Sometimes it’s not so easy to spot trouble in a company because the first thing we notice about a share is all the good things, such as a tempting valuation, a juicy dividend yield or impressive rates of growth in earnings.
But it pays to put your sceptical hat on when evaluating stocks and look beneath the attractions to make sure these three hidden pitfalls aren’t present. Ferret them out, and you could save yourself a fortune!
The directors and managers of a business don’t always perform well. Sometimes they try their hardest but just aren’t much good at it. Sometimes they are less than honest individuals and are working to a hidden agenda.
Warning signs can include excessive pay, easily achieved incentive schemes, related party transactions and frequent restructuring. If a firm is always fighting fires and trying new ways to make the business work out well, it makes me question the directors’ judgement in the first place. I’d also look at the history with regard to acquisitions. Have they added value or destroyed it? And is the boardroom stable or are the directors being frequently replaced?
Given that we need to trust management to run, expand and optimise a business while we hold its shares, finding one with an effective management team is essential for a decent investment outcome.
Business models that don’t work
It’s surprisingly common to find businesses on the stock market that just don’t work. You can pin this one down by looking at the numbers. If you see a record of volatile profits, low profit margins, and poor returns on equity or capital employed, you could be dealing with a poor business model. Worse still, shrinking revenues, periods of loss-making and poor cash flow are all things that scream “avoid!”
Broken balance sheets
A weak balance sheet will have the potential to pull the rug from under a company no matter how well it seems to be performing operationally. And your investment could go down with it. Look out for high levels of debt, pension obligations, leases and a big pile of unpaid creditors.
But not all debt is a bad thing. Sometimes it makes sense for a business, although the key is moderation, I reckon.
Buying the shares of a company that has a high debt load is a bit like buying the shares of a firm that doesn’t have any debt with money we’ve borrowed ourselves. The upside is juiced up when things go well and the downside is exaggerated when things go poorly!
I reckon one of the best moves you can make in your quest to make a million in the stock market is to avoid big mistakes. And focusing on the potential for finding these three toxic conditions could help you do that in 2020 and beyond.
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Kevin Godbold has no position in any share mentioned. 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.