Trading Rule – “Cheap Trash is Trash Anyway”

IT IS QUITE NORMAL TO SEE THE SMARTEST OF INVESTORS FALL FOR THE CHEAP TRASH TRICK. ASK ANY SUCCESSFUL INVESTOR AND HE WILL GIVE YOU AT LEAST A FEW INSTANCES OF HOW THEY BECAME VICTIMS OF CHEAP TRASH SYNDROME. THE SYNDROME IS QUITE SIMPLE. YOU SEE A HIGH PRICED STOCK FALLING AND YOU RUSH TO BUY IT. THE REASON IS THAT IN THE PAST THE STOCK HAS ALWAYS BOUNCED FROM LOWER LEVELS. WHAT YOU NEED TO ASK IS WHETHER SOMETHING HAS CHANGED FUNDAMENTALLY WHICH IS JUSTIFYING THIS FALL IN PRICE?

WHAT EXACTLY IS CHEAP TRASH IN THIS CONTEXT?

Cheap trash here could mean a variety of things. As a broad rule, it means a stock that is correcting because that is what it is actually worth. Take the example of Kingfisher Airlines in 2011. Well before the bankruptcy was announced, the company stock price had started falling sharply. But the media and analysts were overly optimistic about the stock. The company was struggling to make its ends meet, it was already defaulting on salaries and it was also defaulting on statutory payments. There was no way the company could sustain the business model. Not surprisingly, the stock just fell vertically and eventually became a worthless stock. The same is the case with small companies with dubious business models that start crumbling once the plot unravels.

WHY CHASING CHEAP TRASH CAN BE DANGEROUS?

It is quite easy to fall for the lure of cheap trash stocks. They come in various forms and the price performance can be quite dangerous. There are distinct categories of such companies. Firstly, there are the existing companies that have seen a reversal of fortunes. It could be a major shift in the industry (take the case of Nokia), it could be a dubiously uneconomical business model (take the case of Kingfisher), it could be a case of round tripping of funds across group companies (Satyam and Deccan Chronicle) and it could be companies that were always shell companies (DSQ, Himachal, GTS). In each of cases, the principal theme is the same. Either these were worthless companies in the first or they have been rendered worthless due to extraneous or internal factors. The risk is that these stocks do not offer quality management that can redeem the situation. If the tide turns against you the only option for you is to book a loss and run for the exits as soon as possible.

“The biggest risk actually comes from not knowing what exactly you are doing in the stock market” – Warren Buffet

6 INDICATORS THAT A STOCK COULD BECOME A TRASH STOCK IN THE FUTURE…

 

  1. Check the financials of the company. Do you see signs of deterioration? Do you see a consistent fall in profits or narrowing of margins? You must get worried if the company is consistently under performing its peer group. Look out for risk factors like a high debt/equity ratio, too much of short term debt, delay in payment to creditors, default in loan installments etc. Check if the sales of the company are plummeting too rapidly. More often than not it is a case of the industry changing too fast and the company not keeping pace with it.
  2. Try to understand if the operating environment is changing. You need to be careful of companies that are not able to adapt to the big changes happening in the industry. Nokia is a classic example. Indian PSU banks, telecom companies like MTNL are all classic examples of becoming worthless stocks purely because they did not see the larger trend in the industry. Take the case of how Kingfisher lost out to more agile players like Indigo and Spice Jet that managed to discover a profitable way of running the aviation business. Take the IT industry today. You must be cautious of companies that are not able to adjust to the new digital environment. Similarly, banks and financials that cannot effectively use technology to reduce costs will also destroy value for shareholders…
  3. Are the promoters and informed investor gradually exiting the stock? We saw that happen in case of Himachal Futuristic and even in case of Satyam where the promoters and the institutional investors were gradually exiting the company when most of the retail investors were left holding on to worthless paper.
  4. What is the background of promoters of the company? Today the background of promoters is available with the MCA and you can easily access the same. It will give you a good idea as to what has been their experience with other projects. Some promoters are habitual offenders and as an investor you need to be doubly careful of them.
  5. You start seeing a series of negative reports of the company in the press, in discussion forums and in analyst notes. One sign is the number of positive analyst recommendations reducing. Also check if the debt paper of the company is consistently getting downgrade. In case of companies like Amtek Auto it all began with the downgrade of its debt paper and then the entire crisis snowballed. You surely do not want to end up holding on to such worthless paper.
  6. You see signs of large scale downsizing of operations. This could be in the form of reduction of employees or in the form of downsizing of volume and spread of operations. Some amount of right-sizing is part of the game but large scale downsizing is not a good sign. Also be careful if the net external debt of the company is substantially more than the market cap. Such companies are classic recipes for disaster.

THE BEST YOU CAN DO IS TO STAY OFF THESE COMPANIES…

There is no point trying to play these companies either on the long side or short side. As a smart investor, such investments are best avoided. At the end of the day, it is hard to predict their momentum either ways. The moral of the story is that “Cheap Trash is Trash Anyway.” You are better off staying away from it. Remember, the signals are always available to the discerning. It just takes a little bit of effort from your side.

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