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The 1 Question You Need To Ask When Investing In Stocks

When investing in stocks, the one critical question you need to ask isn’t “What’s a great stock to buy now?” Instead, the question should be “What stock should I not buy now?”

Losers aplenty

A 2014 report from J.P. Morgan, titled The agony & the ecstasy: The risks and rewards of a concentrated stock position, had the following eye-catching statistics:

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1. Nearly 40% of all stocks in the Russell 3000 universe since 1980 have suffered a permanent decline of more than 70% from their peak value. (The Russell 3000 is an American stock market index made up of the 3,000 largest US companies.)

2. Since 1980, 40% of all stocks in the Russell 3000 universe have delivered negative absolute returns over their entire lifetime as a publicly-listed entity (the “lifetime” returns of a share start from the date of its listing all the way till 2014 or the date at which it ceased to be a listed entity).

The data above show that there are many stocks that deliver devastatingly poor long-term returns for investors. And this highlights why avoiding the losers is even more important than finding winners. Swedish economist Erik Falkenstein once shared the following observation about the nature of investing:

“In expert tennis, 80% of the points are won, while in amateur tennis, 80% are lost. The same is true for wrestling, chess, and investing: Beginners should focus on avoiding mistakes, experts on making great moves.”

So, how can you avoid mistakes when investing in stocks? You can focus on a company’s cash flows and balance sheet.

A Noble mistake

In January 2015, I used an investing checklist developed by Pat Dorsey on Noble Group (SGX: CGP) and wrote an article about it. Dorsey, who is currently the head of the investment firm Dorsey Asset Management and was previously the Director of Equity Research at Morningstar, included nine criteria in his checklist:

1. The firm provides regular financial updates, has a long track record as a publicly-listed entity, and a market capitalisation that isn’t too small.

2. It has consistently earned an operating profit.

3. It has generated consistent operating cashflow.

4. The firm earns a good return on equity.

5. It has been able to grow its earnings consistently.

6. It possess a clean balance sheet.

7. The firm can generates lots of free cash flow.

8. There are infrequent appearance of one-time charges.

9. There has not been major dilution of shareholders’ stakes in the firm.

The checklist has a focus on a company’s cash flows as well as the strength of its balance sheet. I found that Noble had flunked the test badly because it had a really weak balance sheet that was laden with debt, and it had trouble with consistently generating positive operating cash flow and free cash flow. Incidentally, my article on Noble Group was published shortly before Iceberg Research issued scathing accusations about the company’s accounting practices in February 2015 which kick-started the company’s downward spiral and culminated in a massive and complex financial restructuring plan that was completed in late 2018.

An influx of mistakes

Noble’s not the only company to have run into trouble because of cash flow and balance sheet issues. Water treatment firm Hyflux (SGX: 600) is another good example. In May 2018, the company entered a court-supervised process to reorganise its business after it ran into difficulties meeting its liabilities. Hyflux is currently still reorganising its business, and is awaiting finalised rescue bids from investors.

Prior to Hyflux’s painful decision on May 2018 to reorganise, the company had already been weighed down for a period of time by high levels of debt and problems in generating positive cash flow. In fact, I had written about these two traits in May 2016 when Hyflux was issuing perpetual securities to investors. In my article, I pointed out two things. First, that “Hyflux has been generating negative cash flow from operations in each year from 2010 to 2015,” and second, that “the company currently has a net-gearing ratio (net debt to equity ratio) of 0.98.”

The Foolish bottom line

Not every stock with a business that has a weak balance sheet and problems with generating cash flow will turn out to be a loser. But, when you see these two traits, it pays to be careful. Mixing plenty of debt with an inability to produce cash can produce a dangerous cocktail. There are plenty of stocks that have made painful losses for investors, so it pays to know the signs of danger.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing owns shares in Hyflux.