Invest smarter: Avoid these factors when buying stocks
Now that we’ve analyzed the factors to look for when buying stocks and picking great long-term investments, we look at the many red flags to avoid when buying stocks. The stock market is a landmine and picking the wrong company could lead to large impacts on your portfolio.
When looking at different sectors, there are various factors that apply to each when buying stocks. Without getting into each sector, we look at the ones that apply to companies regardless of their sector or size.
Contents: Factors to avoid when buying stocks
- Stocks with large insider selling
- Companies with high turnaround (employee departures)
- Falling stocks with downward momentum
- Growing losses or decreasing margins
1. Stocks with large insider selling
The people with the most knowledge of a company are the insiders (i.e. the management team and directors).
For companies on North American exchanges, whenever an insider sells or buys stock in their company, they must file a Form 4 within two days of the transaction.
Several sites aggregate these forms — making it incredibly easy to see whether insiders have recently bought or sold stock in their companies. Finviz is one of these free tools:
- See transactions made by insiders here.
- Or search for a specific company in their toolbar and scroll to the bottom of the page to see all transactions from that particular company.
Not all transactions are equal: The insider and transaction size also matters.
- Who’s selling? An inside transaction made by the chief executive officer (CEO), chief financial officer (CFO) or chief operating officer (COO) may have more weight than a director with less involvement in the company.
- How much are they selling? Are they selling $10k in stock or are they selling $10million in stock? A bigger transaction could have more weight than a smaller one.
But don’t blindly follow insiders that buy or sell a stock. There’s only one reason someone buys a stock — they think it’s going up. But there are many reasons to sell a stock.
For this reason, investors could use sell signals as part of their analysis when buying stocks but they shouldn’t solely use it as a basis for an investment decision.
2. Companies with high turnaround (employee departures)
A strong leadership team is crucial to a company’s success and a string of executives leaving the company is often seen as a bad signal for investors. But even the best companies lose executives from time to time.
Employees have many reasons to leave a company — i.e. pursuing new opportunities, retirement, etc. It’s important to understand the context behind the departure and whether the move could impact the company. Some of the biggest red flags include:
- Several executives depart around the same time or after a negative event in the company.
- An executive departs after having only joined the company for a short time period.
- The CEO departs the company.
Did they see something they don’t like? Are they running for the hills? According to CGLytics, between 2013-2018, companies in the S&P 500 with more than one executive departure performed worse than those with zero.
But in some cases, bringing in a new CEO can actually bring positive changes. These are common in turnaround scenarios where a new management team is brought in to fix struggling businesses. But turnarounds are difficult and very few companies succeed.
Some of the best companies — which also happen to be the largest — were run by their founders for a long period of time — i.e. Facebook, Amazon, Apple, Google, Netflix.
3. Falling stocks with downward momentum
Avoid companies on a downward trend. According to legendary investor William O’Neil, a way to ensure miserable results is to buy on the way down in price. When a stock is on a downward trend, it could fall much further than you’d expect.
But when we talk about a stock that’s falling, we’re talking about a long-term trend over months or years. Stock prices fluctuate daily and short-term drops may not signal the start of a trend.
There’s no exact definition to indicate when a stock is on a downward trend but one indicator is if the stock is consistently making all-time lows.
Don’t fall for it: The stock may look like a bargain but there are often reasons why the stock is on a free fall — i.e. slowing growth, potential bankruptcy, deteriorating profits, etc.
- It’s also important to understand why the stock is falling. In some cases, the stock could be falling for external reasons impacting the whole market.
The opposite of this advice is to buy on the way up — a counterintuitive thought for many. Our standard thinking is to buy something for cheap and let it rise but here’s why that might not always work out with investing…
The big get bigger: What we’ve seen over time is that the strongest and largest stocks in a particular industry tend to dominate for a long period of time.
- As companies grow larger and more profitable, they develop moats around their business and begin reinvesting profits into other products or expanding into other geographies.
- The largest US tech companies (i.e. Facebook, Apple, Amazon, Google, Netflix) dominated in each of their industries.
Investors: Instead of looking at stocks that are trending lower which may seem like a bargain, investors may be better off investing in strong stocks that are consistently moving up.
4. Avoid growing losses or decreasing margins when buying stocks
A trend of growing losses or decreasing profit margins could be signals of a financially troubled company when buying stocks.
But growing losses is different from an unprofitable company. Growth stocks are often unprofitable for a reason — reinvesting back into growth.
Example: Amazon showed big losses for many years but a closer look into the company shows a different story.
The e-commerce giant could have easily become profitable if it weren’t investing its profits back into growth — building out its fulfillment centers and expanding into other business lines like Amazon Web Services — which brings in a large portion of its profits today.
But even with growth companies, investors want to see a trend of decreasing losses when buying stocks. The problem is when these losses are growing — or profits are decreasing. These numbers can easily be found with free tools like Atom.
Like the other factors, understanding the context behind the move is important. There are many reasons for falling profit margins, some good and some bad. Here are some examples:
- Rising costs: The cost to manufacture or deliver products could be rising due to external factors.
- Acquisitions: The company may have acquired another company whose products have lower margins.
- One-time expenses: Costs incurred when going public (i.e. employee stock compensation, administrative fees) could impact profits which may only be temporary.
Acquisitions and expenses incurred while going public are often necessary for growth or are a part of a company’s growth strategy.
One or two quarters of falling profits/margins may not be an immediate cause for concern but a longer trend could warrant caution.
New to investing? Dive into our full beginners guide to investing: