Ten Golden Rule on "How to avoid stocks with hidden traps"

by Mr.Arjun Parthasarathy, Author of "The Rich Investor"
-----------------------------------------------------------------------------------------------------

A long bear market helps separate the ugly from the bad. Over the last four to five years, investors have seen many of their investments decline by 70-90 percent and above. Many of the stocks that have fallen sharply are likely to have fallen due to over valuations at peaks of market cycle.

However, there are stocks that have fallen sharply due to factors such as corruption scams, insider trading and price rigging, bad accounting practices and low corporate governance standards.Table 1 gives some of the stocks that have fallen due to factors other than the factor of valuations.

All the companies listed in Table 1 have seen high investor interest before the bad news hit the stocks. As an investor, how do you identify such companies? Investing in such companies, where you are ignorant of the hidden risks but get attracted to them, is like swimming in calm waters ignorant of the strong undercurrents.

Investing in such companies, where you are ignorant of the hidden risks but get attracted to them.

Ten golden rules

Follow these rules when making an investment in a stock and you will avoid being caught in traps where you capital is wiped out.

Rule 1:

Check whether the management’s focus is on pleasing analysts, rather than creating shareholder wealth. Pleasing analysts help companies raise funds through qualified institutional placements (QIP). They can prop up share prices by giving out sensitive information to analysts and institutional fund managers.

Rule 2:

Is the company growing revenue and profit but lacking free cash flows to show for the growth?

Rule 3:

Those companies that show a hunger for funds and take any route — debt or equity — are to be studied harder. Such companies will announce grandiose plans for the future but will not have the management bandwidth to handle the planned growth.

Rule 4:

Companies, which figure in the news excessively, spend more time talking to the market than to run businesses effectively. Press conferences, media interviews, analyst meets, and TV appearances all take up the management’s time. Unless the company has a deep management pool, it will hamper the effectiveness of the top executives.

Rule 5:

Does the management have a history of political links? Does it depend on government licenses and policies for revenues? Avoid such stocks as changing political climate affects the fortunes of such companies.

Rule 6:

Always be suspicious of subsidiaries. The more subsidiaries a company has the more the chances of inter-corporate transactions, leading to a wealth erosion of shareholders of the listed company.

Rule 7:

Be wary of high-growth companies in sectors that are the market’s favourite. For example, if there is boom in the IT or infrastructure sectors, there will be many companies trying to ride the boom at the cost of investors’ wealth.

Rule 8:

Diversification into other businesses should be viewed with caution. Companies diversify without having the bandwidth for diversification and they pay the price when diversification eats into their primary business. Fraud companies diversify to get funds through debt and equity and use the funds for other purposes.

Rule 9:

Watch out if the company’s moto is growth, growth, growth. Such companies will falter as they try to grow as fast as possible in the shortest span of time.

Rule 10:

Extra analysis is required when investing in companies that appear to promise the earth. If you are not capable of that extra analysis, forget it. The pain of investing and losing money is much more than the pain of not investing and not making money.

One-time misdemeanour:

One or two bad apples can destabilise even a well run company. BEML, a government owned company, is one such case, as the bad apple was the Managing Director who was suspended on suspicion of corruption. However, the role of the board is questionable in such companies. Investors pay the price for the wrongdoings of one or two employees and the indifference of the board. It is always good to see professionals in corporate boardrooms. But even then one can make mistakes, for example Rajat Gupta, the Mckinsey head who was convicted for insider trading in the US. Such cases one has to live with.