Hope you are doing well.
Charlie Munger is one of the greatest investors and thinkers of all time and he has this favourite line – ‘Invert, Always Invert’.
What he means by Invert can be understood from the following example relevant to all of us.
Assuming, you want to know, ‘How to pick good stocks?’. You can invert this question by asking yourself, ‘How to avoid bad stocks?’
Yes, most investors make the mistake of picking bad stocks because they don’t do proper due-diligence and and if you know how to avoid them, you will most likely do well and start picking good stocks automatically.
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Here are some key points we use to avoid bad stock picks:
- Low Promoter Holding –
- To put it simply, we believe in the power of incentives and the concept of ‘skin in the game’. When we invest in a stock, we don’t run its day-to-day operations and rely on the acumen, skill of the promoters/management to do a good job.
- Thus, we want the promoter’s interest to be directly aligned with minority shareholders and that’s why only invest in companies with high promoter holding. In general, our threshold is 40% promoter holding or higher.
- Very high valuations –
- Determining right valuation for investment is a very subjective exercise. However, we avoid paying over the top valuations by looking at the past valuations’ multiple history of the company, overall market valuations and lastly also try to determine the next 2-4 years earnings trajectory of the company.
- The objective is to avoid the downward spiral of earnings degrowth and contraction in valuation multiples
- Constant equity dilution –
- If a company has a history of diluting equity at frequent intervals, we generally avoid such companies. Equity is precious and if the promoters themselves don’t value their stake much, as investors we are better off avoiding such companies
- Very high debt –
- In investing, it’s difficult to have ‘Rules of Thumb’; however, in general we avoid companies (excluding NBFCs, banks) with debt-to-equity ratio of greater than 2.5.
- Even when looking at companies with debt-to-equity ratio of greater than 1.5, we look for companies where we think the debt has peaked out and will or has started coming down
- Market darlings –
- If you go on social media (Twitter, You Tube, etc.), most of the time you can easily determine which stocks, sectors or asset classes are being talked about the most. For instance, some time back cryptos, NFTs were being talked about a lot.
- Similarly, a few months back everyone wanted to invest in US Tech stocks. Most of the time when you find everyone talking about a particular stock, sector or asset, it starts topping out.
- One can also corroborate this by checking past 2-3 years return. If you find them extraordinary or significantly higher than peer group, it’s important to become extremely cautious about investing in such segments.
The above points are some of the generic ones for avoiding bad stock picks and to improve the probability of picking good ones. There will always be exceptions and experts can always use negative points to their advantage when they see things turning around.
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