I thought it would be interesting to write an article as a Halloween special. Happy Halloween to all — no matter if you’re going around to collect candy, handing out candy, or enjoying some chocolate yourself.
A stock having one of the following traits is bad enough. Having all of them will make it the scariest stock in the world…
A poor balance sheet
If a company has tonnes of debt on its balance sheet, it could become insolvent. Avoid stocks with excessive debt. What is excessive? It’s normal for certain industries or sectors to have high debt levels. So, the best thing to do is to compare the debt levels of a company you’re interested in with those of its peers. For example, utilities and real estate investment trusts (REITs) typically have higher levels of debt.
Credit rating agencies like S&P make it easy to identify companies with poor balance sheets. Anything with a BBB- credit rating or higher is considered investment-grade. When in doubt, only consider stocks that have a credit rating of BBB- or better.
No or negative revenue growth
Before a company becomes profitable, first, it needs revenue. Therefore, a company with no revenue growth is a red flag. Of course, it’s worse if revenue is declining.
No or negative earnings growth
It’s not enough for a company to have revenue. Ultimately, it needs to be profitable as well. A profitable company is shown in its net income or net earnings. We want to see growing earnings.
You don’t want to overpay for a stock because it could take years for the stock price to catch up (if at all). Identifying a large-cap stock’s valuation is easier because the business is already well-established, and you can review historical data. It’s much harder to determine if a small-cap stock is overvalued or not when it’s growing at a high pace. For example, many investors and pundits thought Amazon and Shopify were highly valued for a long time, but the stocks just kept persistently heading higher.
In most cases, you can look at the analyst consensus price target as guidance for valuation. This way, you won’t depend on one analyst’s view (including yours) so there’s no bias. Notably, small-cap stocks are under-followed and may have 0-5 analysts covering them. If you bet on the right small-cap stocks before others catch on, you could make tonnes of money, though. So, you’ll need to balance the risk and reward and your capital allocation across your diversified portfolio.
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Disclosure: As of writing, we own shares of AMZN and SHOP.
Disclaimer: I am not a certified financial advisor. This article is for educational purposes, so consult a financial advisor and or tax professional if necessary before making any investment decisions.
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