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Business News/ Money / Personal Finance/  How can pre-mortem analysis improve your equity portfolio?
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How can pre-mortem analysis improve your equity portfolio?

The concept of conducting a premortem analysis, similar to Dr. Salunkhe's post-mortem examinations, involves considering potential failure points before making investment decisions. This approach allows investors to better understand and prepares them to react confidently in the face of setbacks.

The concept of conducting a 'premortem' analysis before investing in a business helps investors anticipate and address potential risks, leading to more informed and calculated investment decisions. (Pixabay)Premium
The concept of conducting a 'premortem' analysis before investing in a business helps investors anticipate and address potential risks, leading to more informed and calculated investment decisions. (Pixabay)

During my childhood, I used to watch CID, and out of all the characters, Dr. Salunkhe was my favourite. His ideas and theories seemed almost outrageous at first, but they often turned out to be the key to solving the case. It taught me that conducting a post-mortem examination held a wealth of answers or, at the very least, provided the ability to ask the right questions.

As an investor, I've learned that conducting a "premortem" analysis is crucial. In our context, "premortem" refers to assuming the failure or demise of an investment and examining all the plausible reasons prior to making the decision. Before committing to invest in a business, we thoroughly assess all the potential factors that could lead to regretting our investment. We anticipate and address these risks beforehand to make more informed and calculated investment decisions.

In our investment practice, we focus on examining idiosyncratic risks specific to the business. We deliberately avoid speculating on macroeconomic and geopolitical risks, as these factors are often difficult for individuals, including ourselves, to predict accurately. 

By conducting this exercise, we cultivate a habit of thoughtful consideration before making investment decisions. Following the adage popularised by Charlie Munger, "Invert always invert," we strive to understand the potential challenges a particular business might face. This approach helps us gain a comprehensive perspective and make more informed investment choices.

When analysing a manufacturing company that heavily relies on original equipment manufacturers (OEMs) outsourcing their consumer durable production, we would examine the potential impact of the production-linked incentive (PLI) scheme. 

We would engage in discussions and ponder over whether the introduction of this scheme would make in-house manufacturing economically enticing for brands and OEMs. In such a scenario, we would question how and why the outsourced manufacturer could still thrive.

In the context of analysing a car dealership company, we contemplate the potential adoption of the agency model, where direct invoicing by the auto manufacturer improves transparency and customer control. 

In this scenario, we question whether other brands would follow suit and how it would impact the dynamics with suppliers for dealerships. We also consider if dealerships would become more vulnerable to the influence of original equipment manufacturers (OEMs).

Engaging in this exercise offers two significant benefits to equity investors. Firstly, it fosters a more realistic and nuanced understanding of the business, enhancing the ability to accurately assess and price risks. This helps prevent overpaying for an asset. 

Additionally, it better prepares investors to handle risks. By exploring various plausible scenarios in advance, should the events discussed in the pre-mortem actually occur, investors can react swiftly yet confidently. They would have already debated whether the business can recover from setbacks and assessed the potential impact, enabling them to judge whether the impact is adequately reflected in the asset's price. “Invert, always Invert."

Harini Dedhia, Portfolio Manager and Head of Research, Tamohara

 

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Published: 18 Jul 2023, 02:38 PM IST
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