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.

Cost is an important, though poorly understood aspect of investing. It is important for the simple reason that costs reduce the overall return one makes from an investment option. It is also poorly managed as people focus too much on explicit costs (cost of brokerage or fees) and ignore the hidden ones (such as opportunity costs).

a.    Fixed deposit : cost 0, likely return : 8-9% (pre-tax)
b.    Index fund ETF: cost 0.6% to 1%. Likely return : 14-15% (pre-tax)
c.    Mutual funds (HDFC equity fund): cost 2%. Likely return : 20-21% (pre-tax)
d.    PMS: usually 2% of asset and % of gains.  Likely returns: Who knows?

Fixed deposit and index funds are zero or low cost options with the FDs having no volatility, but much lower returns. IF you want to build wealth, an FD is not going to get you there. Index funds are a decent alternative, where the risk of active portfolio management is removed. You don’t have to worry if your portfolio manager is an idiot who will underperform or worse lose money over the long term.

The last option is private vehicles such as PMS (portfolio management schemes). These involve high costs, and in some cases deliver good returns. However they have a mixed record and are generally not a good option for most investors due to a high minimum investment.

Let’s take a hypothetical case

At the end of 3.5 years, you will have following sums with you
Fixed deposit (pre-tax): 4.05 Lacs (pre-tax) and 3.84 Post tax
Index fund (pre-tax and post tax): 4.18 Lacs (net 1% as cost)
Mutual fund (pre-tax and post tax): 4.62 lacs (net 2% management fee )

The explicit costs
In order to make the higher returns, an investor had to contend with all the volatility and noise in the market. In addition to the emotional toll, there was an explicit cost of around 3% for the index fund and around 6% for the mutual fund.

Inspite of these costs, if an investor could stomach the volatility, he or she came out ahead during one of the lousy periods in the stock market.

If you think explicit costs are bad, I would say the hidden costs are even worse.

This difference only increases over time and would be even wider once the market performs close its long term average (15-17%) and interest rates drop.

If you bought 3 lacs of gold in Jan 2011, you would have around 3.78 Lacs of gold now (at pre-tax). I don’t want to discuss taxes as paying taxes on gold is different issue altogether. So gold did barely as well as an FD. Keep in mind that gold over a 20 year or longer period has delivered 9-10% per annum despite the recent runup (excluding transaction and holding costs)

The returns on a specific investment – a stock or a property is not same as the return of an entire investment class. If you want to look at the average returns, look at this table by NHB. The returns vary from -15% for a Kochi to 249% returns for Chennai over a 7 year period. So we are talking of -2% to 15% per annum for different locations. This does not even include taxes, brokerage, and maintenance fee (For property).

Congrats – but then you are missing the final point. The final point is the cost of time and effort – if you are a full time or even a part time investor in RE, you are using knowledge/ skill/ time to dig out such deals and investment in them. As you do this, you are not using your time do XYZ (spend time working, with your kids, play – whatever you can think of)

Compare all costs
IF you truly want to compare multiple investment options, compare all the costs – implicit and explicit

It is foolish to look at some costs and declare a particular option as better. Maybe I value peace of mind and time with family more than returns – in that case an FD is better.  My own dad valued these attributes more than returns and spent his spare time with his kids and on his own hobbies (without ever depriving us of anything in life)

In addition to these costs and corresponding returns, I would say there are emotional and bragging benefits to various options which will be the subject of the next post.

I had written a note about Selan exploration here. I will not repeat the analysis as the main thesis laid out earlier, still holds true.

The company is cheap from multiple perspectives – enterprise value per barrel of oil reserves, EV/EBDITA etc. However due to lack of timely clearances for drilling new wells, the production and profits have stagnated for the last few years. As a result, the stock price stagnated for a few years, before the recent run from the 200 levels to around 620 now.

In addition to the above disclosure, there is another very key variable which is showing an upward trend – development of hydrocarbon properties. This is the cost incurred by an oil and gas company to prospect for locations for new wells and then drill the well and complete it. The company has spent close to 80 Crs in the last four years in prospecting for new drilling locations.

We cannot be sure how many of these wells will be successful and when exactly they will come online. At the same time, the typical lead time from start of drilling to production of oil and gas varies between 6-9 months. So we are in effect talking of about 3-6 months of time for the oil production to ramp up.

This is not a core position
This is not a big position as i think it is risky for the reasons already detailed in my earlier post. Let me repeat the key ones

–          The management provides the minimum level of commentary on the performance and outlook for the company. There are no interviews, quarterly conference calls etc. In effect short of speaking to the management directly, there are no publicly available sources of information. One is driving through a foggy windshield and being forced to make inferences based on published data

Please do not consider this to be a stock recommendation and do you own homework. Please read the disclaimer if you still have some doubts

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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.