I’m a Financial Analyst: 10 Red Flags I Look For Before Investing In a Stock
The stock market bounced back recently, with the Dow Jones Industrial Average briefly crossing over 40,000 on the news of lower inflation data and a strong labor market, as reported by NBC News. Investor confidence was restored as analysts are paying close attention to the consumer price index (CPI) data, which will heavily impact how the Fed responds with interest rate decisions at the next Federal Open Market Committee (FOMC) meeting.
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Suppose you’re looking to rebalance your portfolio or are considering investing in a new company. In that case, you want to know what to look for before you allocate your funds to purchase shares of a specific company.
What are the red flags to look for before investing in a stock? With input from a financial expert, a financial analyst has outlined three categories that outline 10 red flags to watch out for.
Fraudulent Red Flags
“These are obviously the most serious offenses and would disqualify any stock from any consideration whatsoever,” said Stephen Kates, certified financial planner (CFP) and principal financial analyst for Annuity.org.
You want to look out for these fraudulent red flags before investing in a company.
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1. Incorrect Information Shared by the Company
Kates warned about misstatements in financial statements or promotional materials. If a company publicly shares inaccurate or incorrect information, you should be skeptical about investing in it.
“If something seems wrong when you look at the company numbers, it probably is,” said Scott Lieberman, founder of Touchdown Money. “Make sure the numbers match up before you invest.”
This is the biggest red flag because a company could misrepresent earnings or mislead investors about the cash flow situation.
2. Issues With Company Leadership
Officers or employees being fired, fined or arrested is something to watch out for as one of the biggest red flags. Other leadership issues could include directors selling off their shares or frequent management changes. You want to invest in a company with strong leadership since they significantly control the direction of the business.
3. Regulatory Concerns
Audit issues or regulatory investigations can lead to the stock price dropping. You want to look out for any regulatory issues that could be pending or in process. Regulatory risks will depend on the industry, but they can include government policy or regulation changes. Some industries like finance, energy or healthcare are heavily regulated by the government and any changes could lead to major disruptions.
Regulatory changes could force a company to adjust its business operations or shut down an entire segment of a business, which would hurt the bottom line. Regulatory issues come with uncertainty and investors don’t appreciate that. With lower-than-expected earnings and a decrease in investor confidence, a regulatory change would have a huge impact on a company so you want to stay informed of any potential changes.
Fundamental Red Flags
“These issues are inherent to the operations of the company and demonstrate strength or weakness of the underlying business,” Kates said.
These red flags are fundamental concerns that you want to watch out for so that you don’t watch your savings disappear.
4. Negative Financial Reports
While a company may appear to be optimistic about the future, you want to pay attention to any negative financial reports. Persistently falling revenue or declining profit margins are financial metrics you want to look out for.
Lieberman said growing debt to equity is a red flag to be cautious about and added the following insights:
“Taking on debt isn’t always bad, especially when it’s done to acquire assets. But when you take on debt without getting something back in return, that’s a problem.”
You don’t have to analyze every financial report, but you want to remain informed about how you’re investing your money.
“If a company’s not making a lot of money and it’s seeing that decrease, it won’t succeed for long in the market,” Lieberman said.
5. Growing Competition
When investing in a company, losing market share to a growing competitor should concern you because not every business can survive intense competition. You want to pay attention to the competitive landscape to see how the company reacts to a new competitor.
6. Economic Factors
Economic or regulatory factors negatively impacting business operations are another concern that should factored in. For example, every industry is impacted differently by economic trends, such as changes in the labor market. If you read that the labor market is hurting, you may not want to invest in a company that heavily relies on consumer spending since discretionary income has dropped.
Technical and Trading Red Flags
“Based on the trading activity or momentum of the stock itself, a company may be a good candidate for your investment or it may not be the right timing,” Kates said.
This final set of red flags is all about trading and price movements of the stock or the industry that you’re looking into.
7. Empty Hype About The Company
Another red flag is “hype or promotion-based movement without the benefit of a strong business report,” Kates said. If you’re thinking about investing in a company because you keep hearing about it, you could be making your decision on speculation and hype.
A common example is the meme stock movement, where retail investors rallied together to artificially boost the values of a few companies. While you may get tempted to invest in a company when you constantly hear about it, these movements are disconnected from reality as financials aren’t looked at.
In the most recent meme stock rally, AMC shot up as much as 308% between May 13 and 14, while GameStop peaked at a gain of 271%, only to have those gains almost disappear completely. These hyped-up stocks are completely speculative and highly unpredictable, as they can crash at any given point since the gains aren’t based on financial results.
8. Sensitivity to Interest Rates
Many companies are sensitive to rate hikes that happen when the Fed tries to cool down inflation. Since higher interest rates mean borrowing money becomes more expensive, some industries will report lower earnings since consumer spending will drop. You’ll want to ensure that the company you’re investing in isn’t sensitive to rate hikes or that it’s in an industry that’s resilient enough to withstand them.
You’ll want to analyze the ability of the company you want to invest in to handle periods of higher interest rates by reviewing past financial reports. For example, tech giants like Microsoft or Amazon are typically sensitive to rate hikes as consumer spending drops and earnings are lower than expected. On the other hand, financial institutions may increase in value as they earn more during times of higher rates.
9. What Management Says Isn’t Realistic
If management is making claims in media interviews or during an earnings report that isn’t realistic or accurate, you want to be cautious about investing your funds in this company. For example, management could try to spin financial results as good news when clearly the company had a poor quarter. Another example is that management could state that they’re in a strong position when the company is realistically seeing declining profits and increased competition.
This leads us to the final red flag.
10. Missed Guidance
When you’re deciding which stock to invest in, you’ll want to review a previous earnings report and pay attention to the guidance issued to shareholders when it comes to what expected earnings should be. If the company has a history of missing this guidance or revising it often, this should be a red flag. While the company can’t predict the state of the economy, a missed guidance may indicate that management doesn’t have a firm grasp of the reality of the situation.
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This article originally appeared on GOBankingRates.com: I’m a Financial Analyst: 10 Red Flags I Look For Before Investing In a Stock
