There are two strategies to play tennis. One strategy is that you play offensively and go for a winning shot often. The other strategy is to play defensively and only aim to return the ball while hoping that the other person will himself/herself hit the ball out.
Now if you are an expert and have years of practice then the first strategy might work for you, but it always comes with the risk of hitting the ball out or on the net. If you are not an expert though, then you are much more likely to win if instead of trying to get a lot of winning shots you just try to avoid a lot of losing ones.
While we like to believe that after 12 years of investing in the stock market we have developed some expertise in the field, we make it a point to avoid as many land mines as possible.
In this email, we talk about a few red flags in companies that every investor must stay cautious of –
Low Promoter Holding – If the company you are investing in has a low promoter holding then that indicates that the management has little skin in the game. We prefer that the companies we invest in have its management well incentivized to take decisions for the long term well being of the company. Our minimum requirement for Promoter holding is 40%.
Major growth from inorganic sources – Sometimes you might notice that a company is delivering excellent growth; however, on a deeper look you find that it’s mostly from acquisitions. Such growth from inorganic sources like acquisitions etc. might not be sustainable in the long run. More over, acquisitions come with bigger challenges of their own.
Major CAPEX – If a company is planning a huge CAPEX (~1.5-2 times or more than the current fixed assets) then that is something to be cautious of. Major capital expenditures come with their own challenges of funding issues, time-delays, over supply, down-cycle, etc. Highly leveraged balance sheets can prove to be highly risky if not managed properly.
Dishonest Management – Investing in a stock is no different from partnering with a company. And if your partner is dishonest then there is little to no chance that you will be able to make money. If the management is getting involved in questionable related party transactions or taking decisions that do not reflect the long term benefit of the shareholders then it is a big red flag.
Poor Capital Allocation – In order to generate good returns on a sustained basis, a company must be good at allocating the capital earned. If a company has a poor record of investing earned money into unprofitable and unrelated ventures then that is a red flag. The company should be good at expanding its core business and generating good ROCE (Return on Capital Employed).
Constantly increasing working capital cycle – If the company is constantly increasing its credit line in order to inflate sales numbers then that is a red flag and often not sustainable. A constantly increasing working capital cycle (in terms of number of days) is often a sign of such a scenario.
Note – These pointers are just red flags that demand thorough attention from a stock analyst/investor. This list is not complete and there are many more red flags to stay cautious from.
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