Avoiding the next Vocation: Five “watch outs” for selecting stocks

Leanne Pan, May 2017

Avoiding poor stocks when investing is as important as selecting big winners.

One or two bad performers is all it takes to damage a portfolio. Investors should always consider preserving capital rather than just focusing on potential returns when choosing stocks.

With any stock, you need to ask: what can go wrong? Where are the risks?

Sometimes today’s returns don’t tell the whole story: there are many cases where stocks with big underlying problems have outperformed for a period; Vocation is a recent example which performed strongly before collapsing and ultimately being delisted from the ASX. Other classic examples include Babcock and Brown, and ABC Learning, which also experienced strong growth before being delisted.

There is no such thing as the perfect stock, but what do investors need to watch out for?

1. You need an MBA to figure out the business model: Good stocks should always be simple and easy to understand. A good test is to see if you can explain it to somebody else. If you can’t explain it, how are you going to evaluate it? Overly complex business structures can hide myriad problems, which won’t be revealed until the company is in trouble.

2. Risk of regulatory change: Government regulation may impact many sectors, such as telecommunications, aged care, healthcare, education, child care, and so on. Anything that requires a high degree of government funding is a high potential risk. Investors need to understand the risk and avoid over-allocating to stocks which may suffer from a sudden legislative or regulatory change.

3. The stock is running too hot: Nothing is more tempting for investors than an already hot stock, but following the herd might be high risk. High performance can mask underlying problems, and may also create other issues, as equity could become cheaper than debt. I once heard a CEO say it is cheaper to raise capital than to borrow. The key is always being mindful of valuation – you need to work out if it is fairly valued, and if the company can keep it going. You need to know your timeframe and understand that surprises come along – look at Brexit and Trump and how certain stocks reacted to that news.

4. Poor management track record: Investors who pay more attention to company management can be rewarded. Just as good management may indicate a good stock, poor management may be a warning sign. Management alone won’t make a stock a buy or a sell, but if a stock already has inherent problems then a poor management track record will only make it less appealing.

5. Risk of structural change: Change and disruption is creating opportunities and crises for many different stocks. Structural change can be hugely influential. To take an overseas example, look what happened to companies like Blockbuster. Consider what online real estate listings have done to newspaper classifieds, and what Uber has done to the taxi industry. You can be a good company, but things can change quickly. It’s important to understand the risks of disruption if possible.