10 Tips to Avoid Bad Stock Market Mistakes

[Music] Hey guys, welcome back to the channel. In this video, we're talking 10 quick tips to help you avoid bad investments. These are essentially just tips that I kind of wish I heard, you know, five, six years ago, which someone had told me that I've just kind of drawn out of my own experience in trying to analyze different companies and making investments in different businesses. So I want this video to be quick fire, so let's get stuck straight into it.

So tip number 10 is avoid shrinking margins. What you want to see, over time, is that the revenue of a company grows much faster than, say, the cost of revenue. It grows much faster than the operating expenses. So if that's the case, then the company's margins are growing, whether it be the gross margin or the operating margin. And that's what you want to see because it means that the company is getting better over time; it's getting more efficient. You know, it's learning as we grow our revenue, right? Our expenses to generate that revenue are not growing at the same pace or faster; they're growing slower. So that means, over time, the company is going to make more and more money. So that's a really important point to consider.

Remember, at the end of the day, the margin—no matter what margin you're talking about, if it's gross or if it's operating or whatever—is just what percentage of their revenue does this company get to keep after these certain expenses are affected. Okay? So at the end of the day, you want margins to be growing over time. That's the ideal.

Then from there, the second tip to avoid a bad investment is to make sure that the company, over a long period of time, is growing, not going into some sort of decline. I mean, this one's pretty obvious, but I thought I’d chuck it in anyway. You know, with the investment strategy that I like to follow, I like to see that, over time, companies grow, right? Their revenue goes up over time; their net income goes up over time; that free cash flow goes up over time. What you want to avoid is you want to avoid—maybe you’ve been enticed towards this stock because it’s really cheap. If you’re seeing that the company is in a slow decline over time, its revenue is falling year after year, even just by a little bit, then personally, like, I know there are some people that wouldn’t be deterred by that, but personally, I’m not interested in a company like that.

A lot of people may, if it’s a super cheap price, they might invest in it as a bit of a turnaround story and hope that it turns around. However, for me, I would only invest in that company if it’s proving right now that it’s a turnaround story. So yes, the decline happened, but now it’s growing again. Once that happens, then I might, you know, consider it, but for me personally, I like to see growth over time. I don’t want to see a company in decline. If a company is in slow decline, even if it’s trading at a cheap price, I probably don’t want anything to do with it.

And then, following on from that point, the next tip to avoid a bad investment is to make sure the company makes money. And again, that sounds very obvious, but I have been burnt by this a couple of times in the early days of my investing career. You definitely want to invest in companies that make money. If they are making money, if the machine is generating cash, that is a big step in de-risking the business. And if the business model is de-risking itself, then obviously that is de-risking that company as an investment too.

So what you want to check here is that the operating income is positive. You want the net income to be positive, and you want the operating cash flow to be positive as well. If you get green lights in those three checkboxes, then yes, no matter how you twist the story, no matter how you look at the company, then the company is making money.

Then after you've checked that, first of all, the company is making money, you also want to check that the company has relatively low debt. Some of the things I look at here are the current ratio, which is a short-term measure of whether the company has too much debt. So it compares the current assets with the current liabilities. Ideally, you absolutely must see a current ratio of at least one, but ideally, you want to see it like two or more. That would be an ideal scenario. But you also want to check the total debt because you don’t want your company to be swamped by its debts one day.

So a general rule of thumb that I like to follow, especially when I’m quickly looking at a company, is that the company can pay down all of its debts within three or four years of its free cash flow. If it can do that, then it’s pretty safe. What you don’t want is, say, like for example, a company like Netflix has currently about 15 billion dollars of debt in total. And then when you turn to their free cash flow, it’s negative—that they’re not even producing any free cash flow. So if something were to go horribly wrong in their business—maybe something completely out of their control—they might find themselves in a spot of bother because, you know, maybe, you know, will this company be able to claw itself back and produce enough cash flow to be able to, you know, pay down its existing debts? That’s what you’d have to ask yourself.

So personally, I like companies with very low or no debt, but a lot of companies in a lot of industries, debt is kind of something that can’t be avoided. But you can definitely check whether the company is taking on too much debt. So definitely don't invest in a company that's got too much debt.

Then the next tip to ensure you're not making a bad investment is quite simply to make sure the company is investing well back into itself. Okay? And I know I talk about this a lot, so I’ll keep this one brief. Return on investment capital essentially just shows you, from a management perspective, how good is the management team at taking the capital at their disposal and reinvesting it back into their own business to make the business even more profitable.

Okay? So if you look at, say, a company like General Motors 10 years ago, their return on investment capital was great—it was like 20—and over time, it slowly declined. Now their return on investment capital is 5. I look at that, and I’m not particularly interested. The management team is not doing a very good job at reinvesting back into the business. If you looked at Google as another example, however, their return on investment capital consistently hovers at around 20, and they’ve held that consistency for like 10 years. So that company is much better at reinvesting back into itself to generate even more money. So that’s a company that I like to see, but I would personally—like for me, I would avoid a company like General Motors that’s only getting like a five percent return out of the reinvesting that the management’s doing.

Then from there, the sixth tip to check to make sure you’re not making a bad investment is make sure the CEO’s compensation—the CEO’s interests are aligned with the interests of the long-term shareholders. Now, the easiest way to do this is check how is this CEO getting paid. So CEOs can get paid in a variety of ways. They can get just a straight-up salary, they can get bonuses, they can get stock options, they can get stock awards where stock is, you know, just gifted to them for hitting certain metrics.

