Alpha return on portfolio can not be generate by investing in one or two multibagger stocks, but by avoiding 100’s of poor stocks.
Thanks for asking this question Indeed in investing journey this is the first question which everybody should ask. Answer to this question is the first stage towards peaceful investing-
Random investing never works before i answer your question i will start with break even calculator that shows why it is important to avoid wealth destroyers.
It says if your stock is down by 50% than that needs to be doubled just to recover your capital and if stock is down by 80%, 400% return is required to recover your capital forget the profit.
To manage the risk it's important to learn from history. History tells us what to buy and what to avoid Here are my detailed work with rationale-
Poor Management and corporate governance- “If you don’t know jewelry, know the jeweler!” - In equity investing, management is 90%, industry 9% and 1% everything else. Hence, getting Management Integrity right is the critical first step.
In just a short span of 5 years, almost one-third of stocks lost market value of 70% or more. True, in many cases that the sharp erosion in stock prices is due to business downturn but there are quite a few names in the list where the reason was primarily related to corporate governance issues. Satyam computer, Manpasand beverages, Religare, LEEL electronics, Vakrangee and Gitanjali Gems are the example of poor management and corporate governance. Source- 24th Motilal oswal wealth creation study
Note-Strong board structure, Flow of information, informative annual report, Auditors and Bankers to the company ( Lender) are also key filters.
High Debt companies- Every company faces downturn and economic slowdown slowdown the only thing during the slowdown that they cant change is Interest outlay. Historically also performance of high debt is poor Vodafone Idea, Suzlon, JP group, Reliance ADAG group, Jain irrigation, HCC are few example of high debt wealth destroyers. High debt also signifies that company is unable to expand their business out of internal accrual. Historically net cash companies has given better returns. Below are the name of top wealth destroyers most of the company is highly leveraged-
Capital intensive or Historically Poor cash flow/ Cyclical companies - Steel, Sugar, Aviation, Telecom, Real estate, Infrastructure etc. are some example of capital intensive business. Usually capital intensive companies moves with economic or industry cycle. One should not invest invest in such kind of companies for long term. These are apt for trading only that too with strict trade and risk management rules. Just look at the chart of Tata steel Limited. clear Up and down in zigzag form from years and years. Such cyclical shares runs with the economy but never deliver long term alpha return.
To understand this you may find this video helpful.
As per wealth creation study by Mr. Ramdeo Agarawal out of 161 cases of mega to mid almost 35% is due to cyclical downturn while 29% happen because of management lapses.
Penny stocks- Penny stocks as name itself indicates are stocks with penny value. No company in India ( specially now a days) come up with an IPO at price band of Rs. 5, 10 or 20 Rupees (Penny value) than how stock become penny stocks. In most of the case because of fraud, promoter integrity, regulatory issues, Political problems, very high debt company trades at penny value. Historically there are not cases of revival where company revived and stocks has given multibagger returns. To understand this in detail you may find this helpful. Penny stocks a.k.a Khabar stocks | Should you buy ?
Government owned / PSU- Though PSU’s have some advantage in regulatory approval (e.g. OMCs, Mining companies etc.), business priority from government (e.g. NBCC, Engineers India, SBI etc.) Monopoly (e.g coal India etc.) but because of lack of accountability , bureaucracy, efficiency historically PSU’s has not given decent return. Some PSU’s do pay decent dividends however overall return is meager return . Many a time PSU’s has been used by government for public services ( like crop loan waiver) , Implementation of social schemes ( Jan dhan bank account) that actually becomes cost to the company. You may find this video helpful to understand this in detail-
**Return is derived from data of 2010 to July 2019
Listed PSUs space is dominated by PSU bank where last 10 year average return is approx -50%. Most of the PSUs even trading below 2008 high level.
Low ROCE and ROE- Stock prices is driven company’s ability to generate cash. Even if management is good, company is low on debt until company generates good return on capital employed and return on Equity. Company hardly makes good money for investors. It has been observed that if ROE and ROCE is more than 15–20% for a longer period of time. Such kind of company’s has given alpha returns.
