Reasons NOT to own a stock

As I stated in a recent post about SNCR, even though I’ve decided I need to avoid things that are simply “too difficult,” sometimes it’s not easy to decide whether or not a stock is or isn’t. Here is a list of reasons I’ve come up with when one should at least consider just selling (or not buying) and moving on. Some of these relate to business model, others to valuation, others to uncertainty with the company, others with uncertainty to the industry. In no particular order…

  1. Industry upheaval (SEDG, SUNW)

  2. Large shift in the business model…like a very big acquisition (SNCR, PERI) however, be aware that sometimes this works out very well (XPO, POST)

  3. Customers have all the power – demand or margins may downshift quickly (INFN, RUBI, SUNW, SEDG, FIT) especially like with INFN where large customers’ whims can swamp the ship

  4. Valuation too crazy (MBLY, VEEV) or even just at the point where you wouldn’t consider buying…nothing wrong with taking profits (SKX, DY)

  5. Don’t understand the product (TWLO, TEAM, UBNT, SNCR, SWKS)

  6. Don’t understand the financials (SSNI)

  7. Competition. (SWKS, SKX) This is the toughest for me. Coke and Pepsi can coexist, but there is only one Apple. Still learning a lot here.

  8. Product doesn’t sell itself. With INFN (and probably many others), I think the amount of money they spent on R&D and sales became a monster that got ahead of demand.

If anyone is interested, I’d love to hear some other reasons!

Bear

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Coke and Pepsi can coexist, but there is only one Apple.

There are two basic economic laws: Decreasing Returns and Increasing Returns and that’s the difference between soft drinks (commodities) and proprietary IP (Apple’s user interface).

To learns about increasing returns read Brian Arthur at the Santa Fe Institute

http://tuvalu.santafe.edu/~wbarthur/

The More You Sell, the More You Sell

Brian Arthur’s theory of “increasing returns” is revolutionizing economics. It’s also why the DOJ stopped the Microsoft/Intuit merger.

https://www.wired.com/1995/10/arthur/

Denny Schlesinger

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why I read but have trouble accepting some academic economists

from the article
Until recently, economics didn’t have any well-articulated theory note the word “theory”
That is a fact of life that economists these days don’t dispute.
But to say it’s unproven and untested is nonsense. It’s been tested in all the academic ways – by publication, economic measurement, and so on. It’s now undisputed

economists - the new alchemists.
Never dispute . Disputing is at the heart of real science, a theory is just that. And how well “articulated” it is has little to do with the truth of it for real scientists.

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A few thoughts on these points:

  1. Competition - in fast moving consumer goods with continuous sales and hi frequency purchase then competition is not as significant a challenge as a one time or Long term purchase situation like PCs. It also depends how you view competition. Having high fragmentation allows for a lot of operating plays as well as future consolidation.
  2. Cyclical or Sunset industry plays - I would not want to be investing in untransparent cycles where you cannot see where you are in the rotation. I also would not want to be in sunset industries like coal, western Malls and retail, physical newspapers, PCs or anything that looks like it is going to be totally displaced.
  3. Low margin industries or parts of the value chain - didn’t warren buffet say in the long run your investment return will tend towards the margin and ROCE of that asset?
    Ant
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I guess you could always add a rule about not investing in leaders you do not believe are trustworthy.
Ant
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I find safety in not even looking at any company that does not have certain credentials. Although I do occasionally cheat the rules (I think SHOP is currently my only cheat) when I run my eye down my portfolio columns, I do not really want to see anything too small, without FCF, with significant debt unrelated to a recent acquisition, low ROIC, CR < 1.7, unreliable margins, poor relative strength, an uninspiring 5-year chart, curiously small director holdings etc. For me, the pool of companies remaining is the only pool to look at. I cannot be Saul but find his board most interesting - and occasionally the same company looks good to both of us (SWKS was the best before it began to fail the screens), which is what I wait for, in case I have missed them.

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Also add:

Poor balance sheet, low financial strength. I only invest in B++ (VL ranking) or better in almost all cases.

Unethical mgt., financial restatements, uncertainty in truth of the financial statements. (e.g. VRX). I avoid almost all Russian and Chinese cos.

sw

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Are are two of my rules for Not Buying shares in a company

  1. Everyone else is buying shares

  2. The share price is going up and up and I am afraid of missing out

Wiseguy

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Strelna and Stillwater,

I was mainly considering factors outside the financial metrics, but you are right, of course, that investing in companies that aren’t on firm footing is not good policy.

Ant and Stillwater,

Absolutely management trustworthiness…I would say if there’s even reason to doubt (like with financial restatements or many foreign based companies) it adds more risk than necessary.

Denny and Ant,

I’m interested in what you have to say about competition, but I think I need more explanation. Denny, it seems like almost anything can be commoditized and very little can be categorized as having “Increasing Returns.” Microsoft’s ecosytem with Windows, Apple’s iPhone and the rest…maybe Google’s internet experience? Amazon…I dunno…I’m not thinking of any small companies that fit the bill.

Bear

very little can be categorized as having “Increasing Returns.” …I’m not thinking of any small companies that fit the bill.

