Better Investing Step 3: Avoid Red Flags

  Welcome to The Motley Fool’s ‘5 Steps to Better Investing’ series. With some time for reflection between Christmas and …

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Welcome to The Motley Fool’s ‘5 Steps to Better Investing’ series. With some time for reflection between Christmas and New Year, this is a good chance to review the year just gone, and prepare for the 12 months ahead.

So far, we covered Step 1, you don’t have to make it back the way you lose it, and Step 2, be patient.

Now we have our heads in the game, we can turn our gaze to the businesses themselves.

Step 3: Avoid Red Flags
There is much in investing that depends on the estimation of future prospects – sales, earnings, competition and economic conditions.

One way to shift the odds in your favour is to choose businesses with wide economic moats – sustainable competitive advantages that aren’t easily eroded, such as strong brands, strict regulation, entrenched store networks or high barriers to entry for potential competitors.

For other investors, choosing companies which are likely to benefit from future economic or social trends is another way of earning outsized returns.

Understand the risks
These types of decisions are positive ones – looking for features of companies which are likely to deliver long term share price appreciation.

Part of successful investing is not only identifying the positives, but also in uncovering the potential negatives – so-called ‘red flags’ – that can undermine even the biggest competitive advantage and the greatest growth story.

A couple of the reddest flags are below.

Debt
Warren Buffett has said:

‘Leverage is the only way a smart guy can go broke … You do smart things, you eventually get very rich. If you do smart things and use leverage and you do one wrong thing along the way, it could wipe you out, because anything times zero is zero.’

The same applies to businesses. If a company without debt has a short term hiccup, the market might punish the share price somewhat. If the problem truly is short term, the share price will recover over time, and the long term investor stands to be made whole.

If the company is carrying any significant debt, however, the situation can quickly become dire. As has become abundantly clear in the wake of the GFC, companies with debt exist effectively at the mercy of their lenders. With short-term rolling finance commitments, companies must go cap in hand to their lenders every few years to negotiate the extension of their financing arrangements.

As Centro and its brethren can attest, sometimes the banks become very reluctant to roll over matured finance. If the company can’t access other funds to pay off its lenders, there’s not much they can do but dance to the bankers’ tune.

Inventory
For a company that makes or sells products – yes, that’s most businesses – buying or manufacturing items for sale costs money and takes time. Those products held for sale – inventory – are often one of the largest costs for a business to bear.

When inventory grows faster than sales, investors should take careful note. When inventories grow at a greater rate than sales, one of two things is likely happening – either the purchasing department are buying too much of the wrong products or sales are deteriorating and the company is being stuck with too much stock… or both.

This risk is especially great for retailers, who typically operate on quite low margins. These low margins are the reason many retailers are successful – they keep prices low and that keeps customers coming back. However, such low margins leave little room for error – when sales drop or inventories grow, profits can very quickly come under threat. For fashion or fresh produce retailers, this recipe can lead to a costly stock write-off.

Management
Less quantifiable, but equally impactful, are the public actions of management. While we can’t easily see what happens inside a business on a day to day basis, the little information that is made public can be useful for investors.

Activities to be aware of include sudden management departures, either unexplained or ‘for personal reasons’. Key management personnel are also required to disclose changes in shareholdings in the company for which they work.

There are many reasons they may be selling stock in their own companies – tax and diversification being two of the more understandable reasons – but the presence of selling should at least give us pause for second thought.

Foolish take-away
Investing is inherently uncertain. If it was simple, we’d all be rich – or more accurately, the market would be perfectly efficient, and we’d all earn a return exactly equal to the profit growth of the companies listed on the ASX.

Experience and research clearly tells us that such a perfect market doesn’t exist. Instead, investors need to apply skill and judgement to identify companies which have attributes likely to lead to success. That endeavour usually focuses on the positives – the reasons a company can beat its competition.

None of the above risks are, of themselves, show stoppers, but each raises your investing risk.

Spending too much time on the positives – of what might go right – can blind us to the risks – of what might go wrong. As Warren Buffett says, anything times zero is zero. Understanding and avoiding the downside is one of the most important parts of successful investing.

Are you looking for quality stock ideas? Readers can click here to request a new free report titled The Motley Fool’s Top Stock For 2012.

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Scott Phillips is The Motley Fool’s feature columnist. The Motley Fool’s purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson

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