend to clients.

There’s also the question of hedging. In some instances, resources companies hedge the future prices of their products so they don’t get caught by unexpected drops in market prices. You need to know whether they do this and, if so, the extent to which they do. Otherwise, you can recommend or invest in, say, a gold company whose earnings you expect to rise in tandem with an increase in the price of gold. Then, when the gold price does rise, you find out that the company was extensively hedged and profits didn’t go up as expected.

Companies with sales in different parts of the world may hedge currencies — again, to avoid the negative impact of unfavourable changes. This can make a company more attractive than you might have thought if you were assuming that currencies in its major markets would move against it. But it can also provide unexpected disappointments if you thought it would benefit from currency moves.

> Risk Premiums. The riskier the investment, the more you should receive in interest from a bond for running that risk and the less you should have to pay for the equities as a percentage of earnings or book value.

When risk premiums come down, as they have in recent years, you need to be particularly careful. A trite but true rule of thumb, say Ethans and MacLean, is: “If you see something at a return that seems too good to be true, it probably is too good to be true.” This is particularly so for publicly traded securities, they add; there can still be good returns in private equity.

You always need to be aware of the risks inherent in each investment and decide if your client will be properly compensated for that if he or she invests. Certainly this should have been a red flag with ABCP, as the spreads offered over much less risky bank products were very small.

With the convergence of valuations in equity markets around the world, you should also seriously consider what your clients have to pay to invest in emerging markets’ stocks, given the political risks in some countries. Some analysts feel emerging markets’ valuations are too high, given the risks, and prefer to invest in stock of companies that are benefiting from the fast growth and industrialization of those countries, such as resources, machinery and shipping firms.

> Valuations. Most stock recommendations are made on the basis of the price/earnings ratio — current share price divided by estimated earnings per share for the company’s next fiscal year. This ratio is obviously heavily dependent on the earnings estimate, which can be a problem when, as now, economies are slowing down.

The 16% average earnings increase estimated by analysts for the companies in the Standard & Poor’s 500 composite index certainly seems very high, given expectations of very slow U.S. economic growth and, perhaps, a recession.

This is another instance in which you have to exercise common sense. You want to test earnings estimates against what you think is reasonable in the environment.

Analysts — including Clément Gignac, chief economist at National Bank Financial Ltd. in Montreal; and Ross Healy, president of Strategic Analysis Corp. in Toronto — have done this and conclude that they don’t believe the forecast earnings estimates. As a result, they don’t recommend using P/Es this year as valuation indicators.

A much better measure in the current environment is the price/book value ratio, say Gignac and Healy, a valuation based on two firm numbers if, as Healy recommends, you take goodwill out of the book value when making the calculation. Goodwill is not a hard asset in the way plant, equipment, inventories, receivables, deferred income taxes, cash and investments are.

On June 30, 2000, a few months before Nortel Networks Corp.’s stock started to tumble, US$10.9 billion — or more than a third of its US$31.5 billion in total assets — was in intangible assets, with US$9.6 billion in net goodwill. This rang warning bells in the minds of some savvy investors. By Dec. 31, 2002, the value of the goodwill on Nortel’s balance sheet was only $2.2 billion — and some analysts thought that was too high. Healy’s view is that Nortel’s goodwill was virtually worthless.

Another virtue of book value is that it takes into account debt load. While debt should always be considered, it’s particularly important in periods of economic weakness. That is, debt is a good way to fund growth, but it can produce problems when demand is weak.

Many money managers currently recommend investing in companies that don’t have a lot of debt because the stronger the companies’ balance sheets, the more easily those companies will be able to withstand the negative impact of slow growth or a recession.

The current global credit crunch in a weak economic growth period could make it even more difficult to get loans. So, the less companies have to borrow, the better. This makes debt maturity schedules important. Companies that have to roll over debt have the greatest challenges, says Bill Sterling, CIO at Trilogy Advisors LLC in New York.

He adds that Trilogy is asking its analysts to pay particular attention to credit issues now. One set of companies Trilogy is watching at the moment is capital goods manufacturers whose customers may have been heavily dependent on “sweet financings” arranged by the seller. If these are no longer possible, sales for these companies may be weaker than expected.

The bottom line: always keep a careful eye on balance sheets. Even when growth is not faltering, vigilance can pay off. Note that in some cases, even tangible assets can raise red flags. As of June 30, 2003, $10.1 billion — almost a third of Toronto-based Fairfax Financial Holdings Ltd. ’s $31.1 billion in total assets — was in reinsurance recoverables. This made some investors nervous. As of Sept. 30, 2007, there was still $5.2 billion in RRs outstanding.

This year, you should keep an eye on the “cash and cash equivalents” line on balance sheets. Companies don’t generally spell out the short-term securities or notes in which they are invested, and some may hold substantial ABCP. Certainly, a couple of junior resources companies have said they hold a good deal of it. IE