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Bomb Disposal Made Easy

Equity investors tend to have a fundamentally optimistic personality that blinds them from not spending much time thinking of negative outcomes

   

There are two ways of looking at equity investments. One is that there are a lot of great opportunities out there and the investor should focus on identifying these. The other view is that there are a lot of pitfalls, a lot of hidden traps in the markets, and the main job of investment management is to avoid these. As long as you are able to identify the money-sinks, you'll be fine.

Normally, all advisors, analysts, brokers and the investment media focuses on the first approach. After all, all of us who are equity investors tend to have a fundamentally cheerful and optimistic personality. If we didn't, we would have kept all our money in banks and PPFs and such dull asset types. Since we are fundamentally optimistic, we don't spend much time thinking of negative outcomes. We have a bias for believing that good things will happen to companies that we invest in.

How I wish that were always true. The harsh reality is that the pattern of equity investing is actually not like that. Most people make reasonable returns on many of their investments, and then lose a lot on a few stocks that turn out be big losers. As usual, my spiritual investment guru, Warren Buffett has something to say about this, “Rule No. 1 : Never lose money. Rule No.2: Never forget Rule No.1”.

If we apply this principle to our equity investment strategy, we come to the inevitable decision that we should apply as much effort and analysis to identifying and avoiding the losers as we do to identifying and chasing winners. And that's where our cover story comes in. We have created a framework of fundamental analysis that looks at hard numbers and comes up with a methodology for identifying companies where risk is increasing. Some of these are obvious, such as decline in headline numbers like sales, profitability, cash availability and such. Others like high non-operating income are less obvious to beginner investors. Still others, like a very high growth rate, are counter-intuitive to just about any investor. How can faster growth be a warning signal? But read the story and you will understand the logic.

We have looked at a number of these time bombs and come up with a list of stocks where we can see one hidden away. However, that doesn't mean that you have to immediately drop all idea of investing in the stock. What it means is that these are warning signals. In some cases, the time bomb may be a temporary phenomena, and in others it may actually be outweighed by some other positive factor. After all, there is no shortage of companies that have been in pretty dire straits and have then recovered. In fact, identifying these turnaround cases is probably the holy grail of investing, one that can get you the ultimate in returns.

There's one more element here that is rather more difficult to handle, and that is what we may call 'soft', time-bombs that are not visible in a stocks' fundamentals. These are external factors like regulatory changes or sudden shifts in technology or even general economic crisis. By their very definition, they are much harder to predict than the ones you can see in the financials.

I must point out that the intent of the story is educational rather than prescriptive. As an investor you would do well to understand the logic that we have used and apply it to different investment prospects that you may across, rather than doggedly take our lists as the last word on stocks to be avoided.