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Want to avoid investing in the next Thomas Cook? Follow these 3 rules

Speaking as an investor, there isn’t anything worse than seeing the value of a stock investment turn to zero. To reduce the likelihood of a wipeout, I’ve learned that there are three key things to look out for when investing in a stock.

Watch out for debt

High levels of debt can cripple the most innovative of businesses. A large debt pile usually means high interest costs, which eat into shareholder profits and have the potential to turn a profit into a loss.

Instead of cash being spent on capital investment and R&D, with the aim of improving future profitability, it is instead diverted toward costly debt repayments. In effect, this represents a transfer of wealth from stockholders to debtholders. Debts can easily spiral out of control, with high debts leading to higher borrowing rates, often forcing firms to borrow even more.

Companies such as Thomas Cook and Intu have shown just how dangerous debt can be.

When looking for a company to invest in, I’d pay close attention to net debt, gearing, and a company’s ability to pay debts due in the short term. If there are any red flags, I’d stay well clear.

Don’t overlook corporate governance

Corporate governance issues come in various guises from accounting scandals and fraud, to bribery and corruption. They have the potential to inflict deep financial and reputational damage, and at their very worst can pose existential threats to businesses. They lead – almost without exception – to lower share prices.

While it is harder to proactively avoid corporate governance issues, there are a few things to look out for. Take a look at the board composition: do the board members have good experience? Are the roles of CEO and chair split? Does the CEO have too much control?

In recent times, governance issues have affected the likes of Tesco, Patisserie Valerie, and Watchstone Group (formerly Quindel).

Cash is king

It’s no accident that two of the most famous business adages relate to cash flow. Cash really is king and the lifeblood of any business. This is especially true from an investment point of view, since when we invest in a stock, we are essentially investing in future cash flows.

If free cash flows are persistently negative, then the only ways for a company to stay liquid are by borrowing, raising additional equity, or selling assets. At best, all three of these methods have the potential to reduce shareholder returns. At worst, the result could be fatal, as shareholders in both Carillion and Interserve have found out.

When reading company financials, it’s tempting to focus solely on the profit and loss account, but it’s really important to dig a little deeper and look at the cash flow statement too.

Applying these principles should help to avoid Thomas Cook-esque wipeouts. But sometimes they are unavoidable. Of course, the simplest way to minimise the effect of a wipeout is to ensure investments are well diversified.

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Thomas Carr owns shares of Watchstone Group. The Motley Fool UK has recommended Tesco. 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.