"Rule No.1: Never lose money. Rule No.2: Never forget rule No.1." - Warren Buffett

Every Christmas since 2013 during the Christmas time, I share this topic on how to avoid losing big in the stock market. I almost forgot doing so this year.

As the stock market is filled with uncertainties, losing is a common thing if you dabble with it. Those investors/traders who are in the market this year would have understood very well. Here, we are talking about trying to avoid losing big.

Why is it important to avoid losing big in the stock market?

For simplicity, let us assume we have a portfolio of two stocks equally weighted, one good stock and one bad stock. Over a period of say 5 years we made a profit of 200% for the good stock but we lose 100% on the bad stock. Our portfolio return would be 50% (50%*200% - 50%*100%). However, if we have two good stocks, one makes 150% and the other 50%. Our portfolio return would be 100%, twice better than the first one. That is because although the positive return is lower for each stock, we have no loser, and hence the average return is higher.

What are some of the things to look for to guard against risks and minimize or avoid the downside?

Let us relook at some of the hot Bursa stocks which some people in i3 forums asked me way back in 2013 when I posted a few threads on value investing.

Appended below is the link when I first wrote about this topic 5 years ago.

https://klse.i3investor.com/blogs/kcchongnz/45373.jsp

Return of portfolio and individual stocks

Figure 1 in the Appendix shows the return of the individual stocks in the portfolio.

When I made my first review of the return of the nine stocks in the portfolio, it was at an average loss of 24% in less than a year as shown in Table 1 in the Appendix. All stocks experienced negative return except for Ivory Property, while we know after GE13, most stocks have gone up in prices.

As at to-date, the portfolio has lost an average whopping 57% for the 6 years period, while the broad KLSE Index has gone up by about 20%. If not for the positive gain of 51% by Guan Chong, which obviously I was wrong, the average loss would be more than 80%. Almost all the stocks incurred heavy losses up to more than 80%. Two stocks, CSL and MPCorp had in fact gone into ICU and would likely be delisted soon.

What are the characteristics of these stocks which have fallen so much in prices from their peaks? We will deliberate them based on the fundamental, or value investing approach.

Characteristics of lemons

Characteristic 1: Hypes, rumours, fads and hopes

Those stocks are hypes, rumours and fades, and investing in them is based on hope. Many of those stocks were touted by the interested parties as pumped and dumped candidates.

Investing in Hibiscus was with the hope of the opportunity to strike oil big. Hibiscus share price was chased up by 80% to RM2.70 in just four months from August to December 2013 just because of rumours that when or when the drilling machine would reach the destination, and when it started drilling, as if oil would definitely ooze out as soon as the drill rig is lowered. Its share price just jumped because they were given some licenses to explore oil in some countries. Many retail punters were spilling blood everywhere as its share price dropped below 20 sen not too long ago. Of course, those who have bought it at less than 20 sen not too long ago would have also made a fortune.

Its fortune, however, appears to have changed with some good acquisitions at good prices when the oil price was low in 2015-16. It is still yet too early to tell if indeed its fortune has turned for the better.

Investing in Smartrack and Asia Media Group are also based on hope, hypes, rumours and distorted positive feelings; Smartag has been hoping that with their political connection, the Royal Customs Department would give them the lucrative contracts of RFID tracking the containers which eventually fell through. Asia Media has been hyping that its advertising in trains, LRT and buses would earn them extra-ordinary profits, which eventually did not materialize.

MP Corp is another company which investors live with hope; hope that the management sells their land, or their building which they valued the same high value as the neighbouring one which was transacted, and distribute the cash to them.

Think twice or even 10 times the next time anybody touting you to buy his stocks.

Characteristic 2: High growth, even extremely high growth

Everything equals, a high growth company is worth much more than a slow-growth or no-growth company. But bear in mind, the “growth” we are talking about is an expectation, not an outcome. In investing, the chance of outcome not meeting expectation is much higher than you think. And there is this thing as quality growth, and value destroying growth.

Many of those lemons listed above were high growth stocks at those times.

KNM’s growth for the last ten years prior to 2013 outpaced Microsoft, an international conglomerate. KNM’s was the darling of the market during the mid-1990s. It had big plans; foraying and making its foot prints all over the world with big acquisitions (and lose big money). Its revenue grew by 30 folds from less than RM65m in 2003 to a RM2 billion revenue company in 2013 with a CAGR of 41%! KNM’s share price has dropped by 84% from 45.5 sen then to just 7.5 sen now.

LonBis’s growth is also very high. Its revenue grew by 5 times since 10 years ago from RM82m to RM403m as at 30^th June 2015.

Others were not with high growth in the past but the “hope for high growth” in the future.

Characteristic 3: Low return on capital

Alas, the growth of these companies above were such a poor-quality growth with the return on capital way below their costs. Can you imagine you borrow RM100m at 5% interest rate to grow your business, but it only return 2% on the capital employed? Worse still, the return on capital was in a clear deteriorating manner.

London Biscuit came out as Champion here. This also applies to KNM, GCB (at that time), Ivory. Others had no return to talk about as they incurred losses.

Think like a businessman when investing; the return of your capital must justify its costs.

Characteristic 4: Poor cash flows

Besides GCB which has negative FCF every year since 8 years ago, London Biscuits and KNM behave exactly the same, all with poor cash flows from operations (CFFO) as well as free cash flows (FCF).

