5 BIG Investing Mistakes to Avoid | Stock Market Red Flags

Hey guys! Welcome back to the channel. In this video, we are going to be talking about five really major red flags that you should always be watching out for and avoid companies that show any of these signs. You do not want to invest in any companies that have any one of these five red flags. So hope you enjoy the video, guys. Leave a like on it if you do enjoy it. But for now, let's get stuck in.

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Okay, so the first big red flag is quite simply that the company has no competitive advantage. The way that you check for this is you look at the four big growth numbers. That is the top line of the income statement, the bottom line of the income statement, then flip over the balance sheet, look at the equity growth, flip over the cash flow statement, and look at the free cash flow.

So we're talking about growth in revenue, earnings per share, equity, free cash flow, and what you want to see for your investments over time is that these numbers show consistent, steady growth. Okay? Because that means that the company is not really being interrupted by any of its competitors, and that shows that yes, this company does have a moat, a competitive advantage that protects it so it can grow uninterrupted.

What you don't want to see is these four numbers bouncing up, down, left, right, all around from year to year. As long-term investors, we love predictability. Because we can't see into the future, we want the next best thing, which is to see very steady trends over a long period of time looking backwards.

For example, have a look at this. We'll have a look at General Motors. Now, in the last 10 years, they've had 30% revenue growth. They've had years of no growth, and they've had years of double-digit negative revenue growth. And then have a look at EPS — they've had negative 97% growth followed by 58%, there's a negative 30% followed by 258%, there's a negative 144% followed by a 308% growth year.

So when you look at these numbers, it's just so confusing, isn't it? Are they going to have a really great year next year? Are they going to have an absolutely terrible year? It's these sort of numbers that chop and change that aren't consistently growing over time that makes you think, well actually maybe this company doesn't have a competitive advantage.

Whereas on the flip side, if we have a look at a company like Google, let's have a look. We've got Google revenue growth: 24, 29, 21, 20, 18, 13, 20, 22, 23, 18. That is much more consistent. That is so much more consistent than what was at General Motors that we were just looking at.

And if we have a look at earnings per share growth, we see the same thing — nice and consistent. What this consistency means, as I was just talking about for us as shareholders, it means that this company definitely has some sort of competitive advantage.

Because what it means is that means that as these competitors, like there are so many competitors that want a slice of Google’s pie, but every year in revenue, earnings per share, free cash flow, and equity, Google keeps showing up and just shows consistent steady growth year after year.

So it shows that no matter how hard these other companies are clawing at Google trying to get their business, there’s something about Google’s business that means that it can just continue on its own merry way, uninterrupted, producing the same level of results or better every single year. That's the sign of a competitive advantage, and we never go anywhere near companies that don't show a strong competitive advantage. So that's definitely the first red flag.

Now moving on into the second red flag of investing: investing in businesses that are way too complicated. When it comes to investing, there is no prize for investing in the most complicated business. The only prize you get is for making the most money. To be more certain we're going to do that, we have to be confident that we understand the investment that we are going to sink our money into.

Now, complicated companies can turn out to be great investments, sure. But have a think about this — for example, Samsung is the world's largest manufacturer of semiconductors. And I know that semiconductors are used in electronic devices, and you know, over the next 10 years, it's definitely going to be more and more electronic devices here on this planet Earth. But I've got no idea how a semiconductor works.

So immediately, I don't have a good enough understanding of that industry, of that area of business to make a confident investment. Even though Samsung's number one in the semiconductor space, I don't know that they're semiconductors — whether they're better or worse than Intel semiconductors or any — I just don't understand that area. So it would be very risky; it’s a red flag if I was to put money into that business that I simply don't understand.

But beyond that, not only does Samsung deal in semiconductors, which I don't understand, but you might be surprised to know that Samsung actually comprises 80 different businesses. They've got businesses ranging from construction and shipbuilding to, get this, financial services, consumer electronics, which we know, and even medical services.

Now this is the perfect example of a business that's really complicated. Not only do you have to be an expert in semiconductors, but you also have to understand financial services, healthcare, blah blah blah — it's just a really big, hard company to wrap your head around.

Whereas, let's do some sort of juxtaposition. If you take a company like Facebook, well Facebook, they have four social media apps: Facebook, Instagram, WhatsApp, Messenger. They make 99% of their revenue by selling ad space on their platforms. Simple as that. How much easier do you think Facebook is going to be to understand than Samsung?

There is a huge benefit in being able to invest in simple businesses because you are much more certain that you haven't missed something. Anyway, so that's the second big thing. The second big red flag is don’t invest in businesses that you don’t understand.

Now moving on into the third big red flag. It’s when management is paid a lot, no matter what. This is a big red flag because it means that the CEO could be getting paid big bucks even if the shareholders are doing terribly. Okay?

And we, as shareholders, we want the CEO and the management team's incentives to align with what we want as well. So we would hate it if, for example, the CEO of a company that we're invested in gets paid five million dollars a year, and that's all they get — just as a salary — and it really does not matter at all whether the business does well or not.

It doesn't change their compensation at all. That is a terrible situation for us because it means that the CEO could literally just kick up their feet and they would still get their five million dollars, and we could really suffer at that time.

However, if they say got an annual salary of a hundred thousand dollars and then got $4.9 million bonuses if they got the total shareholder return up over 20% for that year, well then that makes us feel a lot better because they are heavily incentivized to make sure that the shareholders also do very well.

If you do well, then they do well. And if they’re doing well, it means that you’re doing well. That’s the way we want it. But we absolutely do not want a situation where the management gets paid huge chunks of money, no matter how the business performs. That’s the absolute worst.

