Stock Investment Tips: How to Identify the Right Stock and Avoid Losing Money
Here are some ways to identify the right stock and avoid the bad.
Stay away from “capital destroyers”
The group of stocks that are most likely to lose money are highly leveraged companies, that is, companies with heavily leveraged balance sheets. These are the companies most vulnerable to external or internal events. These companies can be described as destroyers of capital. Destroyers of capital would typically have loss-making business operations or negative cash flows and increasing significant debt.
Also Read: How To Reduce Your Portfolio Volatility
During bull markets, the stock prices of these companies may rise. In fact, the stock prices of leveraged companies rise the fastest under favorable circumstances. As stock prices rise, accounts from various sell-side analysts, buy-side fund managers, media and other financial influencers could highlight the ‘big opportunities’ the company has ahead, and even predict higher prices.
At such times, the typical investor would be attracted to buying such stocks. These stocks can even generate very high returns in a short time during the highs of a bull market. However, one should stay away from these companies. Otherwise, bad lessons will be learned when such a bad strategy pays off.
How to identify the “destroyers of capital”?
Learn how to search for it on one of the online financial portals and check if the leverage is high.
You can check the following which are readily available on most portals:
If the business is for-profit and has zero or low debt, or is even rich in cash, then the business is not a capital destroyer.
Follow the trend of the last 5 years
Once you have familiarized yourself with the ratios above, you can start looking at the trend over the past 5 years or so. This will protect you from businesses that are cyclical and show profits only for this year, but have been in deficit in previous years.
Check EPS, debt ratio:
Companies with a low debt ratio in recent years are much stronger than companies which had a high debt ratio but only recently paid off their debts. Once you’ve internalized the habit of researching EPS and debt ratio whenever you hear about a company as a possible investment, you’re probably ahead of 80% of investors. This habit alone will increase your confidence and knowledge.
A portfolio without any capital destructors i.e. highly leveraged companies is likely to be a much safer portfolio than any random portfolio or even the market portfolio. Of course, other risks may still exist but we will cover them in future articles.
Never allocate more than 5% on a share:
Remember to never allocate more than 3-5% of your planned share allocation to a single share. This means having around 20 to 30 stocks in your portfolio. Portfolio design will also be covered in future articles, along with an understanding of how to improve returns or generate alpha.
(The author is CEO and Chief Investment Strategist, OmniScience Capital)