3 things I look to avoid when buying ASX shares

Staying away from the losers could help my returns.

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ASX shares can generate wealth-building returns. But not every investment is going to turn out well, so I look to avoid certain factors.

The ASX share market is made up of a combination of winners and losers. Thankfully, the worst an investment can do is drop 100%, whereas great companies can generate returns of 200%, 500%, or even more, over time.

No one knows what future returns are going to be, but if we can avoid the big losses then overall returns could benefit. These are three things I usually avoid in choosing which shares to invest in:

Strong competition

Companies in industries where there is significant competition can see their returns erode over time if competitors are willing to make smaller returns in a bid to capture market share.

Just look at what has happened to ASX bank shares in the last few years with the decline of their net interest margins (NIMs) compared to the 2010s. That's why I'm not interested in buying banks like Commonwealth Bank of Australia (ASX: CBA), Bank of Queensland Ltd (ASX: BOQ), or ANZ Group Holdings Ltd (ASX: ANZ).

Of course, some businesses may have competitive advantages that enable them to outperform their competition and stay ahead of the game. A few years ago, the telecommunications space was extremely competitive but after a series of acquisitions, the industry is seeing rising prices and stronger average revenue per user (ARPU).

I'll also point out that some markets are so big that all — or most — of the players can succeed. But, for a product like a loan, that can be offered by any qualified business.

Regulation

I believe regulation is important for some sectors to ensure the appropriate levels of health and safety or appropriate levels of price increases.

However, I think it's worthwhile to keep in mind regulation may also limit the possible profit growth a company can achieve. Steady income growth is key in ensuring shareholder returns in the form of dividends and is the basis for securing ongoing passive income.

There's also a danger regulations could increase, which may reduce the possible returns of a company for the foreseeable future.

It's not all downside though. Regulation can also provide protection against potential competitors as a barrier to entry.

Limited growth runway for the ASX share

Ideally, I'm looking for a company that can grow its earnings significantly over the long term. Investors usually value a business on its profit, so profit growth can lead to good share price growth over the years.

The earlier we can identify that growth runway, the better.

For example, McDonald's has been a great long-term investment. It has reached 40,000 global locations and achieved share price growth of more than 10,000% since December 1983. However, it gets increasingly difficult to double in size as time goes on. Growing from 1,000 to 2,000 locations is a lot easier than growing from 20,000 to 40,000.

McDonald's can't keep adding locations at the rate it has, so I don't think shareholder returns will be as strong from here.

However, there may be some ASX shares that still have plenty of growth ahead of them, which is what I'm trying to find for my portfolio.

Motley Fool contributor Tristan Harrison has no position in any of the stocks mentioned. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. 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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