Picture: 123RF/IVAN TRIFONENKO
Picture: 123RF/IVAN TRIFONENKO

One of the first lessons for newcomers to the asset management industry is the first rule of investments: “Don’t lose your clients’ money.” Followed closely by the second most important rule of investments: “Don’t forget rule No 1.”

Despite the pervasiveness of this simple and perhaps trite investment principle, our emotional biases quickly erode our focus on avoiding the next loser in favour of an overemphasis on picking tomorrow’s winner. 

In the last 25 years there have been two years where less than 20% of the JSE all share index (Alsi) had a negative one-year return. In fact, in six out of the last 10 years we have had more than 40% of the Alsi showing a negative return for the calendar year. To illustrate the power of avoiding stock-specific disasters, if a stock goes down 80% it will have to go up 400% just to break even — it’s like adding one rotten ingredient into your milkshake.

Furthermore, we believe it is often easier to identify the next loser than to pick the next winner. The recipe of avoiding disasters and leveraging the power of compounding for the balance of the markets’ modest positive investment returns is a simple but effective investment strategy.   

The next Capitec, Naspers or Cartrack will more than likely become a winner for different reasons than that of these past winners. This means you have to analyse and understand the business model better than the rest of the market to price in future growth better than your peers. Here the adage of “hindsight is a perfect science” applies as it is always much easier to see why these business models were successful after the fact.

However, when it comes to businesses that fail, there are more often than not a number of the same factors present. And yes, when one or two of these attributes are present, it does not mean the business will fail and be a poor investment decision. But often, where there is smoke there tends to be a fire. 

There are a number of telltale signs that should make you cautious. 

Making acquisitions outside management’s core competence or primary region of doing business. It is already difficult to execute a successful acquisition within a sector where you operate and have core competence and where you can extract synergies from your existing business. For companies to stray into new countries or sectors is a complex and risky undertaking, particularly where existing players in that market passed on the deal or were willing to transact at a much lower price. Looking at many recent disasters on the JSE, aggressive merger & acquisition (M&A) activity is a prevalent theme or red flag. 

Rising debt levels. Cash is king. When businesses struggle to fund their growth and maintenance capital spend, they constantly need to use the debt market to fund the business. This is another warning sign. You will find that even a strong management team’s decision-making gets compromised when they have a large debt burden constraining them. They tend to spend too much time solving past problems relative to focusing on future opportunities.

Very complex structures, with a number of off-balance sheet special purpose vehicles (SPVs). This is generally in place to pay less tax or allow a business to gear up more. If a company is set up to trick the taxman, the chances are it is doing the same to investors.

Very limited disclosure. This relates to segmental reporting that is constantly changing, often to hide underperforming businesses. It is not a good sign when you struggle to understand how a company makes its money and how much of the group’s growth is attributable to organic vs acquisitive activities.  

Numerous environmental, social & governance (ESG) issues. This is especially worrying when management does not acknowledge that it is becoming an issue for the business and is not putting forward a plan to address it.

Lots of churn among the executive team. No executive wants to leave a company with excellent prospects and growth opportunities. They are at the coal face and have a front-row seat to the business’s potential and what is going on “under the hood”.

While this is not an exhaustive list, the presence of bad management in control of capital allocation or an uncompetitive business model significantly diminishes the company’s odds of  proving to be a great long-term investment opportunity. When any of these factors are present, a further detailed investigation is definitively warranted, as is a healthy dose of scepticism.  

• Sholtz is head of equity research at Sanlam Investments.

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