NEW DELHI: All I want to know is where I’m going to die, so I’ll never go there. — Charlie Munger
No one likes the idea of losing her hard-earned money. If any sane person can know that investing in certain stocks can have disastrous consequences, she will likely never touch that stock at all.
But the question is how do we identify such names that have the potential to destroy wealth? Money managers at DSP Mutual Fund have outlined fived simple signs that will help you eliminate such bad apples.
“The best way for risk management is to ask the questions: What is risk? Where is that risk likely to be the most? If we can avoid very consciously, identify those pockets and not be a part of them, we will improve our hope of long-term compounding and reduce the chances of making errors,” said Kalpen Parekh, President at DSP Mutual Fund.
He listed out five signs, which he claimed should be enough to forewarn you about a bad apple:
High debt levels: There is an age-old saying that you should not bite off more than you can chew, and this is apt for managing a business as well. Binging on a high levels of debt to fund acquisitions or operational needs is a sign of poor risk management and leaves shareholders vulnerable, especially if some crisis erupts. There are numerous examples in the recent past that went through solvency or had to be sold off because it has become impossible for companies to service debt. Jet Airways, Future Group, Kingfisher, etc. are a few that come to mind.
Data compiled from Accord Fintech shows Bombay Dyeing, Vodafone Idea, REC, Chennai Petroleum, Adani Transmission, IRB Infra, Power Grid and Adiya Birla Fashion are among the non-BFSI firms in the BSE500 basket that have high debt-to-equity ratios.
Excessive Volatility: Stocks with unusual price swings are relatively riskier and harbinger of future trouble. It is a sign that there may be more than what meets the eye and can be avoided. One good way of measuring the volatility quotient of a stock is to track the beta value.
Going by the beta coefficient, Himatsingka Seide, IndusInd Bank, Optiemus Infracom, Indiabulls Housing, Indiabulls Real Estate are some of the names seeing volatile movements in recent times, raising the red flag under this criterion.
Poor Profits: Companies that have heavy investment in assets giving low returns or reporting regular losses should also be avoided. It could be due to lack of pricing power, inability to pass on costs or high input costs. Some of the sectors that come to mind are airlines, telecom, steel, etc. Financially weak companies in such sectors are more prone to faltering in times of crisis.
Poor Growth: Companies showing negligible or poor growth for a few years, whether due to disruption in the industry, stagnation/maturing of industries or simply because there is an incompetent management at the helm, should be avoided.
Highly Expensive: Unsustainable valuations erode future returns and stocks trading at lofty valuations should be avoided. Prices tend to reverse to mean, plus at that valuation most of the positive outlook is already priced in and any disappointment can lead to very sharp price correction.
In the BSE500 index, some of the most expensive stocks trading at price-to-earnings ratios as high as 250-650 include TCNS Clothing Co, VIP Industries, Adani Green Energy, Blue Star, EIH, Lakshmi Machine Works, Bombay Burmah Trading Corporation, Ujjivan Financial Services and Equitas Holdings.
Apart from these signs, if you are already invested or plan to invest in a company, you can also keep an eye on the following red flags:
- Cash flows not matching up to reported profits
- Cost (expense) items treated as investments and assets
- Difficult to value assets making up a large part of the balance sheet
- One-off items propping up the profits
- Sales of shares by insiders and promoter pledges
- Mismanagement of balance sheet (too much debt, over reliance on short term debt)
- Comments on accounts by auditors