RISK IS EVERYWHERE- UNDERSTAND IT
Over the years, I have come across different people using different recipes to churn out success in equity investing. Alas, none of us have found the correct recipe yet. And perhaps no one ever will. Whether you buy a share in HUL or buy one in ABC or XYZ, the returns are not guaranteed.
What we try to aim for is to minimise the riskiness in buying shares and hope that the market will reward us for our methods. We all think that the one method we have stumbled upon is fool proof and are happy when a couple of trades seem going right. However, it is a matter of time before we start searching for yet another strategy or method.
Yes, we can be reasonably good in our fundamental and financial analyses. For financial analyses to be right, we have to presume that there is no structured fraud. I agree that solid analyses can generally spot frauds, but not each and every one. I generally avoid PSU Banks simply because the accounting standards keep changing every year. So, analyses can also be a problem for many industries. The accounting standards have been becoming more and more opaque, in the name of transparency.
Assuming we did all we could and identified a stock; there are so many other factors that will decide its prices. For instance, if there is concentrated ownership with limited number of public shareholders (I could be describing over 99% of Indian companies here) prices will be extremely volatile. For example, if I take a company like CRISIL, it is very unlikely that I could buy more than a hundred shares at the last quoted price. Liquidity in most Indian stocks tends to be very poor. Thus, when somebody gives me a point to point return on a share, it means nothing.
I always emphasise that equity shares should not be the vehicle, if one wants to liquidate it on a fixed date or a predetermined period. This is because no one can forecast the market conditions. Even if the company you picked does exactly as you anticipate, there is no guarantee that the stock price will reflect that.
Then there are possibilities of the promoter having pledged his stock to borrow money. If he defaults, the stock price could go crashing as the lender sells the pledged share.
After detailed analyses, I like to prepare a checklist that looks something like this: i) Promoter holding- Less than 30%, I will not buy. Yes, I have made exceptions for an HDFC;
ii) Number of shareholders- Prefer 100,000 at least, but few companies meet this. Smaller number of shareholders means difficulty in executing trades at reported prices;
iii) Pledged shares- If promoter has pledged shares- surely a negative factor for me;
iv) Average daily traded volumes ; (try and exclude block deals where data available)
v) Actual delivery volumes as a part of total traded volumes- The relevant factor is the delivery volumes- If total delivery volumes in a month equal at least the total non promoter holding, it is a good sign. If not, another worry point;
vi) Do subsidiaries form a significant part of the total business? If yes, I like to get full accounts, do a double check and then take a call;
vii) What is the extent of investment/loans etc to subsidiaries and associates? If it exceeds 25% of the net worth of the company, I keep away. I have difficulty understanding reasons for keeping significant businesses in separate entities;
viii) Do promoters hold any direct or indirect stake in associates or subsidiaries other than through the entity under question? For instance, if a promoter family holds stake in a subsidiary or associate, I avoid such companies;
ix) Does the company have debt and keep resorting to buy backs? Obviously, it is an attempt to hike promoter stake as well as pump up share price.;
x) Does the company raise equity regularly through private placements etc? This is trouble, unless one is in banking business. I like companies that do not need to raise further capital;
xi) Does the company keep making ‘acquisitions’? Not a good sign as far as I am concerned. Acquisitions generally do not work and the acquisition costs often end up as a loss or a write off;
xii) Past regulatory offences by company or any Board member- a good place to check this out is http://www.watchoutinvestors.com and google search;
xiii) A glance at the independent directors is useful, though not a guarantee of anything;
xiv) Change of auditors needs to be examined- Generally an unhealthy sign for an established company.
Thus, it is important to understand that there are risks beyond the business and the balance sheet. An awareness of the entire framework is useful if you want to invest in direct equities. This list keeps expanding with time and learning.