CategoryRejected investment ideas

The following is from my annual letter to subscribers. I will be posting the letter soon on the blog

There are a few irrefutable statistics of the India stock market. Over the last 10-year period around 50% of small caps (and roughly the same for midcap), lost money for their investors. Only 10% of the companies in this space accounted for most of the returns of the index.

In such a scenario, rejecting stocks is an equally important task in building a portfolio.

We have been focused on this aspect from the beginning of the model portfolio but have not discussed it in depth. The last two years has brought this factor into the spotlight and I want to share the process we use to filter ‘out’ stocks.

The first step in filtering out stocks is quite simple. I look at an idea and reject it if any of the following conditions are met

1. Management has past record of illegal actions or are known for bad governance practices. This is a subjective criterion, but one can filter out the obvious cases
2. Debt equity (other than financials) is greater than 1.5
3. PE is greater than 60
4. Company operates in an industry with poor economics (return on capital over a business cycle has been below 5%)
5. IPOs

Some of you may look at this and point out that ‘so and so’ company has been a value creator in spite of meeting some of these conditions.

To this my response is this – An elimination process works on probabilities. If you pick 100 companies which have a very high PE or very high debt, 80% or more will lose money for their shareholders. There will always be some which buck the trend.

I am not trying to win an intellectual contest of picking a winner with odds stacked against it. If you play this game long enough, the probabilities eventually catch up with you.

If the idea survives this step, I move on to the next series of checks. These checks are detailed out in the spreadsheet I upload for every company. I have extracted the specific sections used to reject an idea and uploaded here for reference.

Please keep in mind these checks are not quantitative and there is no mathematical formulae which will throw up an answer. Think of these points as checklist/questions to dig deeper into the company

1. Fragility – I added this section recently and use it to check whether the business would collapse if some of these risks materialize. For example – Does the company have a major concentration with a single customer or supplier. What will happen if this partner pulls out?
2. Management checklist – I have had this section for a long time and have added to it over the years. There are sub-sections to check if the management actions have been ‘suspect’ in the past and point to unethical behavior
3. Accounting – This has an exhaustive list of possible accounting games companies play. I have created this from multiple books on financial fraud and accounting malpractices. 2018/19 had a few repeats and some new ways of fudging accounts
4. Risk analysis – I added this section a few years back and it is for a deeper analysis of risks and their probabilities.

As you can see from the file, this is a checklist to ensure that I don’t miss something obvious. At the same time, this will not prevent mistakes from happening. A management may be able to hide some of its behavior for a long time and it may come to light after we make an investment.

These points are not black and white and involve a judgement call on where to draw the line. In the past, I have been more tolerant of management behavior, but have realized that even if a particular idea works out, the long term average of such decisions will be disappointing ( I have called this riding a tiger in the past)

As you will note, this process works on evidence or past history of a company and its management. If that is missing, we are flying in the dark. This is another reason for me to avoid IPOs. In most IPOs, the business has been dressed up for sale and all the skeletons tumble out after the listing.

The aggregate performance of all the IPOs in the last 2 years bears this point. Pointing out a few successes, only proves that they are the exceptions and not the rule.

The downside of this process is that I may end up rejecting a company which turns out to be a success. I am comfortable with that problem as long as I can avoid failures. A portfolio of 20 companies out of a universe of 3000+ stocks means that will we miss a lot of winners.

The more important criteria is to avoid the losers.

Failure is a better teacher than success. This holds true in the case of investing too. I have been looking closely at some of the recent cases such as Arshiya international, gitanjali gems, CEBBCO, Kingfisher airlines, Zylog limited and some older ones such as reliance communications, DLF, SSI, aftek and many more.

Why analyze such cases? On that count, I am following these comments from Charlie munger on learning from failure

It is not always fraud
I have seen an oversimplification on the cause of failure in the above cases. A lot of investors think it has been caused by management stupidity or greed. The reason for this conclusion is due to some high profile failures such as satyam.

It is easy to say that the management was unethical (Which is true in several cases) and hence the business failed. I think that is intellectual laziness. There are several other companies where the management is a bit suspect, but the company and its stock has not collapsed (though did not perform as well)

1. Low return on asset/ equity due to commodity or highly competitive business (think airlines or telecom)
2. Low free cash flow (after taking into account Working capital needs and obsolescence risk/ business model changes )
3. Growth obsession funded by debt, resulting in high debt equity ratios (2:1 or higher
4. Cyclical industry with 1,2 and 3
5. Growth obsession with expansion into foreign markets (most likely from pricey acquisitions) stemming from management’s grandiose views of building an empire (rather than focusing on value creation)
6. Management failure/ governance issue (with diversion of funds into sister firms in some cases)

The steps to destruction
Let’s look at some kind of chronology of events leading to the eventual collapse in the stock price

1. Company experiences temporary success due to a cyclical high or tailwinds (look at the long term base rate to identify this situation). In some cases, success is from sales perspective and ROE and cash flows are still weak.
2. Management feels bullish and starts adding capacity/ businesses. In a lot of cases this is funded by debt or FCCB type equity.
3. In some cases, management goes abroad and acquires assets at high prices stemming from delusions of empire building (aka ‘Indian name’ in foreign lands)
4. Business encounters a hiccup or a cyclical downturn. The cash flows dry up and management finds it increasingly difficult to service the debt.
5. Management fudges the numbers for some time and tries to keep things afloat (bullish statements, confidence in the business inspite of worsening fundamentals such as negative cash flow, worsening debt service ratios etc)
6. The pack of cards finally collapses when the company defaults on its debt (openly or in private). When the market gets a hint of this, the stock price collapses almost overnight and the outside investor is left holding the bag

What to avoid
If you like the principle of inversion and think high cash flows and low debt is the sign of a healthy company, then one should avoid a company with poor cash flow and high debt irrespective of the story or future prospects (which are always rosy).
It’s quite possible, that you may miss some of the real turnaround cases, but on the balance I think it one would do much better by avoiding such companies

Bull market stocks
A lot of companies with poor cash flows and high debt did quite well during the previous  bull market and a majority of the investors choose to ignore the red flags. Why bother, when you are making money ?
It is during tough market conditions, that the chickens come home to roost, and a lot of investors (me included) get a lesson on risk.

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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.