How to reject a stock

How to reject a stock?

You will generally find ten tips to select the next ten bagger, but not many write on how to reject stocks.

The problem of abundance
A typical well diversified portfolio tends to have 15-20 stocks (anything more does not reduce risk any further).  Let’s assume that the holding period is 2-3 years per stock. So in effect one needs to find and replace 5-7 stocks per year in the portfolio.

We have around 5000+ companies listed in the stock market and a selection of 10-12 stocks means that you will reject 4990 stocks (if you were able to have a look at all the companies each year).  That is around a 99%+ rejection rate. Even if you were to play around with the number of stocks you can analyze each year and the number you end up selecting, I cannot envisage a scenario where you will reject less than 95% of the stocks you review.

Finally a corollary to my point –The main problem is that we are not limited by choice, but by time and effort.

Building the framework

At the risk of oversimplication, I would say a long term investor is looking at high rates of return for a long period of time. Putting it quantitavely, I would say that I am looking at a CAGR of 26% per annum for 3-5 years or longer if possible.

–          The company operates in an industry with above average growth rate which means that the industry is growing atleast at 15%+ rates (higher than the GDP).
–          The company is able to earn a high rate of return on capital (atleast 15% or higher) for a long period of time (sustainable competitive advantage)
–          Company is led by a competent and ethical management
–          The company is selling at reasonable valuations

Easier to reject stocks
You must have noted that I have omitted a lot of factors which go into selecting a winning stock and that’s precisely my point. Selecting a profitable stock is a complicated Endeavour and one can write books on it and still not cover all the points needed to identify a profitable idea.

So let’s look at how we can select stocks to lose money
–          The company operates in an industry which is in a terminal decline (fixed line telephony) or is highly cyclical, commodity in nature and with very poor return on capital (metals, sugar, airlines etc)
–          The industry is subject to a lot of change (regulatory, competitive or technological) which causes several companies to fail or loose money due to sudden change in the competitive scenario (telecom, mining etc)
–          The company is managed by an unethical and incompetent management (do you need examples here?? – just look around )
–          The stock is purchased at high valuations in a cyclical industry right at the peak of the business cycle. To add insult to injury, the company is managed by an unethical and incompetent management. This combination of factors is guaranteed to loose atleast 50-60% of your capital if not more

Is it comprehensive and works 100% of the time?
Of course, this list is not comprehensive. I can come up with a lot of additional points, but I can say that these broad criteria can be used to eliminate a lot of companies at the first glance.

My counter point is – Do you really want to search for a needle in a haystack when there are often gems lying around? If your idea of fun is to find that nugget of gold in a pile of manure, then welcome to my world. I have engaged in it often and the results are not great compared to the effort put in. In addition if you are not a full time investor, then it makes all the more sense to focus your limited time on good opportunities.

The benefit of my mistakes
The list I have shared is not something I have just dreamed up while sipping coffee. I did a small exercise of listing of my failures for the last 15+ years and found a few common threads among all of them.  If I boil it down, it comes down to the four points listed above.

Let me make another bold claim – if you want to lose 90% of your money, buy a highly cyclical and commodity type company at high valuations at the peak of the business cycle and run by an incompetent and crooked management. You will be guaranteed this result. How do I know – I tried it a few times and have never failed to loose my shirt (and other garments!)
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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.