Avoiding the Duds

I realize that so much emphasis has been placed on the choices that one has made in relation to companies that one had bought, that almost no one mentioned about those that one had correctly avoided ! I guess I could not think of a more appropriate title, hence "avoiding the duds" sounded reasonable enough. The same logic applies to mistakes as we can classify them according to "omission" and "commission". Commission means purchasing a company which is a dud and later makes you lose tons of money; while omission means NOT purchasing a company which later turns out to be a star, thus it is mainly opportunity costs.

If we turn the tables around, the same logic also applies. If one consistently avoids buying the "dud" or "over-hyped" companies, one can indeed prevent a substantial loss of wealth. Remember that preserving capital is also one good way of building wealth, as Warren Buffett advises us to "Never Lose Money". Even though cynical readers may point out that I have "lost money" due to this bear market and sharp recession, my argument is that over the long-term, I am confident of adhering to the mantra of "not losing money". This is because I feel that aside from choosing the right companies to take a stake in, it is also important to spot the danger signs for dud companies which may later implode.

Just to give some examples of the companies which I had considered but rejected, they fall into a few broad categories. One of them is "wrong business model", which is what happens when I first review a company's basic business model and decide that it cannot possibly sustain a competitive edge. Either that or the business model seems flawed, risky or inherently unsound. One of the more recent cases which comes to mind is the company GEMS TV, which was listed a few years back. This is a company which sells gemstones through television (akin to TV Marketing) and they had penetrated the UK and USA market. Back after its IPO, it was trading at around $1.50 and analysts were fervently touting for target prices as high as $3 (yes, you heard me right - I still have that report !). By studying the underlying business model, I decided that buying jewellery is a personal process and most people would rather go down to stores to try them out. Moreover, advertising is an expensive business and would require huge upfront capex with limited chances of success (it's a retail operation, not a contract-based business). Hence my decision to avoid the company even though analysts were bullish then. The benefit of omission has saved me a ton of money as the company has gone on to announce 4 consecutive quarters of losses and is now trading at 3 cents per share. It remains to be seen if the company can pick itself back up to its glory days when it IPO-ed.

Another category of companies which I will avoid are those with razor-thin margins. Some industries are effectively commoditized like semi-conductors and PCB Boards so the margin is extremely thin (close to 2-3% or maybe less). This means that a small escalation of costs from suppliers would trickle down into an avalanche for the company, who may have problems raising prices due to lack of pricing power. Some examples would include Chartered Semiconductor (which recently did a rights issue) and Jurong Technologies. The former has seen massive losses due to the plunge in worldwide chip demand while Jurong Tech has been suspended pending the outcome of judicial management proceedings as it was served statutory demands from several banks. Other companies which I have noticed with very think margins are Surface Mount Tech and also Olam* (surprisingly, this "blue chip" has margins of about 0.5-1% only).

*A Note here: If one had purchased Olam during its 2005 IPO at a price of 62 cents, one would still be sitting on nearly a 100% gain (more if you include dividends over the years). This was mainly due to its aggressive M&A strategy which saw many acquisitions (through gearing) over the last few years. These have been driving earnings in the near term. However, I am focusing on the margins which I am not comfortable with. The Company DOES have a sustainable competitive advantage in its total SCM business model, though.

A last category of companies I choose to avoid are - the over-hyped ones ! The hype can be done through various ways, either through analysts strongly pushing the company without taking a close look at the business model, operating risks, cash flow generation, capex and gearing; or else over-hyped on the basis of valuations alone (e.g. 20-30x PER meaning you need 20-30 years to recover your capital !). I guess most of the S-Shares would fall into the over-hyped category, as I remember the heydays back in 2006 and early 2007 when so many China-based companies came here to list. Gosh, there was almost one listing per month that time and if you got in at IPO it was almost guaranteed to make you money if you "stag" it. Such was the immense hype surrounding the "China Growth Story".

Of course, 2 years later, valuations have come down to 1-2x and a slew of scandals have hit S-Shares, notably in companies like Fibrechem, Oriental Century, China Sun and China Printing and Dyeing. This once over-hyped segment has faced almost a total collapse in confidence as investors flee S-Shares as if they were the plague. This situation sort of reminds me of the hype surrounding the dot.com companies during the dot.com bubble in 1999 before the eventual painful crash. Some examples I can think of for companies which I avoided include Synear Foods (trading at 30x PER back then - $2.00 and still being pushed by analysts), China Energy (their DME technology was touted as an emerging technology and valuations were pushed to stratospheric levels) as well as China New Town (ok, this was a dud to begin with, I don't know how SGX managed to get them to list here !).

So after all has been said and done, please do remember to give yourself a pat on the back for the companies that you correctly avoided ! Most people like to tell you about their winners or blue chips, but if you probe further they tell you in a quiet voice about the duds they had bought donkey years ago and are STILL holding on to them. In an environment where making the correct decision can greatly influence your chances of growing wealth, I would think a lot more due diligence should be demanded of the retail investor, or he may risk seeing his capital evaporate like puddles on a hot summer day.