Great investing is not complicated.
Don’t take it from me, but from legendary investors such as Warren Buffett, Philip Fisher, or Peter Lynch. They would tell you to simply invest in businesses for the long haul, based on track-record, fundamentals, and a consistent operating history.
If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes.” – Warren Buffett.
Yet, investors keep on being seduced by certain stocks for all the wrong reasons. They feel like a stock is cheap because it is undervalued based on XYZ or because the share price has recently fallen and “cannot go much lower.” With a small amount of due diligence, it would become apparent that the writing is on the wall and that they should stay away.
Most stocks can’t keep up with a diversified index. As explained recently in my article covering The Art Of Not Selling, in a study covering more than two decades of stock performance, 64% of stocks underperformed the Russell 3000 during their lifetime.
In short, most companies are not worth investing in. And finding ways to avoid the bottom 64% of stocks is just as important as finding the top 36%.
Staying away from losers is a powerful way to generate alpha. But, to do so, you have to identify the factors that should give you pause before you buy.
That’s why I want to cover today a series of 10 criteria that would make me instantly look away when I start reviewing the prospects of an investment.
Let’s review 10 very good reasons not to buy.
Source: App Economy Insights. In the chart: Blue Apron (APRN), GameStop (GME), Uber (UBER), Macy’s (M), GoPro (GPRO), Spotify (SPOT), General Electric (GE), Sears (OTCPK:SHLDQ). Apple (AAPL), saleforce.com (CRM), Shopify (SHOP), Visa (V), Etsy (ETSY), Amazon (AMZN).
1) Poor unit economics
You can create tremendous revenue growth if you sell one-dollar bills for 90 cents. But that won’t be necessarily the foundation of a sustainable business.
Unit economics is defined as the “direct revenues and costs associated with a particular business model and are specifically expressed on a per unit basis”.
Only by looking at a business at the unit level, you can see how profitable each transaction with each customer is. This usually includes:
- CAC (customer acquisition costs).
- LTV (life-time value of a customer) based on purchase value, frequency, and churn.
Churn is particularly important because it can get in the way of what looks like a successful business at first.
If (1) the current users are not generating enough value and (2) there is no credible path to improved profitability, then there is no point in acquiring more users. It’s common sense. You can’t offset bad unit economics with volume.
What really matters is to look into whether or not the underlying business of serving a customer is profitable.
To achieve this, companies need to have a product-market fit.
Uber and Lyft (LYFT) have been subsidizing their rides to drive revenue growth. They have been keeping their prices low for user acquisition, but they are losing money on every single ride in the process. It’s a form of growth hacking, but there is no way to know if the demand for rides would really exist at the price they really need to charge in order to have a sustainable business.
It’s important to note that not all losses are created equal. Some companies are losing money by design because they have a great visibility on their long-term returns.
Product/Content: A company like Netflix (NFLX) is spending heavily on content, which creates a front-loaded cash expense. This makes their free cash flow margins look terrible in the short term. But given that they are fueling their back catalog with more exclusive content over time, the company is poised to see tremendous returns over the long term thanks to limited variable costs and an increasing pool of subscribers.
Sales & marketing: For many Enterprise SaaS companies (such as salesforce.com or Twilio (TWLO)), spending on sales & marketing is hurting the P&L in the short term. But it’s more than offset by the revenue per customer over time thanks to “negative churn.” These companies generate more revenue from a given cohort of customers, amply justifying the initial acquisition cost.
On the other hand, if a company has a razor-thin margin per customer, any disruption (such as a global pandemic) can turn a profit-making business into a dumpster fire. There are many examples of low-margin businesses that have recently suffered due to circumstances beyond their control:
- Airlines (such as Southwest (LUV), American (AAL), United (UAL))
- Specialty Retailers (such as Bed Bath & Beyond (NASDAQ:BBBY), GameStop (GME) The Gap (GPS), Nordstrom (JWN))
- Asset-heavy industrials (such as Hertz (HTZ)
Only businesses with strong unit economics will prove to be anti-fragile during a recession. Seeing poor unit economics should empower you to say “Next!”
2) No economies of scale
If a company has a good product-market fit, you should be able to see economies of scale over time. This would translate to a few things on the income statement over time:
- Gross margin should be relatively stable or improve.
- Sales & marketing costs should become a smaller % of revenue.
- General & administrative costs should become a smaller % of revenue.
- Operating margin should be going up and to the right as a result.
Let’s compare two businesses with a dramatically different performance over the years.
Based on the graph below, you should instantly know which company has a place in your portfolio and which one you should be running away from.
- Visa has seen a very high gross margin, perfectly stable, and above 80% in the past 10 years. The operating margin has improved steadily and is currently sitting at an outstanding 67% of revenue.
- GoPro has seen its gross margin fizzle slowly below 40% over time. The operating margin turned negative almost five years ago and has stayed that way ever since.