Huge amounts of inventories and receivables build up way above the increase in revenue were common phenomena of these companies.

These companies, especially London Biscuits, also spent huge amount of money in purchasing property, plant and equipment, without yielding any positive results, no increase in profit or cash flow, and yet deteriorating ROE, a value destroying act.

Learn from our former Prime Minister,

Characteristic 5: Poor quality balance sheet

It is clear that the balance sheet has to be deteriorating with persistent negative cash flows and free cash flows.

• Where can they get money to pay down debt without FCF?
• Where to get money to pay dividend without FCF?
• How to keep its doors open for business if persistently without FCF?
• Where to find money to do investing without FCF?

You can see their debts keep on increasing unabated to the extent of the high risk of bankruptcy with high debt-to-equity ratio, below unity current and quick ratio, and negative cash flow coverage. This is despite that they have been putting out their hands to ask shareholders to give more and more money in rights issues and “free” warrant issues until the share capital increases in huge amount.

These companies may have low price-to-book value of below 0.5. However, the quality of the assets, mostly in receivables, property, plant and equipment, tax assets, and intangible assets which when liquidated, are worth little or even nothing at all.

A company with heavy debt without the cash flows to service it is precarious and subject to bankruptcy risks. When a financial crisis comes, few of them can survive.

Few shareholders are willing to continue pouring money into a black hole. Recently, Jaks has shown that when the major shareholders just dumped his huge amount of stocks to avoid coming out with more money.

Characteristic 6: The red chip

The Chinese listed companies are notorious for their questionable financial account. Chines Stationery Limited, CSL’s annual report shows they are making tons of money with plenty of cash flows and cash in bank, a few times higher than its market capitalization. And yet the major shareholders dumped the shares, millions of them at a fraction of the cash per share in hand.

CSL is now in ICU now with no chance at all for shareholders to recover any money.

Xingguan, any similarity?

Characteristic 7: A lot of corporate exercises

KNM has made numerous corporate exercises; bonus issues, right issues, “free” warrants, share split, share consolidation after split, share value reduction etc. Its major shareholder even talked numerous times about taking it private because of its grossly “undervaluation”.

London Biscuits follows suit. It has numerous rights issues, private placements, and “free” warrants too until its share capital increased by many folds. It never loses out in this respect.

It was worse for Asia Media; bonus, rights, share split and consolidation.

I have also written about the “fantastic” corporate exercises of EAH and Vivocom. Their share prices have diminished to a small fraction of their previous prices now.

Characteristic 8: Favorites of analysts’ coverage

I received a recommendation from a fund manager and professional analyst to buy KNM at 57 sen on August 3 2015 as below. Oh my God, haven’t we gone through that before many times in the 1990s?

“Dear Investor

With legacy issues resolved, KNM is now on a stronger footing to bid for bigger projects. We are sanguine on KNM's plan to go big into renewable energy where the recurring earnings have better visibility. KNM is currently trading at FY16 PER of 7.7x, at 41% discount to average Malaysia O&G PER of 13x. KNM share price has retraced to a bargain hunting level. Hence, we have a Trading Buy call.”

I also read and commented on this “Irresistible bite” here regarding a rosy report from the investment bank on London Biscuits:

http://klse.i3investor.com/blogs/kcchongnz/60180.jsp

Asia Media also had many favourable analysts’ reports some years ago when it was carrying some corporate exercises.

A couple of years ago, Vivocom was a favorite stocks promoted by investment bankers.

Investors lost their pants following those buy recommendations.

Characteristic 9: Seemingly Low Market Valuation

London Biscuits, KNM, GCB, KNM and Ivory Properties have always been traded with low single-digit PE ratio. The PE ratio of CSL was even more ridiculous at 2 or 3.

The rest of the stocks return “NA” when you check their PE ratios, as they have negative earnings most of the time.

This low P/E or P/B ratios only can deceive naïve investors, or those who don’t even bother to examine the financial statements, thinking that they are cheap. Smart investors and institutional investors will know the poor quality of the earnings and the poor quality of assets and avoid them.

Characteristic 10: High volatility

Many of those hot stocks are volatile in their share prices as insiders, syndicates treat those individual investors as easy meat, frying the share price up and down, resulting many individual investors losing their hard-earned money.

Check the share price movement of KNM, London Biscuits, GCB, Hibiscus, AsiaMedia etc. and you will know what I mean.

Do you think the individual investors can beat these insiders, manipulators and syndicates in this zero-sum game of speculating and gambling?

Conclusion

It is always not easy to predict if a company would do well in the future and that its share price would rise. If someone is so confident to tell you that his recommended stock is a sure and can’t miss thing, think twice, or even 10 times.

However, it is much easy to see if a company is likely not to do well. The evidences are all over the walls.  I seldom get wrong in this respect, may not be in the short-term, but often in the long-term.

If you hold any stocks with a combination of two to four of the above characteristics, you really have to ponder carefully, seriously.

For individual investors, it is best to take care of the downside first and let the upside takes care of itself. Guard yourself against risks. This should be the golden rule in investing.

“You don’t have to pee on an electric fence to learn not to do it.” - Charlie Munger

So, remember, if you can avoid heavy losses in investing, half your battle has already won. But you must know what to look for.

Merry Christmas and happy new year.

KC Chong

ckc14invest@gmail.com

Appendix

Table 1: Return of Lemon as at 31^st December 2018