3 investment red flags to avoid

There are many things to look for when considering what’s good about a business. However, you don’t need to do extraordinary analysis to create wonderful returns over the long-term. Sometimes you just need to avoid picking the bad apples to do better than average.

I’m not just talking about businesses that slightly underperform. There are some shares that have delivered enormous wealth destruction. Here are three red flags to help you avoid that problem:

Excessive debt

A business doesn’t go bust if it has zero debt on the balance sheet. Most individual businesses and economies as a whole have gotten into a heap of trouble because they carried too much debt. It can lead to busts or even bankruptcy.

Would Dick Smith Electronics or Toys R Us have gone out of business if they had no debt? I doubt it.

Would Slater & Gordon Limited (ASX: SGH), Retail Food Group Limited (ASX: RFG) or Vocus Group Ltd (ASX: VOC) have been hurt as hard if their debts were more manageable?

I’m not suggesting you only choose businesses that have no debt, or a net cash position, but you have to be wary of excessive debt – particularly in this period where interest rates are now rising.

Flat or declining revenue

It’s so easy for nearly all shares to be long-term winners when you add population growth and inflation into the mix. For example if a business maintains the same 10% market share and just managed to increase its price by inflation, then 2% population growth could result in selling to tens of thousands more people the following year and it would also achieve 2% more revenue from every one of its customers thanks to inflation.

It’s a worrying sign when a business isn’t increasing its revenue faster than inflation. That could suggest the company is losing market share and/or not able to increase its prices. Both are worrying signs for the long-term success of the company. For example, the Telstra Corporation Ltd (ASX: TLS) consumer and small business segment, the main segment, only increased its revenue by 0.3% in the half-year result. This is worrying.

Non-aligned management

When you can identify what the incentives are for someone, you can easily see what they will try to achieve. If management are rewarded for revenue growth and not earnings per share (EPS) growth or total shareholder returns then revenue is what they will focus on. They may go on an acquisition frenzy to grow revenue, with little regard to the per-share statistics, even if the overall market capitalisation of the business goes up due to more shares being issued.

It’s quite hard to get a handle on the quality of management, it’s not like every single shareholder can ring them up for a chat. Plus, the performance of the business is not just down to one person, or a small team of management, it’s the strength of the entire business.

But, you can easily find management’s remuneration terms and scrutinise their short-term and long-term incentives.

Foolish takeaway

If you can keep these three things in mind then you’re much more likely to avoid any damaging blow-ups for your portfolio.

Three shares that have created great returns and avoided blow-ups are these quality businesses that would likely be a perfect fit for your portfolio.

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Motley Fool contributor Tristan Harrison has no position in any of the stocks mentioned. The Motley Fool Australia owns shares of and has recommended Telstra Limited and Vocus Communications Limited. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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