Six reasons not to buy a stock

Succumbing to hype is an occupational hazard for an investor. But if you only focus on the positive aspects of a potential investment, you're going to end up losing money. So here are six warning signs to make you think twice before buying into any stock.

1. It's too expensive

To make money from trading in anything shares, property, antiques you have to follow one simple rule: buy low and sell high. Easier said than done. But there are plenty of ratios that can help you. For example, a cheap share will have a price/earnings ratio below the average for the market (say the FTSE 100 for a UK stock) and its sector peers. An above-average dividend yield is a good sign too.

As a back-up, avoid a low cash-flow yield. This is one year's operating cash flow divided by a firm's enterprise value (defined on page 44). A low figure indicates that the stock has either low annual cash flows (which may well be a problem see below), or a high enterprise value. The latter indicates that future profits are probably already fully priced into the firm's shares. And if that's the case, then the stock will be left vulnerable to being sold off on any disappointments.

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2. Its business model is flawed...

Some types of businesses seem destined rarely, if ever, to make money. Take airlines. As Richard Branson once quipped, the fastest way to make a million pounds is to start with a billion then buy an airline. There are some success stories, such as low-cost flyer Ryannair, but there are plenty more stragglers. Another example is football clubs (see: Is football bankrupt?) it's generally much better to be a fan than a shareholder.

What do they have in common? Weak business models. Airlines and football clubs suffer from both capacity constraints on revenue (opening a larger capacity stadium for a football club, for example, isn't cheap or easy) and rising fixed costs (think of player wages or the problems facing British Airways with its union-negotiated pay deals). High asset costs (stadiums and aeroplanes cost a fortune to run, even when empty) and big wage bills are a recipe for trouble unless robust revenues are absorbing them.

3. ... or non-existent

You should also avoid business models that you don't understand. Few people had any idea of how dotcoms made money. And in fact, most didn't. There were of course some successes, such as giant retailer Amazon. But what many investors failed to realise was that Amazon was first and foremost a highly successful logistics firm, which happened to operate via the internet. As such, what Warren Buffett calls the "economic moat" was much wider at Amazon than at some of its pure dotcom rivals.

You can sometimes spot a dodgy firm or entire sector by the way it is valued. As soon as you hear of analysts ranking firms using bizarre measures, such as the 'price per click' of dotcom infamy, the warning signs should start flashing.

4. It's losing cash

Profits are great as far as they go. But cash matters more. Without cash a business cannot pay its bills and could go bust. Imagine a very simple business with sales of £1,000 and stock purchases of £800 in its first week. Gross profit is £200 and the gross margin a healthy 20% (200/1,000 x 100%). If all sales and purchases were for cash, the business will have enjoyed a cash inflow of £200 (£1,000-£800). But let's say this is a small business. So 80% of sales have to be made on credit to attract customers, while 80% of stock purchases are made for cash. Under accounting rules, the profit is still £200. But the week's cash flow is now £440. Sales generate cash of just £200 (20% of £1,000) while purchases eat up £640 (80% of £800). If the firm keeps that up, it will make profits, but could still go bust, in a matter of weeks.

Signs that a firm is chewing up cash too quickly include a low, or negative, 'cash flow from operations' figure (at the top of a cash-flow statement). By comparing operating profits to this figure you get a feel for the strength of 'cash cover' the relationship between profits and cash from the firm's core operations.

5. It's spread too thinly

One investing mantra suggests you avoid putting all your eggs in one basket. The trouble is, some firms get carried away and become unwieldy conglomerates that just do lots of different things badly. A classic example was Marconi. As GEC under Lord Weinstock, it built a reputation for competence and caution it always held a substantial cash pile. But once he retired the firm was almost run into the ground by a board of directors who insisted on spending the cash on taking the firm away from its roots.

Of course, you can't prevent a new management team from destroying a firm. But a good rule of thumb is to watch out for firms becoming over-acquisitive. Recently Jerry Levin, ex-CEO of AOL Time Warner, apologised for trying to fuse the two firms ten years ago. He described the merger as "the worst deal of the century". He's probably right but there's fierce competition for the title. Many studies have shown that acquisitions add little value and often even destroy it.

6. It's too dependent on one thing

Be wary of one-trick ponies. Some firms rely too heavily on one person, such as Berkshire Hathaway, which is tied to the fate of Warren Buffett. Dependence on a single customer is also often a problem for firms that have a lot of government contracts, such as defence group Qinetiq (LSE: QQ). With Britain facing spending cuts after the election, firms with Ministry of Defence contracts could well suffer.

This article was originally published in MoneyWeek magazine issue number 470 on 22 January 2010, and was available exclusively to magazine subscribers. To read more articles like this, ensure you don't miss a thing, and get instant access to all our premium content, subscribe to MoneyWeek magazine now and get your first three issues free.