We have talked over here about many headwinds like slow growth, inflation and European crisis. My prediction number one for this year is that though we had a good start this year, we will face similar or equal challenges what we did last year. Value investors should focus on the things that can impact value of any companies and growth prospects (in its value) while picking up few bargains.

The biggest challenge any investor faces today is to identify any rubbish within their portfolio. Once they do, it is in their interest to get rid off those investments before they damage further your returns.

Recently, after talking to few high net worth investors and institutions I have witnessed people throwing their towel completely from investing in equities after witnessing climatic events and are simply fed up with poor medium term performance and increased volatility.

Nifty 50 has given a return of 27% in last five years and BSE 200 has given returns of 24%. Nifty 50 and BSE 200 also contain rubbish stocks so it is no wonder index has given such pathetic returns. step one is to clean up the portfolio which are rated C1,C2, C3, C4, B3 and B4 and step two is to be ready to buy in quality stocks (A1, A2 and B1) when bargain exists.

This is just one of the many framework and scenario I am operating with and I wonder how long this heightened volatility and poor index performance will transpire. Will investors really exit from equities and will believe in all those advisors offering their own brand of ‘safe’, ‘secure’ and stable investments? On the one hand, I hope so. It would mean certain bargain.

Here is my warning to you all who are looking to give up investing in equities. The time to invest in shares and make good returns is precisely when everyone else isn’t.

The life time opportunity which comes very rare (maybe 2-4 times) to own quality stocks at very cheap price should not be swayed for 20-30% returns and expecting to buy them back when they fall down in future.

If price do fall further – and they could – you need to get ready and will need that extra cash to capitalise on that opportunity. It is not necessary that price will fall to previous lows that were experienced earlier, but the best framework to operate in such conditions is to hold your best buy and liquidate that asset which is not performing and invest them when opportunity emerges to buy quality stocks more.

Rule one: Don’t loose money

The key to slowly and successfully build a portfolio in equities is to avoid loosing money permanently. Sure, good companies will see their price swing but poor companies will see downswing more frequently.

So the easiest way to avoid loosing money is not to buy weak or expensive companies. I have avoided loosing money in my private fund by applying value investing rules that I shared with you all in my previous post.

I have seen many companies on a face value of growing revenues and earnings make large and expensive acquisitions and undertake different projects that are followed by write-downs in couple of years. Write-downs are an admission of a company that they paid too much for an Asset.

When too much is paid for acquisition, or the projects to grow businesses are undertaken, equities go up but profits do not and you can see that in the ratio that I have worked so hard to make popular, return on equity (ROE), is low.

If you look in the market you will find plenty of companies with lower returns compare to even what bank is offering on deposits which have much lower risk. Over time, if these resultant lower returns do not improve, it suggests the price company paid for acquisition was in upper circuit and business equity valuations should be questioned now. If you ask me for the examples of companies in such scenario where they are facing issues to sustain their returns then Reliance Industries and Bharti Airtel are few to name.

When return on equity is very low it suggests the business assets are overvalued on the Balance Sheet. That in turn suggests, the company has not amortised, written down or depreciated its assets fast enough. That means the past historical profits that company announced could be overstated.

These sorts of companies with low returns tend to have a very low- quality score (A3, A4, B3, B4, C1, C2, C3 and C4) by Value operations and also their performance is subdued.

If your portfolio has any shares with such characteristics then you could be at risk because these companies might be very expensive compare to its intrinsic values.

Time is not a friend of poor company. And companies that are rated by Value operations as C4 and C3 are best to avoid if you want best chance to avoid permanent losses. Take a look at the companies in your portfolio; have they issued lots of shares to make acquisition? Are they producing low and single digit returns on their equity? If the answer is yes then you might own ‘C’ Quality Company.

Cleaning up your portfolio not only lowers its risk but will produce cash that may just prove handy in coming months.

Now here is the offer from Value Operations, apart from NBFC and financial stocks, list down 5 companies of which you want to know the quality score in comments below and we will share them all together next week.