If a company shows no sign of economies of scale, it’s probably not worth your time and money.
3) Negative return on invested capital
It’s essential to take a step back and look at the operational track record of a company over the years. And to understand whether the business is creating or destroying value over time, looking at ROIC (return on invested capital) is an excellent indicator.
If you see a consistent history of worsening or negative ROIC, chances are you are looking at a lousy business. That’s particularly true of a business already operating at scale.
On the other hand, when you find businesses with high and improving return on invested capital, there is a good chance that future cash flow will be put to good use and create compounding returns for long-term shareholders.
Recognize if a business is potentially creating value for the long term. If not, you are probably better off investing someplace else.
4) Poor Glassdoor ratings
Management, and more generally culture, is widely recognized as an important factor in determining the long-term success of a company.
Glassdoor is a website where employees review their companies and CEOs. Over the years, the platform has become a household name, particularly in Silicon Valley where the competition to attract and retain talent is intense.
The platform enables outsiders to view for themselves if the company is recommended by its own employees and celebrated for its culture.
History shows that the way employees praise their company might be a much more compelling investment factor than P/E ratios, free cash flow margins, or any other financial metrics. This is a conclusion I’ve reached after reviewing the performance of companies appearing on the Best Places To Work on an annual basis based on Glassdoor’s rankings.
I take pride in the fact that the App Economy Portfolio has an average CEO approval score of 86% and an average Glassdoor review score of 3.9 stars (out of five).
If a company caught your interest, take the time to look at what employees have to say on Glassdoor. Average or low CEO approval should give you pause. Is the company’s future in good hands if many employees are concerned about their leadership? Is the future of a company really bright if more than half of the employees would not recommend working there?
Let’s take the example of GameStop. Not only is the company in a secular downtrend that will likely cause it to file for bankruptcy sooner rather than later, but 65% of employees are also saying it’s not a good place to work. It gets worse, with seven employees out of 10 disapproving of the current CEO. The writing is on the wall. If you decide to invest in such a business, you have only yourself to blame if you end up losing money.
Overall, poor Glassdoor reviews should be more than enough of a reason to remove a company from your watch list.
5) Stock performance below the market returns in the past 12 months
The idea of “low” prices and potential rapid mean reversion can be seducing. After all, the Wall Street adage is to “buy low, sell high.” But more often than not, if you buy cheap, you’ll get what you paid for.
Rather than trying to find new opportunities based on the list of new stocks hitting a 52-week low, your focus should be on the ones hitting a new 52-week high.
The rationale behind this is simple. I covered in my previous article that the top 25% of all stocks were responsible for all of the gains. This means that the bottom 75% contributed 0% collectively.
Furthermore, 64% of stocks can’t keep up with a diversified index.
By definition, strong performers will keep on reaching new highs, time and time again. They may face challenges creating a temporary weakness in their stock price, but rarely for more than a few months.
If a company has a negative stock performance over the past 12 months, it’s far more likely to be part of the 64% of companies that underperform the S&P 500 (SPY) over time.
You could find a diamond in the rough, a turnaround story giving you 100% gains in a matter of weeks. But how many times will you need to find the perfect situation that enables such a performance? How many times will you be wrong and see your previous gains wiped out when a turnaround story doesn’t pan out? Hope is not a strategy.
By ignoring companies that do not show past stock price appreciation in the past year, you are ignoring the vast majority of losers that could take a toll on your portfolio returns.
6) Free cash flow to debt is below 25%
In their book, Warren Buffett and the Interpretation of Financial Statements, Mary Buffett and David Clark touch on long-term debt. They write:
“Warren has found that a company with [a] durable competitive advantage spins off a lot of cash and has little or no need for debt.”
To assess the financial health of a company, you can divide its long-term debt by its free cash flow of the past 12 months. By doing so, you can find out how many years it would take the company to pay off its long-term debt with its existing cash flows.
Buffett’s historic purchases indicate that a company should have sufficient yearly free cash flow to pay all long-term debt within 3 or 4 years.
I often bring up Match Group (MTCH), an important company of the App Economy as a top dog and first mover in the online dating industry. The company has $2.1 billion in long-term debt, which is very high compared to the types of companies I usually invest in. But once you consider the fact that the company has generated more than $600 million in free cash flow over the past 12 months, it would take about three years for the long-term debt to be paid at the current run rate.
On the other hand, if we look at a company like General Electric, it would take more than 30 years of free cash flow for its current long-term debt to be paid off. A clear sign to stay away.
If you see a company with an FCF to debt ratio below 25%, you might want to think twice before adding it to your portfolio. With rare exceptions, you are probably better off without such an investment in your portfolio.
7) The business is in secular decline
A business that appears “cheap” based on its backward-looking valuation metrics such as PE (price-to-earnings) ratio or dividend yield can be very seducing. But have you looked at the underlying business?
- Is the top line of the business still growing or going down?
- Is the past truly an indication of the business’s future?
