Buy a well-managed company, look at the growth prospects, check for valuation and adequate margin of safety, and you should be on the road to riches. That sounds right in theory. But investing is complex when emotions come into play.
Investor Nitin Jain details some commonsense checklists and questions that can act help you avoid losses.
- Situation: Management has announced a clear path towards profitability over the next two years.
- Impulsive Action: Buy.
Why are you not considering businesses with track records of delivering profits? Why are you considering an investment in a loss-making entity? The company is predicting, not making actual profits (margins is a separate discussion).
You may be led to buy into the narrative that the new company can generate higher stock returns over a specified period. Do you have any exclusive insight here or are you getting away by the management’s spiel? If the former, you are taking a calculated punt. If the latter, there is a greater risk of you getting punted.
The management spoke about turning profitable few years back. Why has it not happened? What is different now?
Is the management’s prediction already discounted in the current price?
Which are the comparable companies in the industry that are already making profits? Do a comparison. Find out what is working and what is not.
And even if the company turns profitable, would that be sustainable? If yes, would it be able to quickly achieve respectable margins?
- Situation: A big corporate with deep pockets is entering into this sector.
- Impulsive Action: As competition will be tough going forward, let me sell and book profits before it’s too late.
This chatter was so common after Jio disrupted the telecom sector. If it can be done in one sector, why not in others?
Is it really true that whenever a company with deep pockets enters a business, others shut or become laggards? How many cases do you actually remember? Don’t generalize, get specific.
Is your fear is based on some well thought through analysis for the concerned sector or only based on fear? Have you analysed the strength of the invested business and the strategy of the new entrant?
Does my business (the stock that you own) have a strong moat? If yes, piercing that would not be easy. E.g., customer habit of using my product or the undivided laser sharp focus of my promoters. Regulations, execution, brand loyalty, quality, R&D – lot of factors impact a business and not everything can be played through money.
- Situation: My company is being over conservative, sitting on cash and not buying anything new. The competitor on the other hand is aggressively buying across.
- Impulsive Action: Time to switch investments.
We love action and want our companies to be in the news with acquisitions and launches. And feel that we are being left behind if it is not being done.
Is the competition overpaying for acquisitions? Is your company safeguarding your interest by not doing so?
Has the capital structure of competition become more risky because of too much expansion? Is your company better placed to generate a stress-free sustained business growth?
Is your Company being lazy or being conservative? Former is a red flag, whereas latter will mostly work out well.
Yes, we are aware of the relevance of efficient capital allocation. We do know that companies sitting on cash should either utilise that to expand or distribute it back to the shareholders. But what exactly is the management’s reason for not returning cash to the shareholders: Siphoning (bad), manage working capital volatility (good), reserves for selective value acquisitions (very good)?
Some argue that one cannot buy cheap, and by not utilising available cash aggressively weakens a company against the competition. I personally don’t agree. Future Group’s aggressive growth vs. DMart’s build up over the years is a relevant example to think and decide on a case-by-case basis.
The right questions open the best opportunities and mitigate the worst risks.
Let me add some questions to the above examples.
For DCF, you have assumed a 25% annual growth rate for the next 5 years based on the company’s annual growth rate of 35% in the last 5 years. Have you thought that as the base grows bigger, even 25% may be too high?
On expected growth and last 3 year’s average trailing P/E multiple, the stock seems to be 50% undervalued. Is last 3 year’s trailing multiple double of the last 20 year average multiple and is because of recent momentum in the overall sector? The sector was under owned and now institutions may have gone overboard.
Everyone is recommending this stock one social media and TV channels. The business performance of the company is good. Can it be a pump and dump strategy? Does the recent business performance include any one-offs or is a result of any temporary trend, such as post Covid pent-up demand (to cite an example)? If everyone already knows that, won’t the stock price reflect that and hence is already trading at fair value?
Why stock prices are a distraction
Read this if you want to be a trader
Why every investor must understand position sizing
8 guidelines when questioning company management
