If you don’t understand it, don’t invest in it

It’s a fact: investments don’t always perform as well as investors expect.
 
However, as much research we as ordinary investors undertake, there’s always a chance that some unexpected turn of events will upset our plans and throw our cosy assumptions out of the window.
 
And the latest investors to learn that lesson — or perhaps more probably, learn it again — are investors in household and motor insurer Direct Line Group (LSE: DLG).

From hero to zero

On 11 January, the company announced that it was scrapping its plans to pay a final dividend for 2022. Given that many investors hold the share as a source of income, the news was quite a shock.

Note the terminology: not ‘trimming’ the dividend, or ‘reducing’ the dividend, but scrapping it altogether.

Why? Well, the decline in Direct Line’s fortunes seems to be rather a recent affair: the board spoke of a “challenging environment” in the fourth quarter.

And when the word ‘challenging’ is used in such communications — take it from me — it’s never a good sign. Especially for shareholders.

Ready. Aim. Foot. Fire!

First — and presumably foremost — there had been a “significant increase in claims”, said the board. This was due to the cold weather in December, as householders’ pipes burst. The cost of motor repair claims had also risen. And commercial property valuations had fallen.

Er, hang on. December’s weather wasn’t that cold, surely?
 
And shouldn’t an insurer of Direct Line’s scale have money put aside for a cold snap lasting a week or two? Likewise increases in the cost of motor repairs — which will surely be reflected in rising premiums, anyway? And was it really necessary to scrap the dividend due to falling property valuations?
 
Ah! Wait! All is clear: all of this has resulted “in a capital coverage that is now expected to be at the lower end of our risk appetite range”. In other words, the damage was seemingly material enough to significantly impact the balance sheet. Goodbye dividend, as the board attempts to shore up the business’s finances.
 
And goodbye shareholders, too. By 8:30am, the share price was down by almost 30% as shareholders delivered their verdict: cheerio, we’re off.
 
So, what can investors do to minimise the risk of suffering such missteps?

Dig into the summary data

First, minimise exposure to companies with opaque accounts. Financial businesses tend to be the worst offenders here, but they’re not the only ones. Banks, insurers, financial institutions of almost all shades: I don’t avoid them, to be sure, but I minimise my exposure to them — because I don’t fully understand the financial accounts.

The problem? They call for me to take too much on trust. And I don’t feel comfortable with that.
 
Second, look at the direction of travel. Many companies publish a page or so of key metrics in the first few pages of their annual reports, often with five-year histories: study these slavishly. (If you’re lucky, there might be a ten-year history at the back.)  And if there isn’t any five-year data, dig out a report from five years ago, and (ideally) those in between.
 
Ideally, you’re looking for a nicely rising progression — revenues, profits, earnings per share, dividends, cash flow, and so on. Of course, some things you like to see go down — debt, for instance. And then there are what are usually often coyly described as “alternative performance measures”, which are generally company-specific (or industry-specific) operating metrics.
 
Then dig out your compound growth calculation tool (Excel, say), and calculate a few annual growth percentages. Are profits rising more slowly than sales? Is dividend growth lagging profit growth? How quickly is debt rising (or falling)? What is happening to cash? And what can you glean from those “alternative performance measures”? (Quite a lot, usually.)

Keep it simple

Finally, just as I don’t like opaque accounts, I don’t like opaque business models, either.

What I like are simple and straightforward business models, hopefully denoting simple and straightforward businesses that — to quote famed investor Peter Lynch — any idiot can run.
 
(The full quote: Go for a business that any idiot can run ‑ because sooner or later, any idiot probably is going to run it.)
 
What business models do I like? Quite a few. Make things, sell them. (Manufacturing.) Buy things, sell them. (Retailing.) Own things, rent them out. (Infrastructure, REITs.) Dig things up, sell them. (Mining.) Own shares, pay me the dividends. (Investment Trusts.)
 
And there, in a nutshell, you have a fairly large chunk of my portfolio.
 
Boring, maybe. But readily understandable, yes.

Mea culpa

And finally, it’s true confession time: yes, I do own a very small chunk of Direct Line. A very small chunk. (671 shares, to be exact, worth £1,180 at the time of writing — and now down 46% on my purchase price.)

It was a tiny purchase. A flutter. A dabble, to stick my toe in the water and see if greater exposure helped me to like the business.

It didn’t — and it’s done nothing to persuade me that my fairly conservative approach to share selection is anything but sensible.

The post If you don’t understand it, don’t invest in it appeared first on The Motley Fool UK.

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Malcolm owns shares in Direct Line Group. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.