Don't Let the Weakest Link Destroy Your Portfolio

Do you remember Kaun Banega Crorepati?

In the early 2000s, reality game shows were quite popular. And KBC was right at the top of the popularity charts.

In fact, it's not an exaggeration to say KBC changed the Indian television landscape forever.

After its soaring popularity, several game shows were launched.

One of them was Kamzor KadIi Kaun. It was the Indian version of BBC's The Weakest Link.

The premise of this game was simple.

A team of players answered a chain of questions trying to achieve and 'bank' a set target within a limited time.

The chain was broken if a player answered incorrectly, or if they decided to bank the money already in the chain.

Interesting, right?

It gets more interesting when it came to voting out a player who was the weakest link.

Ideally, a player who answered the questions wrong should have been eliminated.

But the teams didn't always recognise the weakest link.

The result?

The weakest player would go on and sabotage the team in the next round.

Finally, when the weakest player was eliminated, the damage would have already been done. The winners would take home less money because of this mistake.

Clearly, the weakest link in the chain reduced the overall winning pot.

This concept, of the weakest link, is applicable is so many places - sports, business, government...even our own habits.

Here's what Warren Buffett had to say about this:

• One of the things you will find, which is interesting and people don't think of it enough, with most businesses and with most individuals, life tends to snap you at your weakest link. So it isn't the strongest link you're looking for among the individuals in the room. It isn't even the average strength of the chain. It's the weakest link that causes the problem.

Consider a company which has the weakest link problem. Investing in such a company is very risky.

Should the weakest link break, it would destroy your wealth.

And the weakest links in your portfolio need not be the so-called risky smallcaps. They could very well be amongst the biggest blue chips in the Sensex or Nifty.

Just take a look at today's chart of the day below.

How do you avoid the weakest link problem?

By recognising patterns.

In my study of India's super investors, I've found professor Sanjay Bakshi to be very good at this.

My fellow analyst and editor of Smart Money Secrets, Kunal Thanvi, interviewed him last year.

I highly recommend reading this.

Kunal asked the professor a specific question on patterns to avoid.

His answer was fascinating.

• I have a longer list of patterns to avoid as compared to success patterns.
  
  • Serial acquirers: I generally dislike companies which grow inorganically, especially when they take a lot of debt to finance the acquisitions. One needs to be sceptical while evaluating serial acquirers.
  • Industries going through disruption: I like to avoid companies in industries which are susceptible to disruption.
  • Weak balance sheets: I avoid businesses with weak balance sheets.
  • Inefficient capital allocation: I also avoid businesses where there are serious instances of capital misallocation. I don't like businesses where one segment is doing good and other segment is burning cash.
  • Bad governance: I try to avoid managements with bad corporate governance track records. I avoid companies where related party transactions reflect greed in the management at the expense of the minority shareholders.
  • Short-term over long-term: I really don't like managements which display propensity to show near-term earnings at the expense of long-term earnings.

So, there you have it. These are some weak links in a business that can cause serious trouble.

The Smart Money Secrets team starts its stock selection process by eliminating companies which have these characteristics.

Ultimately, the weakest link in a chain is the limit of the entire chain's strength. No matter how strong the other links are, the chain is no stronger.

Chart of the Day

Big Wealth Destroyers of the Past Decade

Today's chart illustrates how the biggest blue chips could become the weakest links in your portfolio.

Good examples are India's telecom companies such as Reliance Communication and Bharti Airtel.

It shouldn't come as any surprise that Reliance Communication is the biggest wealth destroyer in the last decade. It was the weakest link in its industry.

Apart from the huge amounts of debt on their books, companies in the telecom sector are facing intense competition. The entry of Reliance Jio has put significant pressure on the industry. The pricing pressure has dented overall profitability.

Similarly, continuous capital expenditure in acquiring spectrum has put a lid on the probability of improving returns.

Clearly, there is pattern here.

A pattern to avoid.

Regards,

Sarvajeet Bodas
(Research Analyst)

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