How To Know If A Stock Smells Bad
There is no halfway house when it comes to durians. A person either loves it or detests it. I can’t think of any other fruit that can be so divisive.
I love the so-called King of Fruits. I once flew all the way to Penang to savour durians at their freshest – straight from the tree.
But until this year, I wouldn’t have known how to fully appreciate the distinct flavours of a Black Pearl or Red Prawn, let alone the nuances between D24, a Tai Yuan, a Chook Kiok and a Mao Shan Wang.
This year, I was determined to learn. And learn I did.
But at prices between of $10 and $24 a kilogram, the “lessons” weren’t exactly cheap. But they were, nevertheless, very enjoyable.
Sight and smell
I still haven’t quite reached the levels of skilled durian vendors, though. These experts can tell the difference between the various species just by sight and by smell….
…. they can also distinguish a good fruit from a bad one, simply by dropping it gently on the floor or tapping it a few times with the blade of a knife. I kid you not.
Maybe one day I will get to be as expert as they are.
When I watch durian sellers at work, they remind me very much of how stock pickers can tell the difference between a good company and one that should be avoided at all costs – often just by looking.
Same but different
Not all shares are the same, just as not all durians are alike, even though they might appear remarkably similar.
For instance, two shares with the same dividend yield, the same price-to-earnings multiple and the same price-to-book valuation may not be more different.
But analysts can look at a company and know almost immediately that it just doesn’t smell right.
However, screening stocks by sight and smell has its limitations. Good stock pickers need to delve deeper – much deeper. That means rolling up sleeves to the elbow and digging into the accounts.
Analysts are looking for consistency. For instance, profits and cash flow need to be aligned. After all, it is possible to massage profits. But it can be a lot harder to fake cash.
Debt is something else that analysts are looking out for. It can sometimes seem like a clever idea to run a business on someone else’s money, which is what bonds and loans are, effectively.
But companies that depend too heavily on borrowings can be badly caught out when interest rates start to rise.
Borrowings, we need to remember, are a double-edged sword. It can be a great way to magnify shareholder returns….
…. But they can also amplify risks to such an extent that it could even result in total loss for shareholders. So, it is important to ensure that interest payments are adequately covered not only by profits but by healthy cash flow too.
Good companies should also have pricing power.
Warren Buffett said that the single most important decision in evaluating a business is pricing power. These companies should be able raise prices without losing business to a competitor.
Another sign of a good company is the ability to grow. It is all too easy to make more profits by cutting costs. But does the company have the capacity to grow its sales, sustainably in both good times and bad?
Hang out with me
Anyone can learn how to analyse stocks. It just takes time.
A better way, though, could be to learn whilst we invest, and maybe make some money in the process.
In the same way that I am learning all about durians from vendors that I trust, we can learn the finer points of stock picking from analysts that we have faith in.
Warren Buffett said: “It’s better to hang out with people better than you. Pick out associates whose behaviour is better than yours and you’ll drift in that direction.
I believe that I am much better investor today because I hung out with people a lot smarter than me.
So, join me as I show you how we do it the Motley Fool way.
A version of this article first appeared in Take Stock Singapore.