A 60-second test to avoid disaster stocks

We all have different skill sets, the important thing is knowing when you're reaching your boundaries.

If a stock shows up on your radar and, in that first 30 seconds, you aren’t certain how the industry works and what variables determine the company’s profitability, then it’s probably outside of your circle of competence ... or, at least, your existing circle of competence.

Complex businesses and industries can sometimes make great investments because fewer investors tend to be looking at them. If you’re happy to do the extra research to deeply understand how a new business works, that’s great. If you want a 60-second filter, though, avoid complexity.

That four-letter word                              

Extreme leverage can get even the strongest businesses into trouble. For most companies, the ideal amount of debt is zero. When operating conditions and revenues are able to change quickly, as in cyclical industries, debt can swiftly turn profits into losses, particularly for businesses with large fixed costs.

Worse, a company may be unable to meet repayments or it may breach loan covenants, which could lead to trouble refinancing or even bankruptcy. Shareholders can be completely wiped out if their company has more debt than assets.

For any stock you’re interested in, look at the company’s balance sheet before making an investment. It may take just 30 seconds to know this company isn’t right for you. If the “borrowings” number is larger than operating earnings or equity, you should think carefully about your next steps.

Some stable, regulated businesses can handle a large amount of debt, such as infrastructure assets, but even then, there are risks. Check when the debt is due for renewal, which you will find in the notes to the financial statements. An even spread of long-dated debt maturities is better than it all coming due in one year. And the less debt, the better.

Figuring out whether a stock is undervalued or not can’t be achieved in under 60 seconds, no matter what your filter. No amount of screening can replace a deep dive into a company’s business fundamentals like its competitive position, profitability, supplier and customer relationships, or growth outlook. Avoiding complex and highly leveraged companies won’t guarantee success, but this 60-second health check means you’re more likely to avoid the next disaster-in-waiting. 

To find out more about InvestSMART, visit their website.

Graham Witcomb is a senior analyst at InvestSMART (under AFSL 282288). This article contains general investment advice only. It has been prepared without having regarded to or taking into account any particular investor’s objectives, financial situation and/or needs. All investors should therefore consider the appropriateness of the advice, in light of their own objectives, financial situation and/or needs, before acting on the advice. This article does not reflect the views of CommSec. The article was originally published on 13 March 2019.