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Wait! Don't buy these stocks!

May 21, 2007

"It's only when the tide goes out that you learn who's been swimming naked," said the legendary billionaire investor Warren Buffett of stocks that rose with the tide in market manias and crashed in market panics. When economies and industries grow, benefits accrue to both good and bad companies. But as times get tough, and as the real test of companies' strength begins, grain can easily be differentiated from the chaff. While investors have behaved irrationally (sad, but that is true!) at more times in the past than one, those who have identified their risk-return profile well in advance and have set their faith in fortunes of quality companies, have seen their investments multiply. They would, indeed, continue to do so. By maintaining prudence, the chances of going wrong and thus losing money reduces dramatically.The rally in the Indian markets over the past 3-4 years have been fueled by a sea of liquidity, which has indeed swamped the global financial markets taking all kinds (and qualities) of assets to their historical high levels. However, as and when this sea (of liquidity) recedes (or shows signs of ebbing away), many people (read, investors) are ought to be caught without a bathing suit!

As for equities, one often tends to get swayed by 'market momentums' and 'swings' and buys into anything that is rising, not really understanding the reason why a particular stock(s) is on its way up - fundamental reasons or plain speculation? While people spend a lot of time discussing the companies (stocks) that could be bought, they do not give heed to the red signals that indicate why something should 'not' be bought! In this article, we present a small 'do not buy' list that shall help you in staying clear of potential duds.

Companies with large borrowings
Avoid such companies! This could be found out by calculating the current debt to equity ratio of a company (as also studying its historical numbers). Strong businesses generally do not need large amounts of external borrowings (debt) to achieve an acceptable return for shareholders. So, if a company needs debt to achieve reasonable returns, it is less likely to be a great business. Debt is generally used by companies to perk up their 'return on equity' ratios, as a high amount of debt lowers the net asset position (Total assets minus current liabilities & debt). This needs to be a critical judgement point for investors before investing in a company, which has an 'artificially' high return on equity position.

Also, while in good times large amounts of debt mean that cash could be put toward growing the business or rewarding shareholders instead of servicing the debt, in a crisis situation, debt greatly limits a company's options and can sometimes lead to bankruptcy. Investors also need to study the interest coverage ratio (Profit before interest & taxes divided by interest payments) to understand whether a company is generating enough pre-interest profit so as to repay the cost of debt.

Companies with consistent requirement of growth capital
Now this factor goes almost in line with the one mentioned above. Companies that do not generate adequate return on capital (debt plus equity) are the ones that can be given a miss. Companies that constantly need additional capital to keep its business growing do not actually generate enough 'bang for the buck' for each incremental rupee employed in the business. Against this, companies that do generate high 'return on capital employed' can use these extra returns to reward shareholders by way of either buying back shares, or paying dividends, or for that matter reinvesting in future growth.

Companies with no 'competitive' edge
Ever imagined 'why Infosys is what Infosys is', or for that matter 'why HLL is what HLL is'? What is that 'edge' that separates these companies from the rest in their respective industries? What 'competitive advantages' do these companies hold, and hold them tight, which have helped them grow in both good times and bad? Competitive advantages can come from ethical leadership and execution strengths such as those held by Infosys, or from distribution systems and scale like those enjoyed by HLL, which also enjoys a recognisable brand. All of these qualities allow companies to maintain high returns on capital and equity, and stay profitable over the long term (while there might be occasional blips in performance due to changing dynamics of the company/industry in which they operate. As such, to make strong long-term investments, stay aside from companies that do not have any 'competitive advantage' to sustain growth year after year. A company's gross and operating margin profiles can be a starting point here as these indicate if the company holds any pricing power, cost leadership or a differentiation advantage over its peers.

Companies with questionable management
Too much has been said about the management quality and its importance in judging a good investment from a bad one. We strongly recommend avoiding companies where investors could even sense of the management lacking in honesty and integrity. Read the management's vision statement for the company as also its thoughts on the company's performance and prospects in the annual report to find more on this issue of management strength.

Conclusion
Investors need to cautiously evaluate each of these factors in their potential investment target. As Warren Buffett has indicated time and again - "Buy businesses (represented by their stocks) with consistent earnings, good returns on equity, able and honest management and at sensible prices." These will make sure that when the great global tide of liquidity finally ebbs into reverse, you will be one of the forward-looking swimmers dressed for the occasion.

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