Spotting a diamond in the rough

Investing is like uncovering gems. How do you spot a diamond in the rough?

This was a question posted in investingnote, and got us thinking. Here are the few steps we’ve identified.

 

The surveying process

At this stage, investors are just as in the dark as everyone else. Looking through rock after rock, here is where acumen from business, fundamental or technical analysis can give an edge to investors. People with experience knows where to look for gems.

Stocks includes everything in the market. Hints such as new IPOs, companies announcing new contracts, buybacks, signs of a revival, low P/E, low P/B are areas frequently looked at.

Prices are low, and chances of success equally low. It’s almost the same as closing your eyes and picking a stock at random.

Chances of success (profiting)

Top end investor (Warren Buffett): 10%
Experienced investor (>10 years experience): 5%
Average investor: 0%

 

The harvesting process

At this stage, intensive research should be carried out on the potential gem. It’s hard, tough and dirty work.

When experts hold such rocks in their hand, it can further confirm their view on whether a diamond is hidden in its core. The level, proficiency and depth of research will distinctly separate the various tiers of investors.

Screening through reports, analysis and research will filter out companies that are potentially undervalued.

 

Chances of success (profiting)

Top end investor (Warren Buffett): 35%
Experienced investor (>10 years experience): 15%
Average investor: 5%

 

The breaking stage (“Diamonds” in the rough)

Here, the outer layer of stone and dirt is removed from the exterior to reveal the core. Whether or not there is something inside will be known at this stage.

High risk, high return is a suitable phrase for this stage.

Experienced businessman, insiders and analyst will be able to know a rough potential impact of the new breakthrough on the field, and estimate a price for such a discovery. Average investors tend to over/underestimate such impact and move according to market sentiments.

Stocks with  new breakthroughs, game changers for the industry falls into this category. Experienced investors and business man with an in depth understanding of the field can significantly increase their chances of success.

Undiscovered gems have low prices. Recently discovered gems are extremely pricey based on expected future profits, but chances of success remains to be seen. (Think AEM, excelpoint)

Chances of success (profiting)

Top end investor (Warren Buffett): 60%
Experienced investor (>10 years experience): 30%
Average investor: 10%

 

The polishing stage

You’ve got something, but is it a diamond? A company needs to stand the test of time to tell the true impact of its discovery. Improving sales figures year after year, taking good care of shareholders will prove that it’s a true diamond that will be able to shine for a long time.

Chances of success (profiting)

Top end investor (Warren Buffett): 75-80%
Experienced investor (>10 years experience): 50-60%
Average investor: 30%

 

To move between stages, a company has to do everything right. Outwitting competitors, remaining relevant, one needs not just a strong product/ service, but also a shrewd management to bring the company forward.

 

How to increase your chances of success?

To increase our chances of success, we must combine a margin of safety (from buying at a low price) with a strong company (a confirmed diamond). Buying at high prices reduces your chances of success.

The key to success, is not to purchase a “diamond” in the rough. Buying something that seems to be diamond, at a price for a diamond, without a confirmation whether it is really a diamond is a losing deal.

What we are aiming for, is low risk, high returns. A diamond that was somehow neglected by the market, due to down turn or a bad quarter. (Think DBS at $13)

Ironically, it is the average investors who usually seeks to buy at the stages before a diamond is confirmed. Warren Buffett only buys quality business that he can understand, and at a fair price. That’s the reason for his consistent success.

 

Oh by the way, if you use our full analysis to help in harvesting, this is what it looks like.

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About the author: Simple Investor SG