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  • Rohit Musale, CFA

I Do Not Invest in These Companies

Whenever I am screening companies in the stock market, I am looking for red flags.

My focus is not on selecting companies.

My focus is on rejecting companies.

Occasionally, I come across a company that I simply cannot reject at all.

That's the company I would consider investing in, for the long term and hold on to it forever.

It usually takes me less than 60 seconds to reject a company.

Here are some ways I use, to reject companies.

1) I do not invest in companies that are leveraged.

If a company requires debt to operate, it means, either the company is in a capital intensive business, or the company does not have any competitive advantage in the market, which is why, it cannot fund its future investments from internal accruals.

Moreover, a leveraged company is more likely to go bankrupt than a company which does not have any debt on its balance sheet.

If a company has debt, then it will also have interest expense.

This reduces the net profit of the company.

2) I do not invest in companies that have reported a negative operating cash flow.

I look at the cash flow statement of the company for the past 10 years.

If in any one of those 10 years, the company reports a negative operating cash flow, then I am not interested in the company.

It is out of my watch list.

Because in that year, the company spent more in operations than it earned.

That's not what I want.

I want companies that generate more cash than it needs, to function smoothly.

3) I do not invest in companies that have a very low return on equity.

A company makes 5% return on equity.

Another company makes 20% return on equity.

Which one would you invest in?

I want to know, how much can I expect from a business, per dollar invested.

That's the return on equity.

Usually, companies that have a high pricing power show very good returns on equity.

More competition means low pricing power.

Competition is good for consumers, not for the shareholders.

I like companies that dominate their respective sectors.

4) I do not invest in companies whose business is cyclical in nature.

These are businesses like autos, cement, sugar etc...

These are cyclical in nature.

I am very bad at timing these cycles.

Moreover, I don't want to get into a game where, I am required to catch the bottom of the cycle, to ensure higher returns.

I want companies with consistent operating history.

A mismanaged cyclical business does not take much time to go into bankruptcy.

5) I do not invest in companies that have related party transactions.

For me, this is the biggest red flag, because this is the best way, a promoter of a company can move funds out of the company into some other entity, where he or she has a majority stake or complete control.

That same money could have been passed on to shareholders in the form of dividends.

Too many related party transactions indicate that, something is wrong with the company.

A good company makes money and either reinvests it in the same business or gives it back to its shareholders.

6) I do not invest in loss making companies.

There are some companies which are valued at billions of dollars, yet they haven't made a single dollar of profit, in their entire operating history.

I do not invest in such companies.

Some companies don't even have gross profits, forget about operating profit, and net profit.

I am better off, investing my money in a fixed deposit in a bank than invest in a company which is burning cash.

This is common sense.

However, people invest in such companies and drive their valuations to stratospheric levels.

This eventually leads to a disaster.

History is proof of that.

7) I do not invest in financial companies.

I do not invest in banks or non-banking financial companies.

Any company that is in the business of taking deposits and lending it out is not on my watch list.

The reason is simple.

These are leveraged entities.

They themselves have borrowed money and their customers too are borrowers.

Any borrowing or lending relationship is subject to serious consequences, if that relationship is not managed properly.

I don't want to get into a game where, it's difficult for me to figure out the quality of the borrower.

Moreover, the quality of the borrower can be great at a given point in time.

However, it can be terrible in some future point in time.

I don't want to take that risk.

I am a conservative investor.

I like to keep it safe and simple.

Rejecting companies is not rocket science.

It's easy to spot them, if you are clear about what you are looking for.


Rohit Musale, CFA

4 January 2023


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