The Art of Not Picking Bad Stocks!

Stock Market is a land of plethora of opportunities. But as a retailer with little to no time to devote to researching and analyzing companies, we either end up in frustration or making mistakes. This consumes plenty of energy, giving less output than the output you could have received through index investing. 

Rather than giving up, we need to understand where our energies should be channeled so that we can get the right amount of output through it. 

Let’s dive into data first. 

Taking example of Nifty 500 Universe

Source - Samir Arora

Looking at the past 19 years data, we can see that on average 221 stocks perform better than the NSE500 Index. That means you have 44% universe which, if you pick, can beat the NSE500 Index. 

And even if you are within the 150th best category, you are performing well, beating the index by margins in the long run. But this is what everyone advises, and it looks easy as per the data but it’s not easy to execute.

So, the next data will play a crucial role in today’s article. What this data shows is that we need to limit ourselves within the first 221 stocks and we definitely don’t want to be on the other extreme (>400th best), then we practically are losing our portfolio. I don’t mean to scare anyone, but if we just avoid ourselves from these 221 stocks, we can easily sustain in the market.

This looks like a glass half-full - half-empty situation. But trust me it is not. 

Let’s delve deeper. 

Think how you confirm whether any business is good and worth investing in?

You may say, future earnings, size of opportunity, cash flows, strength of balance sheet, valuations and a bunch of important metrics. But most of the time, these metrics are quite subjective, and you cannot expect a binary answer for this. For example, for decades, people have debated on whether the valuation of Titan is overvalued or not. But with the dynamic nature of the stock market, we cannot be exactly right on this. 

But what can we be definitely right on is if there are any red flags which we can see in a company. Through this, we need not worry about how correct we are on this, because even a slight red flag is a red flag. We can then start eliminating companies and whatever is left will increase our probability to be in the top 221 stocks as seen above. 

Based on multiple articles, interviews, books and my personal experience.

Following are the important red flags I believe are present in a company. - 

• Industry is slowing down and potential headwinds (short-term & long-term)

• Company is misallocating resources.

• Red flags in Auditor's opinion and resignation.

• Bad Corporate Governance. 

• Low quality Accounting.

• Potential for Disruptions through substitution.

• Unreasonable Valuations.

Now, if any of the above 7 factors are getting triggered during analysis, then it will straight up reject the stock, acting as a clear signal.

With this simple framework, we can eliminate companies in a structured way. 

In Conclusion, picking good stocks is definitely an art and it requires the right amount of time, energy and management to make exceptional returns. But we can reduce our energy consumption, by eliminating the bad stocks straightway. Whatever pool then we have left we can make calls more sensibly and might still outperform the index in the long run. In the short term, anything can happen. For example, HDFC Bank, it is not triggering any of the above flags, but it can still underperform in the short term (we don’t know about long term yet). During such times you need to have multiple factors into your portfolio which can balance this out and still generate the appropriate alpha without much risk.

Thank you for Reading!

Views are purely personal and to be taken for educational purposes.