The contagion bias describes how we are incapable of ignoring the connection we feel to certain items – be they from long ago or only indirectly related (as with the photos).
When we have faced some events in life and if anything related to those events comes Infront of us then we cannot ignore it and cannot stop reacting. Connection in our minds comes alive and we start getting disturbed.
One person has cheated on me a long back but when I met a family member the person, I cannot ignore the connection between both the person and I became rude in conversation.
If we have made an investment in any stock and have incurred a loss, then that sector, management, valuation, or anything will stay in our mind. When we meet up in a similar situation then our mind again lives that connection that impacts our thinking and decision making.
We heard that companies that originated from particular cities have a higher probability of wealth destruction. When any investment opportunity comes in front of us from similar cities then we used to ignore that opportunity without doing proper research on it.
So that we need to prepare a checklist for every stock, every time. If a stock is passing that checklist, then we must invest in it rather than getting biased from any past events.
When we have decided to make an investment then we need to perform an analysis work so that we do not be stuck with the wrong investment avenues or at the wrong time. For making an analysis, we must need to focus on a few points.
Profitability – how the company performs? Return on invested capital, margins, growth in sales-profits, earning per book value, etc. If the profitability of the company gets hampered then we need to check whether it is permanent or temporary.
Stability – earning of the company decline in any of the years from the past ten years? Do the earnings of the company get fluctuations? Does a company involve in a seasonal or cyclical business?
Growth – companies with higher growth command for the high multiples and lower growth with low multiples. The growth of the company can help us to grow our wealth also. The growth provides an opportunity for the company to use capital appropriately.
Financial position – liquidity ratio, the position of a balance sheet, debt, preference share, etc. Tree does not grow in the sky. If financials are not strong then the business will not be surviving for a longer period. So that we need to put emphasis on the financial. How does a company utilizing assets? Company is capital intensive or asset-light? Working capital intensive or negative cash conversion cycle?
Also, we need to check what the company is doing with the capital generated. What is the capital allocation decisions of the management? Long dividend track record, increment into the dividend, buyback, buyback at higher than intrinsic value or lower than intrinsic value and if a company requires fund for growth then reinvest profits for growth rather pay dividend or buyback.
Disclosure – Companies mentioned in the article are just for an example & educational purpose. It is not a buy/sell/ hold recommendation.
Many of the companies having smart enough management who know that analysts and the majority of investors focus on the bottom line so that they also emphasize the boosts earning at any means. Manipulating earnings for the few years can reward them a better way by offloading their stakes. Thus, we require to study earnings quality by putting a huge emphasis.
I have a different series under the “Simple is Better” category which covers tricks to identify earning manipulation.
Management of companies can be hungry for getting recognition which makes them involved in the playing with the earnings. We should not focus on the short-term earnings or one year earning for deciding for investment purpose otherwise we can be stuck into the trap. We need to focus on the footnotes for understanding properly for onetime earnings. Whether such earning will be going to recurring or one time? We also can perform an adjustment to the one time earning and need to check that still stock available at cheaper multiple or not. Does the company involve the frequent selling off assets for boosting profits? Does Company has change revenue recognition policy, change other accounting policy? Does the Company involve accounting shenanigans? When things available at dirt cheap then first need to check it thoroughly that why such cheapness is available with the stock. Cheapness is attractive always but the reason behind cheapness is an important factor.
One of the exchanges
The company got other income due to stake sell into the subsidiary company which has boost earning by ~3x and due to such one-time earning P/E multiple has fallen drastically. And, this fallen P/E multiple misguide investors and attract them to make a mistake.
We have to remove the effect of one time gain in the normal business and need to take an average of the 10 year or entire cycle for elements temporary and extreme profitability effects.
One of the automobile company has a reverse of the provision made during a slowdown time
If businesses into the cyclical nature then it is advisable to take an average of past seven to ten years or a business cycle earning average for nullifying the effects of ups and downs into the earnings due to changes into the cycle. If we focus on the earning at the best cycle then we can attract to buy and end up with the losses or has to wait till the next good time of the cycle. Reversely, when we focus on the worst cycle then we avoid the opportunity and we end up with the opportunity miss.
Example of the cyclical company regarding buying at top of the cycle which resulted in losses and the bottom of the cycle resulted in a profit
We are habituated to buy at the lower P/E and sell at the higher P/E but the same is not applicable in the cyclical industry. We have to buy company during the bad cycle which has depressed earnings that shows higher P/E and need to sell during the good cycle which has good earning that has depressed P/E. So, if we buy at the lower P/E then we end up with losses though P/E will be increased. Also, higher-earning is temporary and as the cycle turns out then earnings will disappear.
We can start reading an annual report from the backside so that some facts which the company wants to hide in the last section which comes first to us. Always read footnotes, focus more on learning about financial reporting.
Disclosure – Companies mentioned in the article are just for an example & educational purpose. It is not a buy/sell/ hold recommendation.
In the previous article (SIB-16) of the same series, I have explained needs for checking a management quality. And also explained what if we invest in the company which has troublesome management. Now, I am going to explain how we can judge the management through accounting and protect our wealth.
Entire series of “Numbers tells you everything” is based on the books –
