Finding a good investment is not as easy as the stock market commentators would have you believe. The best way to avoid a bad stock is to ignore all the stock promoters and rely only on advice from reputable stock analysts. Find good stocks on your own by using your online broker's stock screener and researching company financials and news releases. Stocks to avoid have limited available information and can be spotted by taking a few precautions.
A variety of "warnings signs" may be present which indicate that a stock poses excessive risk for investors. These signs can include low liquidity, a spotty earnings history, or poor metrics on standard financial ratios.
Low Trading Volume
Beware of any stock that has low liquidity levels. If you can't sell your shares easily and quickly because the stock rarely trades, it could be a dangerous investment choice. As a general rule, low liquidity can increase price volatility due to the fact that a single trade carries far more weight than it would in situations where a large number of trades are happening at any given time.
Check the stock price chart to determine historical price movements, historical volume and the stock's potential direction. Even though the company might have a good product and potentially good future potential, it is not a good investment candidate unless you are willing and able to ride it for the long term -- which could be several years.
Bad Earnings History
A company can experience temporary earnings shortfalls because of positive moves such as reorganization, expansion and acquisitions. However, an extended history of earnings disappointments over several quarters because of lower revenues or higher expenses is a good indication that the company's future prospects are limited.
Understanding Insider Selling
Many investors watch insider stock sales as an indicator of potential problems with the company that have not yet come to light. Watch for unusually large insider sales, and check annual and quarterly reports, the stock's price chart and news releases for hints about developments at the company. After all, if only one insider is selling a lot of stock, it may mean that person is buying a bigger house. When considering insider sales, look for patterns that could indicate liquidation of several insiders' positions over time.
Exploring Financial Ratios
Most bad stocks can be avoided by checking their reported financials, which can be found through the SEC's EDGAR database. Use a few ratios to get an idea of the company's financial strength:
- Total liabilities divided by total assets shows whether the company is drowning in debt.
- Quick assets divided by current liabilities tells whether the company can pay its bills.
- The stock's price divided by its earnings per share tells whether the stock is overvalued relative to other stocks in its industry.
Avoiding Stock Scams
Although stock scams may seem a fact of life, they can be avoided by applying the "Is it too good to be true?" rule to any email alerts from stock promoters, phone calls from strangers promoting the stock as ready to make a big price move and rumors spread on online investment discussion boards. If the story seems logical, check the fundamentals and financials or ask your broker or financial adviser for an opinion.
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