Investing is generally considered an art where no single formula works for everyone. There are too many parameters to consider for an investment to become successful in the long term. However, there are some types of stocks which a skilled investor can completely avoid to increase the chances of the success of his/her portfolio. This article looks at 4 types of companies which a Long-Term Investor should avoid.
1. Circuit Stocks
Circuit stocks refers to stocks which do not freely trade in the stock market. Unlike most stocks which are traded freely and can be bought or sold at any time in the stock market, circuit stocks are stocks which get stuck in continuous Upper or Lower circuits leading to a pause in their trading.
- Upper Circuit – When a stock reaches its upper limit for the trading day and the price cannot move any higher until the next trading day. Stocks which are in the Upper Circuit cannot be bought due to the overwhelming number of buyers which led to the rapid rise in price. However, selling the stock at upper circuit is possible.
- Lower Circuit – When a stock reaches its lower limit for the trading and the price cannot move any lower until the next trading day. Stocks which are in the lower circuit cannot be sold due to the overwhelming number of sellers which led to the rapid fall in price. However, buying the stock at a lower circuit is possible.
Most stocks have a circuit limit of 5%, 10% or 20%. Circuit stocks get stuck in the upper or lower circuits frequently making them a must avoid for long-term investors. These stocks are typically small unknown companies which are moved by large investors for the sole purpose of trapping retail investors. A series of upper circuits is used to lure novice investors after which a barrage of lower circuits begins. Since, the stock cannot be sold on a lower circuit, investors are forced to hold onto these stocks for a long time leading to massive loss of capital.
Circuit stocks do not provide the fundamental requirement of an investor – the ability to freely exit the investment position!
2. Micro-Cap Companies
Micro-Cap companies typically refers to companies which have a market capitalization under ₹100 Crore. These are amongst the smallest companies which are listed in the stock market. Many investors get lured by the dreams of making big returns in micro-cap companies. However, these are the riskiest investments in the stock market & should be avoided by long-term investors. These companies have the highest probability of failing since their business model is not completely proven. These companies also typically have a high debt which makes them vulnerable to economic downfall. These companies also get the lowest valuation from experienced investors since they are yet to prove their trustworthiness to the stock market participants.
Such companies also receive the least amount of attention from the media which can make them easy targets for financial scams, frauds, leaks, etc. leading to the downfall of the company. The financial information (such as financial results, strategic decisions, investor presentations, etc.) are much less trustworthy as compared to large-cap companies due to limited regulatory oversight making them a high risk investment.
3. Low Promoter Holdings
Shareholding pattern is an important parameter for long-term investors to consider for making their investment decisions. A company which has low promoter shareholding should be an immediate red-flag for investors.
Promoters are generally the founders of the company or they are the people who are driving the business towards its success.
Consider the following shareholding pattern of a company.
Such a stock should not be considered a good investment by long-term investors because the promoters own a very small portion of the company. Promoters cannot drive the success of the business since they do not own a controlling stake in the company which increases the chances of the failure of the company. There are no strong buyers such as institutional investors, mutual funds, etc. who are invested in the company. These shareholders are generally much more stable as compared to retail investors because they invest in the company with a long-term vision.
Shareholding pattern for a fundamentally strong company typically looks as follows.
It can be seen that the controlling stake of the company (over 50% ownership) is with the promoters of the organization. Promoters are able to take the right decisions towards the growth of the company only if they have a large stake in the organization. Also, a stock which has good shareholding by institutional investors, mutual funds, etc. is much more stable since big institutions only invest in companies with a proven business model.
A company where the owner doesn’t have the ability to drive the future of the company is much less likely to succeed in the future.
4. Very high PE stocks
PE ratio is an important fundamental parameter to analyze a company which every investor should use.
P/E ratio = Price of the stock / Earning per stock
A company with a low P/E ratio is typically considered attractive & a company with a high P/E ratio is considered overvalued. However, this is not always the case. For more details, visit – Why do some companies trade at a high P/E multiple? Even though some companies with high PE ratio can still be a good investment, a long-term investor should typically refrain from companies which have extremely high PE ratio. Such companies have a very expensive valuation which can make them a risky investment. As Warren Buffet says – “It’s far better to buy a wonderful company at a fair price, than a fair company at a wonderful price”.
Companies with high PE ratio always have a risk of major correction which can be triggered by one bad financial result, one bad news about the company or even failing to meet the rising expectations of the investors. A stock which has already discounted the earnings of the company in the future has generally nowhere to go, except downwards.
Conclusion
A long-term investor should stay away from companies which circuit stocks, micro-cap companies, companies with low promoter shareholding & companies with very high PE ratio. There are over 5,000 listed companies in the Indian stock market which provides the investor ample opportunities to select good companies for investments. However, the final decision of investment depends upon the reader.
However, the final decision of investing depends entirely upon the reader!
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DISCLAIMER : I am not a financial advisor. I am not for or against any company which I have mentioned in this article. All the information provided here is for education purposes. Please consult a financial advisor before investing.
Contact me at investmentabshuru@gmail.com
- 4 Types of Stocks which Long-Term Investors should avoid! - May 6, 2023
- Why do some companies trade at a very low P/E multiple? - November 1, 2022
- Why most investors end up buying stocks at the wrong time? - October 26, 2022
