OLD ARTICLE – Original posted April 1, 2016
Given the small cap space as a capital growth asset class and my predisposition towards being long, this website tends to be about which stocks to buy.
Let me turn that on its head and give some (hopefully intuitive) pointers for which stocks to not buy.
When you are researching an investment in a stock, consider the following five points as “one strike, you’re out” and move on to finding another stock that does not exhibit any of these nasty little negatives:
- You use a competitor product/service: Assuming you have access to this company’s product/service, yet you choose to use a competitor one. In this case, if you are choosing a competitor over this company’s product/service, the odds are that the market will too, therefore I would seriously question why you expect this to be a successful business?
- Management cannot communicate what the company’s competitive advantage is: Company’s without competitive advantages have no pricing power and often shaky sustainability. No matter which industry they happen to be in, they are all commodity companies, except at least commodity companies have a cost curve and strive to be the lowest on it. It is simple, in the long-term if there is no competitive advantage, there is no business, there is no company and there will likely be a worthless share.
- Returns on Equity below Cost of Equity: This one is a bit financially esoteric, but let me explain it this way… If you borrowed money to invest into something, surely you would want your investment to generate a return greater than the cost of borrrowing it? Well, in the case of stocks, their “cost of borrowing” is a thing called Cost of Equity (as a Rule of Thumb in South Africa, this is around 12% to 17% in nominal terms at current rates). And the return you make on your investment (in the long-term) is the aptly-named Return on Equity. Thus, if a company cannot generate an ROE larger than its COE, walk away. It will probably be a bad investment.
- You cannot understand its valuation / it is obviously over-valued: Sometimes these things are one and the same. Firstly the latter point, an investment’s return is always price senstive, so if a stock is simply too expensive according to your sense of value, then look elsewhere. It is a big wide world with plenty of stocks in it and you don’t need to over pay for anything. Then secondly the former point; if you cannot understand or work out a sense of value for a stock, then if you bought it you would be investing blind. This is akin to gambling, as you don’t know if you are on the right side or wrong side of a trade. In this case, I tend to shelve a company, follow it closely and keep trying to get a sense of valuation for it.
- It’s Board is dominated by Cancer and/or Taurus star signs: Typically these star signs are over remunerated…. No wait, what date is it? 1 April? April Fools! Please don’t send me hatemail here, just a little joke given the day…
If you have any other thoughts on “one strike, you’re out”, please drop me a mail…