2009- Thoughts on investment. Still green A few friends have called up and discussed the matter of building a portfolio for the long term after publication of my article about my friend at Mangalore (Adding Zeroes, Money Life, Oct_ 2009). The first and most important requirement is that the money you keep aside for investing in stocks should be money you can totally afford to ignore for at least ten if not twenty years. Ideally, this is the money that you plan to leave aside for your children in the form of stocks (barring unforeseen circumstances). Treat this for your personal calculations as money spent. And, also, do not invest if you are the type who will look at prices everyday and worry about the portfolio. Clearly you should not be in the stock market at all, your greed notwithstanding. Let me begin by listing out my biases towards stock picking. Since I am more of a pessimist than optimist, l will start with the characteristics I hate. In other words, I rule out companies with these characteristics: 1. Absence of dividend. A genuinely profitable company should pay out dividends. If the company does not pay dividends in spite of showing profits year after year, I avoid it; 2. Non-tax paying or low tax paying. A company that pays no tax or very low tax year after year is ruled out. If the profit is real, the company ought to be paying taxes; 3. Companies with very high debt worry me. In a good year, the business will earn a rate of return higher than the interest cost, but could be in trouble in a bad year. If the company passes muster on all other criterion, then maybe I will probe further, but in general, high leverage is a red flag; 4. Third generation family owned and managed companies. Indian companies are generally family owned and are passed down from father to son, like heirlooms, corporate governance be damned. Typically, in the third generation, the number of claimants increase and lead to a combination of poor management, siphoning and lack of focus; 5. Companies that show profits year after year, but do not pay dividends and yet keep raising equity regularly; 6. Change of auditors is a red flag. Investigate thoroughly. If not satisfied with the reasons, avoid the company; 7. Companies that keep advertising even if they are not in the consumer space; 8. Companies that are managed by so called professionals, but treat it like a fiefdom, engage in random diversifications that do not make any sense and award huge stock options; 9. Companies where the promoter has several other unlisted companies which siphon profits. (I believe most Indian companies do this, so the level of check required to ascertain this may not be possible for everyone); 10. Suspect management integrity. This is the most subjective one and in most cases, it would be turn out to be a question of degree rather than one of principle. I have hardly come across any company which will pass total muster on this score, so have decided to be a bit practical and take my chances; 11. Super normal profitability is another worrying sign. In most cases, this happens at a nascent stage, just around the time a company goes public and is planning further fund raising. If the whole industry is making 10% of sales as profit and someone is making 25%, my first instinct is to be sceptical. This is certainly a ‘red’ flag; 12. A ‘me-too’ company is one to be avoided. The company I choose should be clearly number one or two in its business. Only when you pick up companies that are in new segments (so called ‘sunrise’ industries like bio technology etc) can you look at small players. There is no point in looking at a small player in the textile business or in the FMCG business; 13. Companies in industries that are overly regulated by government. This is a debatable point, but I believe that given the circumstances, it will not be possible to dismantle controls on industries such as fertilizer, oil etc., Whilst ultimately it should happen, I prefer to keep away. In general, government interference (like in PSU banks) generally makes an investment less attractive whereas the event of government getting out completely from any company would make it more attractive. 14. In today’s funny accounting world, I am also wary of this thing called “consolidated’ accounts, when it includes profit shares of entities that are not 100% owned by the company. And, the companies do not even show the accounts of the subsidiaries on their websites! After this, I use some financial screens of which I hold the ROE (Return on Equity) to be perhaps the most important criterion. I would like it be steady to improving. Generally, my attempt is to focus more on cash flows rather than mere earnings. For instance, in any industry, you can NOT provide for bad debts and show earnings. However, the cash flow picture would be terrible. I give high importance to management in terms of competence and integrity. I also like to see companies that have the potential to grow at more than the pace at which economy grows. For instance, if we expect industry to grow at 10% and inflation to be 5%, then the company has to grow at more than 15%. Financial analysis is simple, but needs time and effort. I usually like to sit with at least three years annual reports. Unfortunately, today I see the annual reports getting more opaque. Financial information shared with the investors is getting less and less. I get a lot of useless diatribe from the management under the head “management discussion”. Here, no company is going to openly admit its faults. You will get to read only good things or blame on external factors for poor performance. Real issues are buried. From the above, it is clear that for investing directly, you need to spend time. Once you decide to invest, have a specific sum set aside and stick to the discipline. NEVER borrow to invest. And review your investments at least once a year. After making an investment, if you realise you have made a mistake, get rid of it immediately, without bothering about the price. I have seen people not selling their mistakes because of an inability to take losses and then see it becoming worthless over time. Do not sell unless you really need the money or have a better use for the money in terms of returns. One more weakness I have is with regard to timing. If I like a company and it is doing well, I will not sell. The price does not bother me. And another thing I have found out. If you hold an investment for more than a decade or so, then the dividend income generally is quite substantial as compared to your original cost. I believe that over time, dividend income should become quite substantial, if you are a patient investor. What I have given above is from my experience. More importantly, my attitude to investment is totally different from most. For me, investment is with money I have to spare. I do not trade. So, you see, I am the complete ‘gambler’. Investment in shares is no different, to me. When I invest in shares, I am taking a chance on the business competence, outlook and the promoter. Sometimes I win. R. Balakrishnan (email@example.com) November 2nd 2009.