Investing is as much about not losing money as it is about making it. The cumulative nature of losses mean that any drawdowns in a stock of over 50% mean we need to achieve a 100% return just to get back to where we were.
Warren Buffett was exactly right when asked what his investing rules were: “Rule number one: don’t lose money. Rule number two: follow rule number one“.
Over the last few years, we have seen many stocks go under, such as Interserve, Carillion, and Thomas Cook Group, and the common denominator was that all three businesses were saddled with large amounts of debt.
Other reasons to avoid stocks are because of failing business models, or because they are overly reliant on external funding.
Too many problems
One stock that I would avoid this year is Rolls Royce (LSE: RR). This stock has been struggling to turn itself around for years, and problems with the Trent 1000 engine are persisting. Already the company has said that it is likely there will be a £1.4bn exceptional charge to operating profit because of this issue, and there is no guarantee that the problem won’t become any worse.
The company also mentioned in its recent trading update announced that, despite improved trading, full-year operating profit and free cash flow would be towards the lower end of guidance ranges.
The company does expect to generate £1bn of free cash flow – so it’s not all bad news – but with the amount of stocks available to buy I will be avoiding this one.
Not enough certainty
The future of Sirius Minerals (LSE: SXX) is unclear, and until there is some clarity on both the cash position and financing of the polyhalite project, shareholders are going to be in the dark on the business’s future.
One thing that I have learned is that the chances of successfully avoiding large losses increase when you avoid stocks that could go bust. This is subjective, but while many private investors were tempted to buy stocks such as Thomas Cook and Carillion, I avoided them because I felt the equity was like purchasing a lottery ticket.
I generally avoid stocks that are leveraged with debt twice over (a net debt to equity ratio of two), because in the event of a stock going bust, bondholders always get the first scraps of a business. Very often, there is nothing left for shareholders.
That is what I believe could happen at Sirius Minerals. If the company can’t raise enough funds to continue as a going concern, then the stock may collapse and the project could be picked up for a few pennies in the pound from an external party – wiping shareholders out completely.
That said, if the company does get financing, then the investment case becomes a different story.
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Michael Taylor does not have a position in any of the shares 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.