- Is the company’s dividend really sustainable?
A perfect example is, once again, GameStop. As gamers shift from physical to digital copies of games, the company will continue to see its sales go down quarter after quarter. The full transition to digital may have taken longer than the video or music industry, but the secular shift is happening nonetheless.
The top line of a business in secular decline is going to look like this over the years:
Meanwhile, let’s look at the revenue trend of a group of relatively young cloud-based services that are disrupting a wide range of industries, from B2C communication to inbound marketing, to database management, HR tools or cybersecurity.
That’s the revenue trend you should really be looking for when you invest with a multi-year time horizon. And over an extended time, the stock price chart is likely to resemble the revenue chart, up and to the right.
When you invest in companies like Macy’s, Kohl’s (KSS), or Bed Bath & Beyond, don’t be surprised if your portfolio is trailing the market in a few years. These companies have been declining long before COVID-19.
8) It’s a penny stock
The term “penny stock” is defined by the SEC as a security issued by a very small company that trades at less than $5 per share.
No company goes public with a share price below $5. If you find one trading this low, it’s likely a company trading more than 80% down from its previous high. Unless we are in the middle of a cataclysmic bear market, the implication here is that the business is recognized by Wall Street as ill-fated and unlikely to turn around.
It can be seducing to see a company trading at $0.34 per share. Even if you have only a few hundreds of dollars to invest, you get to buy hundreds or maybe thousands of shares. Meanwhile, a company like Amazon is trading above $2,600 as of this writing, giving the impression that it’s unlikely to go much higher. The reality is that it makes no difference whatsoever. The price at which a company is trading doesn’t make it more or less likely to go lower or higher.
Penny stocks are used in classic pump-and-dump schemes. There can be sizable gains for lucky traders who time it right, but there are equal risks of a permanent loss of capital in a short period.
By ignoring this category, you can exclude an incredibly high amount of potential losers from your portfolio.
9) You don’t really understand the business
Charlie Munger puts it best:
“We have three baskets for investing: yes, no, and too tough to understand.”
In the world of Warren Buffett and Charlie Munger, investment opportunities fall into one of these three boxes: “In,” “Out” and “Too hard.”
You don’t need to make it hard for yourself by investing in businesses that are too complex for you to grasp. You are often better off sticking to what you can understand well. Staying within your circle of competence, or staying focused on businesses you can fully comprehend, will go a long way to protect you from bad surprises.
This idea was also brought up by Peter Lynch in One Up On Wall Street:
“Know what you own, and know why you own it.”
In fact, Peter Lynch’s quote goes a little bit deeper. Besides the fact that you need to understand the business you are investing in, you need to identify why you want to be a shareholder. If you were given a hot tip at the water cooler and can’t explain to yourself the bullish thesis behind an investment opportunity, you either need to do a bit of homework or move on.
Warren Buffett spoke to graduate students at Columbia University’s Business School in 1993 and explained:
“Risk comes from not knowing what you’re doing.”
Your own temperament is the biggest risk your portfolio is exposed to. If you don’t fully understand what you own, chances are you will sell as soon as it performs poorly. You won’t have a good reason to hold an investment if you didn’t have a good reason to buy it to begin with.
10) The company is not aligned with your own values
In a world where individuals increasingly want things to change for the better and look for ways to make a positive impact, you have to ask yourself if the investment opportunity you just found is aligned with your core values and the way you see the world.
If you don’t like a company’s impact on the world or what the CEO has to say, why would you bother being a shareholder of the business?
How is the company you are looking at treating its employees, partners, and customers? How is it impacting the world and society at large?
There are thousands of investment opportunities out there. By finding those that match the way you see the world, you are much more likely to be proud of your portfolio, through good and bad times. Given the importance of staying the course and sticking to your strategy for years on end, you can give yourself much better odds of succeeding by being aligned with what your portfolio represents.
It comes down to a simple question: Do I feel good about being a shareholder of this business? Whenever there is any doubt, there is no doubt.
Great investing is 1% buying and 99% waiting.
All you really need is to nail that 1% by putting the odds in your favor.
I hope these 10 factors can help you second-guess yourself and keep you away from investing pitfalls the next time you are about to buy a new stock.
If you are looking for a portfolio of actionable ideas like this one, please consider joining the App Economy Portfolio. Start your free trial today!
The rise of the App Economy is disrupting many industries: retail, entertainment, financials, media, social platforms, healthcare, enterprise software, and more.
While keeping in mind some of the best recommendations from experienced gurus of Wall Street such as Warren Buffett, Peter Lynch, Burton Malkiel, or Philip Fisher, I am trying to beat the S&P 500 index by a significant margin.
Here are some of the trends reflected in the portfolio:
Disclosure: I am/we are long AAPL AMZN AYX BABA CRM CRWD ETSY HUBS MDB MTCH NFLX PAYC SHOP TTD TWLO V. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.