Value Investing: Differentiating Between Conviction Vs FoolishnessVW Staff
Via SG Investor
A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful
This phrase is one I believe resonates deeply amongst investors, especially value investors. It depicts the mindset of a great investor and how they should react when the stock market keeps breaking new highs or tanks. The point Buffett is driving at is that one does not get rich by buying into a high market or selling into a falling market. Instead, one gets rich through taking a contrarian approach, buying into market corrections and beaten-down markets.
The point of this article is not to stress on on this mindset, but rather Conviction vs Foolishness. As much as these phrases contains much wisdom, one must be mindful of the many caveats that comes with it. Being greedy when others are fearful is indeed the right mindset one should adopt when we see stock prices constantly dropping. However, to show conviction means we have near 100 percent faith in the company and financials. Not being able to trust the company or financials and trying to display ‘conviction’ is mere foolishness.
Sino Grandness Food Industry Group Limited (T4B.SI):
Many should be familiar with the recent scandal circling Sino Grandness Food Industry Group Limited. For those who don’t, essentially Sino Grandness have been accused of channel stuffing, over-inflating their sales figures. Within roughly a month, we see the share price of Sino Grandness tanking roughly 42.9%.
Quindell PLC (QPP.L):
Many would probably be unfamiliar with Quindell PLC (LON:QPP) given it being listed overseas on the London AIM. However, it once had an amazing growth story, a catalist being listed on the AIM and about to be listed on the FTSE. Furthermore, many institutional funds were invested alongside such as Fidelity. Once again, it was accused of fraud resulting in the share price dropping sharply 50% during mid April followed by a recent drop of another 79%. Cumulatively, during this whole period, the share price has dropped approximately 91.4%.
One who follows strictly by the phrase, showing convictions in his investments would probably have bought in more and averaged their buy price down. However, such conviction is it truly conviction or just plain foolishness? Many a times, I witness people averaging down their buy price when the share price takes a large plunge, thinking to themselves that they have accomplished the phrase ‘greedy when others are fearful’. When in fact they may just be further digging deeper into their grave.
How then can we differentiate companies we can trust versus those that we should be wary of?
Questions to ponder:
Financials. Are there any potential red flags amidst its financials?
- Ratio of Total Receivables to Revenue (Channel Stuffing?)
- Related Party Transactions (Tunneling?)
- 5 Year Earnings Trend vs Industry Trend (Does this company consistently keep growing revenues when all companies in the industry are showing otherwise)
- Margins (Comparing the margins of the company to peers to understand the average)
Management. Is management one that is transparent or dubious?
- Transparency of Annual Reports (Does the CEO only report positive announcements every year?)
- Board of Directors (Country of Origin)
- Chairman vs CEO positions managed by separate individuals (Problems of family-owned companies)
While this list is not exhaustive, however, it covers some of the key points when first assessing the company. Many a times when analysing companies we may take on very stringent and ultimately conclude that we have conducted an analysis that is very conservative and has reasonable margin of safety. However, one question we always miss would be is the cash really there? Perhaps only those that have been bitten would understand this constant fear of fraud companies, especially S-Chips. However, one needs to understand the fine line separating ‘Conviction’ and ‘Foolishness’.
At times, sacrificing your hand to protect your arm may just be a smarter choice.
Disclaimer: The authors have no vested interest in T4B.SI and QPP.L