Market and Growth- market is discounting machine that discount future cash flows of the company. There is a direct correlation between profit growth and stock return in long run. We can also validate the same 2 example given below-
Castrol India Limited- As per figures below Castrol india was trading at around Rs. 130 in Sep 2010 and Current market price of the Shares is also 130 a share while ROCE is 101% and ROE is 65% the only negative is growth- 7 Years Sales growth of castrol india is 3.87 % while 7 years profit growth is just 5.49%
Price chases the profit -PAT CAGR of top 100 wealth creator for 5 year is 19% and stock return for the same period is 24% (Data 2013–2018)
Low promoter holding or High pledged share- Continuously lower promoters holding and high pledge share also indicates low confidence of promoter in their own company. Zee media, Religare, fortis is the perfact example where promoters has pledged their share and later bank has invoked the same and sold in open market. If there is a professional management along with very strong board structure low promoter holdings can works (e.g. HDFC group, TATA gourp, Infosys etc. however High pledge share by promoter along with high debt in the company is very poor sign and a clear avoid. Reliance ADAG, Suzlon, yes bank, Religare are few example of high pledge of promoter share along with high debt.
Business with hard cash revenue- One should also avoid business with cash revenue e.g. Gym, Hospital, franchise model etc. there is a high chances of revenue leakages Management integrity, role of auditor and a Professional board a is very crucial in such cases.
B2B companies- Usually business to business companies does not generate alpha. Though this is not the formula for success however it has been seen that historically 80% of the biggest wealth creators are consumer facing company with a strong brands. Nestle, HUL, britannia , Pidilite are few example.
Below are some of the multibagger stocks most of the long term wealth creators are consumer facing business we can validate the same with below example.
*Return as on date will vary from the above return.
IPO ( Specially SME IPO’s)- Behind every D-mart and IRCTC there are 10’s of wealth destroyer IPO’s so Never invest in an IPO blindly ( Do more detailed research) . There is one bias survival bias which we never think of while investing. Most of the investor invest in an IPO for listing gain but 10 years data shows that only 50% of the IPO has given any listing gain. and only 1/3rd of the last 10 years IPO shares has given positive return. I am not saying that one should avoid all the IPO but surly it requires more research. IPO is like wedding for a company so they tried to be their best at the time of an IPO just like bride and groom.
There were 218 IPO in last 9 years ( from Feb 2010 to June 2019) average return of all the IPO is -12.5%. Data till today will depict different return but similar outcome here are the details-
SME IPO are’s are injurious to your wealth never never invest in such company without professional advise ( not from broker but from adviser). SME IPO data shows almost 40 SME IPO has given negative 75%. Just think before you put your hard earned money. Read more about the SME IPO of jiya echo products and GST fraud.
Avoid bottom fishing - Bottom fishing as the name indicates is the process of finding value in a share that fell substantially. Again market is a discounting machine. Point here to understand is there must be some reason for downfall and if there is some wrong doing why to buy such share. Vodaphone idea and yes bank is the perfect example of this. Because of ongoing issue stock falls more than 80% still retail investors accumulated both the share. I have never seen in history where bottom fishing works at the end stock end up becoming penny stocks.
Source- The economic times article on 16 Feb 2015
Keep media, Brokerage and moneycontrol analysis off - Though i can write entire book on why to avoid such buzz and hot shares of media brokerage, I will rather share some of the snap from media and brokerage report to make you understand. But before you see those snap just recall how many times you have seen discussion and recommendation on HDFC bank, Bajaj Finance, Nestle,Pidilite, asian paint, HUL, Tital, Infosys.
Here is the example of media buzz vs reality-
Sources- Kwality reports -
· 13 July 16 Economic time article -KKR commits to invest Rs 520 crore in dairy company Kwality Ltd
· 6 Oct 16- Nirmal bang report -Kwality could turn out to be the next multibagger, Nirmal Bang Securities
· 17 Aug 17- Edelwiess- Edelweiss report- Price 136, target 200 upside 47%
· 22 Oct 18 - KKR starts bankruptcy proceedings against dairy company Kwality
Though there cannot be a exhaustive list of things to avoid in market, we have tried to cover the broader things which one should avoid. Exception may always be there.