And all of this stuff can be found in the definitive proxy statement. So you can either go onto the SEC website or you can just go type in your company’s investor relations page. They should have the definitive proxy statement. It is listed as the DEF-14A form, and in there, you can read about how the management team is compensated. So ideally, what you want to see is that they just run the CEO—especially runs with a modest salary—and then any bonuses, stock options, stock awards are directly tied to the success of the business and the success of the business in a way that also benefits the long-term shareholders.

Okay? So for instance, Apple does a total shareholder return. So what is the total return for shareholders? If you hit it above a certain percentage, then Tim Cook, the CEO, gets a big fat bonus. So there are some things you want to look into, but ideally, there’s no strict right or wrongs here. You just want to make sure, reading through the definitive proxy statement, that yes, you definitely can see that the compensation package for this CEO is definitely in the best interest of the long-term shareholders. If you know the CEO benefits when the long-term shareholders do.

Then from there, another point to consider to make sure you’re not making a bad investment is to definitely ask questions if the company is consistently raising more money. Okay? Because remember, as a shareholder, every time a company does a capital raise, they issue more shares, then your position—your ownership portion of that company—is getting diluted.

Okay? So it’s not always bad when a company issues more shares, but you just want to make sure that there’s an actual solid reason as to why the company keeps going back to the market for more money. Okay? For example, sometimes capital raises can be good if they’ve got this big, ambitious growth project that they need to fund, and in the long term, it’s going to definitely pay dividends. Then that’s fine, they can raise money. You know, if they’re trying to make a big acquisition that will really bolster up their business, then that’s okay; they can raise money for that.

But what you don’t want to see is just every now and again, the company just kind of raises more money but doesn’t really tell you where that money’s going or why they’re doing it. Because, in most instances—not all, like for instance, we’ve seen Tesla do that quite recently for, you know, just general balance sheet bolstering purposes—they don’t really need to, but they’re just taking advantage of the fact that their stock price is so overvalued. But generally, in smaller companies, if they just continue to raise more money and don’t really tell you why, then usually I’ll direct you back to the drawing board. Go and have a look at the numbers of that company because what you probably find is that the company itself isn’t profitable, and the reason they’re raising more money is quite simply their cash reserves are being depleted.

Okay? So I’ll definitely recommend if the company you’re invested in is consistently, you know, raising more and more money, go back, have a look at the business—is it making money? Why do they need to raise all this money?

Then from there, the eighth tip to avoid bad investments is to quite simply make sure you understand what you’re getting yourself into; understand what you’re buying. Now I left this one towards the end because I just talk about this so often, but I still have to include it, right? It’s really important that no matter what you’re buying, you understand the business. If you’re buying into Disney, okay, make sure you understand all the different ways that Disney makes money. What’s important to Disney? What’s less important to Disney?

Okay? Understand where their money comes in from, understand where it goes out to, have an understanding of the management team, the competitive advantage, and all those things. But make sure you actually do understand what you’re getting yourself into before you pull the trigger. So I hope that goes without saying, but I thought I’d put that one in there anyway because it is super important.

And flowing on from that point, the ninth tip to make sure you’re not making a bad investment is, following on from that, making sure you understand where the future growth of the company is coming from. Right? Because that’s a really big part of the investing strategy that we follow as long-term investors. You know, we want to buy this company because it’s going to be worth more in 10 to 20 years, but if we’re going to do that, we better understand why the company is going to be better in 10 to 20 years.

Right? We should have an understanding of their general growth avenues and what they’re trying to work on and the projects that they’re going to implement to make their business more valuable. You know, for a company like Tesla, they’re obviously going to build battery factories in the future, build lots more batteries, lots more cars, and lots more grid-scale storage. They’re going to increase the production of the solar panels. They’ve got their full self-driving, which will be a big unlock of revenue for the company.

It’s those sort of things that you need to understand. And then from there, the last tip, but certainly not least, and this is really important to make sure you’re not making a bad investment, it’s quite simply don’t overpay. I feel like, in the current environment that we’re in—the investing environment that we’re in—people are forgetting about this one quite a bit. But it makes sense, right? We have to have an understanding of what the business is actually worth. We have to make sure that we’re buying the shares at a discount to intrinsic value. Right? We have to figure out where the company is going to be in 10 years. We have to figure out what return we want to get each year, work back to what we’d be willing to pay for the business today, and then take a margin of safety off of that.

We have to make sure that we pay a fair price because if you’re paying, you know, 50 times what the company is worth, the company could execute perfectly over the next 10 years, and you could still—it’s a real possibility that you might still lose money in the long run, even though the company executes perfectly because the price you paid at the start was just so crazily high for the business that even though they’ve built themselves up into something fantastic in 10 years, you know, the price you paid was still overvalued based on where they are in 10 years.

So definitely get comfortable with, you know, your valuation methods—discounted cash flow, owner’s earnings, margin of safety—make sure you don’t overpay because, you know, a great business can turn into a terrible investment if you pay too much for the shares.

Anyway, guys, that will do me for today. They are my 10 tips to ensure that you’re not making bad investments. Uh, yeah, I wish I could have told myself these 10, uh, rewinding the clock, you know, five, six years ago. But hopefully, maybe you guys found some value out of the video. I hope you did. Make sure you leave a like on the video if you found it valuable; if you found it useful, I certainly appreciate it.

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But thanks very much for watching, guys, and I’ll see you guys tomorrow. [Music] [Applause] [Music] [Applause] [Music] [Applause]