Hi Bear, without looking very hard, and just off the top of my hat:

HUBS: Gets more revenue from each subscriber each quarter than the year before (because it sells them additional services), and it gets more subscribers.

SPLK: Companies pay for the amount of data they analyze, and have much more data to analyze each quarter than the year before. And more companies sign up.

SHOP: Sells more services to their merchants, and the merchants sell more goods, and they get a cut on all sales. And they sign up more merchants.

etc:…small companies with increasing returns

Hope this helps,

Saul

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So basically anything that’s a service instead of a tangible product?

I guess it’s starting to make sense…it’s not the iPhones (product) that gives Apple its network effect…it’s the fact that once they’ve got you on their phone, you’re likely to continue using their stuff. That makes sense.

PAYC would be another, then.

But tangible products like semiconductors and networking equipment will always get commoditized, right?

So like I said yesterday, sell UBNT. Just kidding.

Bear

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Denny, it seems like almost anything can be commoditized and very little can be categorized as having “Increasing Returns.” Microsoft’s ecosytem with Windows, Apple’s iPhone and the rest…maybe Google’s internet experience? Amazon…I dunno…

Apple, Microsoft, Google and Amazon all started small. They got big precisely because they were in “Increasing Returns” situations. They are competitor killers, something commodities can’t do except by becoming the low cost producer.

In times past IBM, Xerox, and Kodak were in “Increasing Returns” situations until they got commoditized or disrupted.

It’s not easy to find these companies when they are small but once they catch on, they are good for a long ride so there is no hurry to get in on the ground floor. It ties in with how growth happens and the “S” curve is the best descriptor. You can divide the lifetime of a technology in three equal parts:

  • the first third trying to catch on – slow growth.

  • if it catches on, growth accelerates creating the upward curve in the “S.” This typically happens when around 15% market penetration is achieved. Fast growth continues until the market penetration reaches around 85% and the top of the “S” is put in place. During this time P/E ratios expand.

  • during the last third growth slows, the company typically becomes a cash cow as it goes from fast growth to value. P/E ratios compress.

I try to buy stock of companies in the middle of the “S” curve. The uncertainty of innovation is past and the return should be well above average.

I’m not thinking of any small companies that fit the bill.

It is indeed difficult. The Gorilla Game tried to find them in high tech with mixed success. A central mantra was “buy the basket and sell the losers.” Say four small companies are competing for the database market, there is no way of knowing that Oracle is going to be the winner so you buy the stock of all four. As Oracle takes the lead you sell the other three.

I think my way makes more sense, wait until Oracle is the established Gorilla and then buy it. I think Amazon is in that position now.

Another possibility that I’m just now testing, is to buy the right ETF. I recently bought PowerShares S&P SmallCap Info Tech ETF [PSCT] which has 91 small cap Information Technology companies

Product Details

The PowerShares S&P SmallCap Information Technology Portfolio (Fund) is based on the S&P SmallCap 600® Capped Information Technology Index (Index). The Fund will normally invest at least 90% of its total assets in common stocks that comprise the Index.

https://www.invesco.com/portal/site/us/financial-professiona…

Denny Schlesinger

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But tangible products like semiconductors and networking equipment will always get commoditized, right?

In time – but there is a nice long window before it happens.

Denny Schlesinger

Another reason not to own a stock is when management does not work for shareholders. GWR is of no interest to this board but their recent secondary is an interesting case study that is of interest to this thread.

GWR Downgraded by Denny

I’ve had Genesee & Wyoming (GWR) on my fast growth wish list based on their policy of consolidating the short haul railroad industry. Growth, organic or not, pushes stock price up creating the kind of fast price appreciation I’m looking for. The problem with GWR is that they are going to market with a secondary offering that dilutes the shares and cuts into the share price appreciation of existing shareholders negating the beneficial aspects of the growth policy.

http://discussion.fool.com/gwr-downgraded-by-denny-32521834.aspx…

Denny Schlesinger

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Companies I will NOT to buy:

  1. Companies with poor financials.

  2. Companies with limited opportunities future revenue growth

  3. Companies with complex business models (conglomerates, companies that grow mainly by acquiring other companies, etc)

  4. Companies in asset-intensive businesses (auto manufacturing, steel, airlines, etc.)

To frame it in a positive statement, I look for high (and accelerating) earnings growth, reliable and growing free cash flow, industry-leading (and hopefully expanding) EBIT and net margins, high (but not highly levered) ROE, a balance sheet with more cash than debt, and significant opportunities for growth paid for out of cash flow, not from borrowing. I want companies with plenty of room to expand sales, and I like simple, asset-light business models.

Reasons that I might SELL a company:

  1. Leadership change (especially when the founder/CEO leaves)

  2. Company drifts off-course, or takes a purposeful change in direction. Related to this is when a company makes a major acquisition that is out of their normal business area.

  3. The company stops executing well, as indicated by declining sales growth, declining earnings growth, or negative free cash flow over an extended period (more than 3 quarters)

  4. Evidence of corrupt or unethical leadership

  5. The company is one of my lower-conviction holdings, and I find a better use for the money.

Tiptree, Fool One guide

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