🚩 7 Reasons Not To Buy A Stock
These red flags are great reasons to stay away
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“If you aren't willing to own a stock for 10 years, don't even think about owning it for 10 minutes."
This guiding principle from Warren Buffett underscores the importance of focusing on the long-term potential and fundamental strengths of a company rather than short-term market fluctuations. The value of a stock lies in the underlying business’s ability to generate profits and return value to shareholders over time.
As explained in our previous article 🏆 Let Your Winners Run:
3 out of every 5 stocks underperform the index.
2 out of every 5 stocks are money-losing investments.
1 out of every 5 stocks is a terrible investment (losing 75% or more).
Given these statistics, the importance of discerning investment choices becomes clear. Most stocks are not worth investing in. Avoiding the ones that underperform is just as important as finding the ones that overperform.
As the late Charlie Munger said:
“Invert, always invert!”
There are tens of thousands of companies listed globally. By identifying undesirable traits in a potential investment, you can streamline your decision-making process and avoid common pitfalls.
Let’s review seven critical red flags that prompt me to steer clear of a stock. From financial metrics to company management and market trends, these filters provide you with a comprehensive checklist to refine your investment strategy.
Let’s tackle them one by one.
1. Poor unit economics
Unit economics refers to the direct revenues and costs associated with a particular business model, expressed on a per-unit (or per-customer) basis. It’s a critical measure to assess whether the business model is sound.
In their book Warren Buffett and the Interpretation of Financial Statements, Mary Buffett and David Clark explain how Buffett prefers businesses with a gross margin of over 40%. A low gross margin typically indicates a weak competitive moat, signaling potential issues in the sustainability of the business.
Take Spotify, for instance. Despite its popularity, Spotify struggles with low gross margins. This is primarily due to its high content costs, which consume a substantial part of its revenue. Such a scenario raises concerns about the long-term viability of its business model, even if it shows robust user growth.
Spotify could turn things around over time with a new strategy, but it has underperformed in its first six years as a public company.
Here’s a breakdown of what you need to look for in terms of unit economics:
Cost Structure: Assess if the business can sustainably grow without compromising on profitability. High customer acquisition costs (CAC) relative to the customer’s lifetime value (LTV) indicate poor unit economics.
Churn Rate: A high churn rate can quickly erode the gains from new customer acquisition. It’s crucial to evaluate whether the business model can retain customers profitably.
Operating leverage: Businesses may show temporary weakness if they subsidize their products or services to gain market share. However, the model is unsustainable if the pricing strategy doesn’t eventually lead to profitability. We recently discussed how Uber ultimately demonstrated clear signs of operating leverage.
Investing in Growth: Differentiate between loss-making strategies that are growth investments (like Netflix’s content creation or SaaS companies’ sales and marketing) and those due to inherently unprofitable operations.
Resilience in Adversity: Low-margin businesses, especially in sectors like airlines and specialty retail, can quickly turn unprofitable under external pressures, such as economic downturns. There is no margin of safety.
Takeaway: While growth is essential, it should not come at the cost of poor unit economics. Businesses that fail to demonstrate how they can be very profitable at scale are often riskier investments.
2. No economies of scale
When a company has a solid product-market fit, economies of scale should become evident over time. This phenomenon is reflected in various aspects of the income statement:
Gross margin: Look for stability or improvement over time.
Sales & Marketing expenses: These should decrease as a percentage of revenue, showing that less spend is needed to generate more sales.
General & Administrative expenses: Lower G&A costs as a percentage of revenue is another positive sign, indicating more efficient operations.
Operating Margin: Ideally, this should improve consistently, reflecting overall operational efficiency.
To illustrate, let’s compare two businesses with starkly different performances.