I'm a big fan of using other fields of sciences in the investment process - history, psychology, anthropology and many other sciences can give you new ideas and test your old beliefs. In the book “Why most things fail”, Paul Ormerod links his economic models with models of biological evolution, Ormerod's book is hugely interesting and entertaining, and there is one statistic that got my full attention; of the 6 million American companies in the American Office for advocacy, on average 600.000 companies a year disappear, and its not only the small and medium sized companies that are affected. From the 100 biggest companies in the world in 1912 only 19 remained in the top 100 by 1995 (29 of the original 100 went bankrupt).

The extinction pattern is not steady. In one year only a small percentage of companies disappear, while in times of economic turmoil whole groups of companies disappear, for instance the dot.com companies from early 2000 and several financial giants in the ongoing banking crisis.

Extinction has many causes; new technologies make old technologies obsolete, a financial crisis forces the less financially robust to go bankrupt or simple bad management can all lead to the downfall of a company. The problem for the investor is that it is difficult to predict factors that might lead to extinction.

New technologies are introduced on a daily basis, some might be ground breaking while others have little to no effect. The recent discovery of Bisin, a naturally occuring lantibiotic, which prevents the forming of bacteria and therefore decay of fresh food might lead to a fundamental change of the economy.

I used the example of Bisin to illustrate that, not only high tech companies might be affected by technological breakthroughs. Investors might argue that food retailers are safe investments because people always have to eat. In most cases this is true, but what if your vegetables, meat or milk can be kept fresh for 2 years? What would happen then? On one hand we have the food retailers with supermarket on every corner, on the other hand we have a company like Amazon specialised in the delivery of non-perishable goods. A simple article in the scientific section of a newspaper can be the foreteller of the disappearance of a complete sector.

In reality things wouldn't go that fast. Bisin might have serious side effects and even if it is completely safe it would take a long time before the general public is convinced it is safe. Other exciton factors are a lot more instant, in my article “Don't get burned by the Sun King” I describe the effects of fraudulent behaviour by the senior management. The prudent investor should be aware that bad management is more likely in a sector that is booming. The less scrupulous CEO might be tempted to massage his or her accounts if all his competitors are making huge profits and his/her companies profit is lacking.

The only thing that can protect an investor is diversification. Never assume that a certain company is immune to extinction. Many investors are tempted to concentrate their money in fast growing companies in hot sectors. This sector might however be part of the next wave of extinction. The prudent investor should therefore diversify his money by investing in different sectors. If the size of his portfolio is sufficient, diversify within the sectors as well. Have a look at the geographical spread of the turnover and try to invest in companies that are active in different regions. Be aware that extinction can be more or less instant and unpredictable. Keep your eye on hot sectors and/or sectors with imminent technological breakthroughs. It might be a good idea to take some profit and use this to diversify your portfolio further.

It is easy to be swayed by a positive story told by a charismatic CEO. His/her company will be an absolute success, turnover will increase significantly while costs will be cut. The bottom line will blossom making his/her company an absolute winner over the coming years. The CEO will emphasize the positives and downplay the negatives.

This might or might not be true. The CEO and the rest of the board might discuss the state of the company a little bit more frankly within the confidence of a board room. If an investor could turn into a fly on the wall he might be able to eavesdrop a board meeting and listen to the board discussing all the positives and negatives . However as far as I know it is not possible to turn into a fly and other methods of eavesdropping, like wire tapping, are illegal. This leaves the investor with a problem, how can we trust the words of the board? Do they really believe in the strategy? Believe it enough to risk their own money?

In my years as an informal investo,r I learned that it is not that relevant to listen to what the CEO has to say. They are trying to sell something to you. It is only natural that they will be positive. Rather then trying to be an amateur psychologist and guessing how truthful the statements were,  I would look at what the CEO did. Was he/she willing to risk a significant amount of his own money? Was the starting salary a bare minimum to make sure that the company had as much funds as possible to grow? If the answers were negative, and there wasn't a very good explanation, I would pass up on the opportunity no matter how good the story was.

The same applies to quoted companies. Wouldn't it be obvious for the board to buy more of the companies shares if they were convinced that the future was bright? If on a recent presentation the board told the investment community how good the prospects were, and the investors more or less ignored the statements keeping the shares attractively priced, making it a good opportunity for both the company and the board to buy some stock in the company. This insider trading(*) is a powerful signal that the people in the know,  think you should buy these shares.

Research on the subjects of insider trading reveal the existence of excess return using public available information. In the paper “Contrarian Investment, New Share Issues and Repurchases” Bali, Demirtas and Hovakimian explore the effect of the issue and purchase of company stock by the company itself. It turns out that companies that purchase their own shares do significantly better in the following years compare to companies that issue new shares. The effect is most pronounced in Value Stock but also applies for Growth Stock.

The dealings of the management are just as significant, there are several papers dealing with this subject. One I would like to highlight is “The Profitability of Insider Trades in the Dutch Stock Market”  former colleague, R. Doeswijk, is a co-author. In this paper Biesta, Doeswijk and Donker study the predictive power of stock dealings by (non)- executive directors. Even corrected for value/growth effects they find the can achieve a higher return mirroring the share dealings of the insiders.

Using the public available information on insider trading is a valuable tool. Say you researched a company and like what you see, checking the share dealings of the management might be a good idea to see if they share your enthusiasm. On the other hand if the company and it's management is selling their shares it might be a good time to say goodbye to your shares as well.

* Insider trading is defined as trading of the companies stock, bonds or other forms of securities by individuals with potential access to non-public information about the company. In most counties there is strict regulation to prevent abuse of insider knowledge. A CEO buying his own companies stock the day before a take over bid has a lot of explaining to do.