The problem of almost-good stocks

Like a cricket team playing to win a limited-overs match, many investors feel that aggression is a great quality in choosing stocks. However, as we all have realised while watching the World Cup, effective aggression, which gets results, starts with not trying to hit everything but deciding what not to hit. Stocks are the same. In our cover story of 'Wealth Insight' December 2023 issue, we have explored a fascinating idea that should be of interest to all equity investors - what looks like a safety-first approach to investing is a profits-first approach.

There are good stocks, and there are bad stocks. Neither of these are any problems. Good stocks make money for investors; bad stocks are easy to spot, and thus, sensible investors manage to avoid them quite easily. The problem arises in the case of 'almost good' stocks.

When we start investing - no matter what kind - the first thing to do is to classify them into the bad and the rest and not look at the bad again. So far, so good. Everyone does that. No, that's not true. Everyone does NOT do that. The conventional wisdom in investing is to focus on finding the best opportunities - the stocks, funds, or assets that seem likely to outperform. Investing in resources like books and websites is mostly geared toward picking winners. On the surface, that makes sense - good investments generate returns, so identifying them should be the priority.

However, the most skilled investors take a different approach. Rather than start by searching for good stocks, they concentrate first on avoiding the rest. Their main concern is filtering out and eliminating investments that could lose money, the ones that give the appearance of being good but have some caveats. This defensive stance is crucial for any investment vehicle. This principle of eliminating poor choices before seeking great ones applies well beyond just investing.

The masters of investing exhibit a negative orientation. Before hunting for standout opportunities, they devote their efforts to developing screens highlighting warning signs and red flags. First, they simplify the selection process and safeguard their capital by crossing off objectively risky or overvalued investments. This discipline and patience put them in a superior position to capitalise when quality bargains surface. In essence, a good offence starts with an even better defence. The best investors understand that, and their results reflect it, just as they do with the best cricketers.

Some time back, I interviewed Samir Arora, who has just launched Helios Mutual Fund in his second innings in the Indian mutual fund industry. In the 1990s, at the dawn of India's contemporary, post-liberalisation mutual fund sector, Arora was the CIO at Alliance Mutual Funds in India.

Arora says that over the years, he has settled down on eight factors that are the starting point for evaluating a stock. They are all fairly obvious factors like management quality, profitability, growth, valuation, etc. However, the important thing is that these are initially used not as indicators of whether a stock is to be invested in but whether it is to be avoided. That's not the same thing. These factors are go/no-go indicators. The crucial thing about Arora's methodology is that if a company falls short in even one of these factors, its stock is off the table, regardless of how exceptional the other aspects might be. To take the obvious example, consider valuation. Plenty of great companies are wonderful investments in every way, except that their stocks are overpriced, i.e., the valuation is too high. This means that they cannot be touched.

This disciplined strategy ensures investors avoid pitfalls, even if they initially seem alluring. This is exactly what our cover story of 'Wealth Insight' December 2023 issue focuses on. There is a set of specific mistakes like this that investors often make. Learn all about them and how to avoid them.

Also read: The ugly, the bad and the good