As investors, on top of searching for companies to invest in using a set of criteria, we should also be clear on the type of companies we should avoid investing.
Having such a framework helps to ensure we don’t put our money in the wrong set of investments.
Here are some of the companies I’d avoid buying shares in. If it makes sense to you, you could adapt them for your own investing journey as well.
Companies That Rely on Commodities for Growth
Back in 2014, the oil price started to crash. From a peak of around US$115 per barrel in mid-June, crude prices plummeted to about US$50 per barrel in early 2015.
That was when many listed companies that were dealing with the black gold also saw their share prices plunge.
I saw this as a rare opportunity to buy into unloved oil and gas (O&G) companies that still have potential to grow over the long-term.
My view was that oil is an integral part of the economy and that the oil price would eventually recover.
I looked for companies in the O&G industry that were beaten-down but still had businesses in non-related sectors that were doing well.
That was when I came across Sembcorp Industries Limited (SGX: U96).
I analysed the conglomerate and came to the conclusion that due to the stock price crash, the stock market was assigning very low valuations for Sembcorp’s utilities and urban development business segments, which were doing better.
I could buy Sembcorp stock at an undervalued price and wait for the marine sector to recover. All these while, I would still get decent dividends from the company.
Therefore, I took an initial stake in January 2015. I subsequently bought more shares in July and December the same year as Sembcorp’s share price fell, along with further decreases in the oil price.
That was when I realised that my theory was flawed and that betting on the upward price trajectory of a commodity is a fool’s errand.
Oil price is determined by demand and supply, and Sembcorp has no control whatsoever over what oil does.
I sold off my entire stake in Sembcorp after that and took a 30% loss.
Till now, the oil price has not recovered to 2014 highs. I’m not sure when it will too.
From this episode, I learnt that investing in companies that rely on commodities to drive business growth is not for me.
Warren Buffett’s investing partner Charlie Munger once said:
“At Berkshire we have three buckets: yes, no and too hard. We just throw some decisions into the ‘too hard’ file and go onto the others.”
On hindsight, Sembcorp should actually have been chucked into the “too hard” bucket.
Lack of Free Cash Flow
Cash is the lifeblood of any business.
The earnings of a company tell us nothing about the cash coming into the business; a company can sell products and book revenue even without the actual cash comes into its coffers.
Therefore, one crucial aspect to look out for when investing is whether the company has free cash flow.
Free cash flow is the amount of money generated by a business after accounting for operating and capital expenses.
Free cash flow is essential in any business as it allows the company to reinvest the cash for growth, make acquisitions, pay dividends, buy back shares and pay off debt.
Without any free cash flow, the business has to borrow money from banks, undertake private placements, or issue rights to its shareholders to sustain its business.
One infamous example that comes to mind is Hyflux Ltd (SGX: 600).
Since 2010, Hyflux had negative cash from operating activities and thus, had no free cash flow to speak of.
The following is a snapshot of the company’s cash flow statements from its most recent history:
We all know what happened to Hyflux, which has now been suspended from trading.
This brings me to the next point.
Companies With Lots of Debt
Without sufficient cash to operate its daily operations, a firm may have to rely heavily on bank borrowings or external parties to sustain its business.
Due to the negative free cash flow situation for Hyflux, the firm had to borrow a lot of money to fund its business. As of 31 December 2017, its debt-to-equity ratio stood at above 260%, which is way too high.
Relying on borrowings to sustain business operations is never a great idea.
In general, when demand falls during an industry downturn or economic crisis, highly-leveraged businesses might find it hard to pay off their loans. Such companies may also face the risk of bankruptcy.
Warren Buffett famously said, “You only find out who is swimming naked when the tide goes out”.
When times are good, and the stock market is cheery, investors tend to ignore business fundamentals and buy any stock that rises.
Stocks that climb during a market upturn may do so due to positive investor sentiments, and not necessarily due to growing earnings.
And that stock that rises may well be loaded with a massive amount of debt.
Therefore, when it comes to investing, we should focus on buying companies that have strong balance sheets and generate plentiful free cash flow consistently.
Such companies also tend to have some form of competitive advantage that help to keep competitors at bay.
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Disclaimer: The information provided by Seedly serves as an educational piece and is not intended to be personalised investment advice. Readers should always do their own due diligence and consider their financial goals before investing in any stock.