For example, during the GFC, this guy here, Vikram Pandit, was paid $10.8 million in 2008, and this is while Citigroup lost nearly $20 billion in 2008. This guy here, Joseph Cassano, he earned an estimated $34 million worth of bonuses in 2008 as his company AIG went bankrupt.

So as investors lost literally everything! Or what about this guy, Richard Fuld? He was the CEO of Lehman Brothers, and he got paid $22 million in 2007. It wasn’t a year later that Lehman Brothers again was bankrupt.

How does that feel as a shareholder? This guy’s walking away with $22 million while the company he was running has gone bust. So that right there — that is a really big red flag.

Now moving on to the fourth red flag that I wanted to talk about. It’s when the management team, even if they’re really nice, really genuine people, they’re just really bad at their job.

So remember the job of the management team — is to run the company and invest in different projects within their business to grow the business over time so that the shareholders can benefit. So what we need to see as shareholders is that the management team is able to make really smart choices and get the most out of the reinvestments that they make into the business so that we benefit from that.

It grows the value of the company and it grows our stock position, right? One of the ways that we do that, the most common way, we look at that is through the return on invested capital.

And that is the direct number that will show us how effectively is the management team investing the capital that they have at their disposal back into the business. What return are they getting on those investments?

For example, we can go back to our Google example. We can see that the Google management team has been able to produce about a 20% return on invested capital every year, with the long-term, the 10-year average return on invested capital being 18.7.

Then on the flip side, we could have a look at a company like General Electric, where if we look at their 10-year average annual return on invested capital, it's only 2.5. So the management team of General Electric really aren’t getting much of a return out of the investments that they are making back within their own business.

So that’s definitely a red flag if the management team is just, unfortunately, not very good at doing their job.

And then the fifth red flag that I wanted to talk about is another one that’s very closely related to the management, and that is that the company is just taking on way too much debt. The more debt that a company takes on, the more likely it is that it will go bankrupt. That’s just the reality.

Now, debt isn’t always bad. You can think about it. If you took out a loan to start a store, you took out a loan for $20,000, and then in the first year that you're running that store, the store rents you $50,000, then that is a perfect use of debt.

You've taken on money to enable you to do something which has made you more than what the debt was worth. However, in a lot of cases, debt can be very poorly managed by management teams, and they can let the debt get so high that even just a small issue within the company that maybe affects its profits just for one or two years can actually mean that they can no longer repay their debts.

And that is when the company ends up going bankrupt. They can't pay back the banks, and the banks say, you know what, liquidate the company because we want to get our money back.

For example, the company that I always go to when I'm talking about debt is Netflix. If we rewind the clock seven years ago, Netflix had $200 million in debt. But look at what's happened over time; management have gone crazy — 2, 3, 6, 10, 14 billion dollars in debt.

And actually, most recently, out of their most recent quarterly report, they're now up to $16 billion of debt. Now as we were just talking about debt, the absolute number isn't the be-all and end-all. Because we've got to have a look at, okay, what's their income in relation to that debt? What's their ability to pay that off?

Well, if we flick over to Netflix's cash flow statement, and let's look at the operating cash flow, how much cash do the operations of Netflix's business make for Netflix? And unfortunately, this is still consistently negative for Netflix.

So not only are they taking on billions of dollars of debt every year, well unfortunately they’re still not even making money. They're not even producing cash flow. So if Netflix had $16 billion of debt but they could use the money that they’re making and pay off that debt within say two or three years, then you’re going, oh no worries, that’s not too bad.

But the fact that Netflix isn't even turning a profit, that makes you scratch your head and go, wow, okay, is it really safe for the management team to be going into this level of debt when the business itself isn't even generating cash?

So overall, that is one of the situations where you’re like, okay, well debt can actually be a big red flag. Because you know for Netflix’s example, if they don't — you know, they've obviously taken on debt which they will have to repay at some point in the future. If they get there and the business still isn't making money, what are they going to do?

They’re going to take on more debt to pay off old debt, or are they just going to get swamped by debts? You can see how this can quickly turn into a bit of a slippery slope. So that is absolutely a big red flag, is a company that just goes into a massive amount of debt and can't service it.

So anyway, guys, they are my five big red flags. Obviously recapping: number one, if they don't have a competitive advantage, that is a big red flag. Two, if the business is overly complicated. Three, if the management team gets paid even if you as a shareholder do terribly.

Four, if the management team is unfortunately incompetent and they're just not doing very well with their company. They're not getting good returns out of their reinvestments — then that’s obviously a red flag. And then fifth, just letting the company get swamped with debt.

So three of these are just about the management team, which is pretty crazy, but definitely management teams can definitely be the makers or breakers of companies. So it's probably fair that some of these red flags are about who's in charge and who's making the decisions of that company.

But anyway, guys, they are my red flags. There are probably a stack more out there that I just haven't included in this video. So what are some of your red flags when you’re looking at investments? What are some things where if you see that, that's an instant no? You close the book, you close the annual report, and you move on.

I’d love to hear from you guys — what are your investing red flags? But that'll do me for today, guys. I hope you enjoyed the video. I hope you found it useful. If you want to support the video and you did enjoy it, or if you found it useful, leave a like on the video. It is the easiest way to support the video and support the channel — just a click of a button.

So I really appreciate it, guys. If you want to learn more about these red flags and more about this investing process of understanding the business, looking for a competitive advantage, checking the management team, and valuing your stock so that you don't pay too much for the shares, then check out "Introduction to Stock Analysis." That is linked down in the description below.

That is a full in-depth eight-hour course on teaching you guys how to evaluate stocks and pick winners. So if you're interested, check that out. But that will do me for today. Thank you very much for watching. I'll see you guys in the next video.

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