10 ways in which we will attempt to avoid the stock market’s turkeys this year

Building a successful portfolio is as much about dodging the turkeys as it is about picking winners. Think about it: any stock that halves will have to double just to get back to where you started. And in a portfolio of say 25 equally sized holdings, a stock that halves wipes out 2pc of your pot, just like that.

In light of this elementary mathematics, and experience of the past 30 years in the markets, which include spells as a fund manager (what the City calls the “buy side”) and as an analyst at an investment bank (the “sell side”), this column tends to focus on protection from losses first and on seeking gains second.

To do this, it runs a checklist against which every potential investment idea is measured. Few if any stocks will emerge completely unblemished from this test. But some of this column’s biggest setbacks have come when exceptions have been made for companies that scored badly here but had a tempting valuation. 

In the end, the market was right, this column was wrong and the stock deserved to be cheap. Sticking to the disciplines demanded by our list, rather than backing hunches, will therefore (once more) be this column’s key new year resolution.

Our 10-point plan for avoiding portfolio pitfalls

Be wary of firms with dominant chief executives and/or a dominant shareholder At the very least make sure that the interests of the executive and/or investor are correctly aligned with yours as a shareholder and those of other stakeholders, through mechanisms such as pay and boardroom governance.

Be wary of frequent acquisitions or any deal billed as transformational So-called “roll-ups”, where a company snaps up rivals to create momentum, work well until they don’t, usually when a purchase goes wrong. And calling a deal transformational is usually an admission that management is overpaying for an asset they feel they must have (for whatever reason). 

“Bolt-on” acquisitions designed to supplement existing momentum are fine; big deals that aim to generate momentum from a standing start are usually trouble.

Be wary if management says its focus is growth Fred Goodwin grew Royal Bank of Scotland, as what is now NatWest was then, but it did no one any good in the end. Growth is not a strategy. Growth is what results from a sound strategy, well implemented.

Be wary if management bonuses are easily triggered Paydays or options that linked to earnings per share targets are to be treated with particular caution, as such figures can easily be massaged by the unscrupulous.

Be wary if the accounts regularly feature “exceptional items”, or if the footnotes are unintelligible When things are going well, companies will make it as easy as possible for the investor to see that. When things are going badly, the opposite applies. A change in key performance indicators or a restatement of the accounts can also be a warning sign.

Be wary of weak cash flow and poor conversion of profits into cash Profits can be manipulated relatively easily but cash cannot. A comparison of annual growth in sales, operating profits and cash flow over three to five years will usually help to show if there is anything amiss regarding the quality of the profits being reported.

Be wary of mixing “operational gearing” with “financial gearing” Operational gearing means that, say, a 1pc fall (or gain) in sales (owing to a fall or rise in either pricing or volumes) leads to a far bigger percentage change in profits. This is great on the way up and scary on the way down, especially if a company has lots of financial gearing, otherwise known as debt. Such stocks are not for the faint-hearted.

Be wary when interest cover is less than two Interest bills must be paid no matter what and if profits barely cover the interest expense there could be trouble ahead should earnings unexpectedly drop.

Be wary when dividend cover is less than two You can make exceptions if cash flow is very predictable but if earnings cover dividends by less than two times when things are going well, a cut in the payout (and an inevitable fall in the share price) may not be far away if anything goes wrong.

Be wary of management that focuses on the share price as a measure of success The board’s job is to generate a return on the company’s assets. It can control that, and should focus on it. If it does it well, the share price will take care of itself.

Read the latest Questor column on every Sunday, Tuesday, Wednesday, Thursday and Friday from 5am.

Read Questor’s rules of investment before you follow our tips.

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