Every investor, regardless of size, has the same primary concern when investing in stocks: losing money. Here, we’ll examine several common ways investors lose money in the stock market and discuss precautions to take. You must adhere to one fundamental rule in order to prevent losses: Which stocks should you avoid?
Here are some ways to identify the right stock and avoid the wrong ones.
Stay Away from
The group of stocks which is most likely to lose money are of companies that are highly leveraged, meaning companies that have high debt on their balance sheets. These are the companies that are the most vulnerable to external or internal disasters. These companies can be labelled Capital Destroyers. The main characteristics of capital destroyers include loss-making activities, negative cash flows, and significant amounts of debt that are rising.
During the bull markets, the share price of these companies might go up. In fact, the share prices of leveraged companies go up the fastest under favourable circumstances. Stories about the “great opportunities” the company has ahead may be highlighted in narratives from different sell-side analysts, buy-side fund managers, media, and other financial influencers as the share prices rise, and they may even forecast higher prices.
At such times, the typical investor would be lured into buying such stock. At the peak of a bull market, such a stock may even generate extremely high returns quickly. However, one should stay away from such companies. Otherwise, wrong lessons will be learnt when such a wrong strategy makes money.
How to identify “Capital Destroyers”?
Find out how to look it up on any of the financial websites online, and see if the leverage is large.
You can check the following things which are easily available on most portals:
EPS > 0 (meaning that the company is profit-making)
Debt-equity ratio < 0.1 (meaning that the company has relatively low debt)
The corporation is not a Capital Destroyer if it is profitable, has no or little debt, or is even cash-rich.
Track Last 5 Years Trend
If you’re comfortable and familiar with the aforementioned ratios, you may start examining the trend over the previous five years or so. This will protect you from cyclical businesses that have made losses for numerous years in a row but are only seeing profits this year.
Check EPS, Debt-Equity Ratio:
Businesses with low debt-to-equity ratios over the past few years are significantly more resilient than those with high debt-to-equity ratios but recent debt repayment. You will be well ahead of 80% of investors if you develop the practise of checking the EPS and the debt-to-equity ratio whenever a company is mentioned as a potential investment. You will become more knowledgeable and confident by adopting this one habit.
As comparison to a random portfolio or even the market portfolio, a portfolio free of Capital Destroyers, or highly leveraged corporations, is likely to be significantly safer. Of course, there may still be more concerns, but we will discuss those in upcoming sections.
Never Allocate more than 5% on one stock:
Remember, never devote more than 3-5% of your targeted equity allocation to one one stock. This means holding roughly 20-30 equities in your portfolio. In subsequent parts, portfolio design as well as strategies to increase returns or produce alpha will be covered.