When looking to buy a company that you want to add to your portfolio, there are several things to look for. There are also several things to beware.
I believe that any of the following red flags — signs of a bad stock investment — are sufficient cause to pass on a specific company.
Major debt
A large amount of debt is not a good thing. When a company has too much debt, especially long-term debt, that company is more than likely in above its head and could potentially never recover.
This can be defined as debt equaling more than a couple of years of free cash flow (FCF).
When a company is experiencing this kind of debt, they can use it as an excuse to file for bankruptcy, which means investors lose everything while the company gets to restructure.
Bad management
This can be determined by looking at return on invested capital (ROIC).
If they have a good ROIC, that means they are using the money they are being lent wisely. This usually indicates that management is interested in looking out for their investors and not just their own interests.
ROIC should be at least 15%. Anything above that is even better.
If ROIC has been declining over time, that is usually a bad sign and you should beware investing your money in this company.
No moat
A “moat” is when a company has a durable competitive advantage over the other companies in its respective sector. Without a moat, other companies will be able to come in and steal market share or even wipe a company out completely.
Famously, Warren Buffett refers to Coca-Cola having a moat in its branding. “It’s the real thing” and so forth. Cola is just sugar water, yet Coke is known worldwide. The same thing could be said for Nike athletic shoes or Starbucks coffee. Shoes and coffee are commodity goods. Branding makes the difference and creates a protective moat.
No moat means no guarantee a company is a safe investment. Also, having a strong moat will help a company stay viable and strong during a recession or any kind of event that could potentially affect the stock market as a whole.
Complexity
Always try and buy companies that are easy to understand. It will make it much easier for you to evaluate and understand in the long-run if it’s an easy to understand company.
For example, it is probably much easier for most people to understand burritos than vaccines or microchips.
That is why I would invest in a company such as Chipotle (CMG) before a company like Moderna (MRNA) or Advanced Micro Devices (AMD).
Maybe you understand vaccines or microchips. If so, invest as you see fit. But most investors don’t. Stick with what you know and it’s hard to go wrong.
