Many hard problems are best solved when they are addressed backwards. Munger called this inversion, and it’s a potent idea for both life and investing.
It’s pretty obvious when you think about it: if you want to be happy avoid things that make you miserable. Similarly, if you want to improve your investment returns, don’t focus on finding the next big winner — instead, look to excise the duds hiding in your existing portfolio.
Indeed, in explaining Berkshire’s track record Munger once said “it’s not brilliance, it’s just avoiding stupidity.”
So how, exactly, do you identify the dogs lurking within your portfolio, and do the humane thing before they cause too much damage?
There are no surefire rules, sadly. But the following may present some red flags that warrant deeper contemplation.
Lofty valuations
Paying too high a price, even for a good company, reduces your margin of safety. No company, no matter how wonderful, is worth buying at any price.
Promotional management
Be wary of managers who are always aggressively selling the story and hyping the stock. They may be trying to pump up the price rather than focusing on running the business well.
Story stocks
Related to the above, plenty of stocks on the ASX, especially at the smaller end of the market, have an exciting story but no real business. At least not yet. A significant proportion never will. Pop them on a watchlist if you want, but it’s usually best to wait for evidence of commercial traction before you take the plunge.
Hot sectors
When a sector is hot, like AI is at the moment, valuations tend to get stretched. For some players in the space, the high prices may well be justifed, but be wary of those looking to ride their coat tails.
Poor management track record
If management has a history of poor delivery and exaggerated promises, tread carefully. Leopards don’t tend to change their spots.
Structurally challenged industries
Businesses that operate in industries undergoing significant disruption are really sailing into some stiff winds. No matter how good the management team, or how cheap the stock price, the odds are really stacked against you.
Weak balance sheet
Debt isn’t necessarily a four letter word, but companies that owe a lot and have little in the way of real assets are usually a risky bet.
Misaligned management
You want to see managers with large ownership stakes or compensation tied to long-term metrics. Short-term minded hired guns are usually more interested in feathering their own nest, rather than creating value for long term shareholders.
Customer/product concentration
If most of a company’s revenue comes from a small handful of customers, or relies on a single product/service, there’s a lot to lose if something goes wrong.
Deteriorating competitive position
It’s easy to overthink competitive threats, but if your company is consistently losing ground to other players that’s not something that is easily turned around.
Insider selling
There’s a lot of truth in the saying that “insiders sell for many reasons, but they buy only for one“. Still, a pattern of regular and significant divestments from insiders isn’t what you hope to see.
Changing guidance
Business is hard, and even the most talented and honest CEO will find it necessary to walk back guidance from time to time. But if the goal posts are forever shifting, and unapologetically so, it’s not a good sign.
Unresolved issues
If a company is under active investigation, or is facing legal issues, be careful. They’ll talk a good game and project confidence, but don’t always assume a favorable resolution — at least not without good reason.
Unexplained price declines
Stocks are volatile, especially small-caps. So it’s dangerous to impart too much meaning to short-term fluctuations. Nevertheless, if a stock plunges on meaningful volume without any obvious reason, it could signal something negative is afoot.
Conclusion
While these red flags are worth keeping an eye out for, you don’t want to jump at every shadow. The last thing you want to do is ditch a long-term compounder just because of one or two less than ideal issues. Nevertheless, hope springs eternal, and in an effort to preserve your ego you’ll come up with all manner of reasons to ignore the warning signs.
As is often the case, a deep and objective understanding of what you own, and why you own it, will help you understand what can be ignored, and what requires decisive action.
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