Choose Safety First – Learn How To Identify Risky Stocks
By Ray Mullaney
Originally published in Senior Digest
This is the first of a series of five articles to help you understand and avoid risky stocks and the losses which often follow. Please print this out and put it in a notebook, along with the four following articles, and you will have a thorough and highly useful primer to help you identify, understand and avoid risky stocks.
A company’s Solvency should be the first test you perform on any company before you buy it.
Prudent investors, like yourself, should only buy a company if it has “the ability to pay-off its all their debts, from liquid assets and easily liquidated assets”. That’s a high standard of solvency. Such companies literally can’t go bankrupt.
But most investors settle for and buy companies with much higher financial risks. They ask, “can this company, presently, manage their debts”. That’s a far cry from a company that can easily “pay-off all their debt”.
Moreover, most investors look to a company’s “earnings” to assess how well they expect a company can “manage” their debt. That’s a risky proposition. How many public companies, in the past 20 years, had great sales and earnings, then faced such declines in sales and earnings that they went bankrupt? What’s the chance of that happening to the company you own? Can your current “advisor” honestly tell you he or she has the expertise to answer these two critical questions?
Let me illustrate: When you’re starting off in life you buy a house. You pay your mortgage from your earnings. But then, if you prosper down the road, you build up savings (equity) apart from your house and your savings (your total liquid equity) becomes far greater than your mortgage. Now you’re solvent! But when you started out, you managed your debt. Now, your liquid assets can be used to pay off all your debt. Now you have a safe financial structure. Buy companies with little financial risk and that’s one less thing that can hurt their price.
But if you just look to a company’s earnings to manage their debt, if their earnings fall, how long will it be before they no longer manage their debt, and their debt begins to manage them?
A company whose debts are far greater than their liquid assets is out on a limb. It doesn’t mean that limb will break. But how do you know it will not? Why take the chance? Your “advisor” will say they’ll be fine! But neither you nor your salesperson knows for sure.
We purchase risk analysis research from Equity Performance Sciences. This company does not make stock “buy or sell recommendations”; they focus exclusively on risk research.
How much of your savings can you afford to lose? Whatever the amount, the rest of your savings are funds you can’t afford to lose. For that part of your savings, protecting is more important than growing, right?
With that portion of your savings would you say that you simply cannot afford to lose? For your “safe money bucket” it is wise and prudent to avoid investing in companies with debt levels that cannot be paid from current liquid assets. There’s one more crucial consideration; if you pay too much for such companies, you may still lose a fair percentage of your investment.
Capital Preservation Trust, LLC is a Rhode Island Registered Investment Advisory firm focused exclusively on protecting capital. We will be happy to show you how we use our advanced proprietary technology to protect your capital.
Here’s a short list of bankrupt companies that you may know… but there are over 9,000 more!
Florida Coast Paper
Fruit of the Loom
Great Atlantic & Pacific Tea
House of Fabrics
Imperial Capital Bancorp
Kimball Hill, Inc.
Kinder Care Learning
Koll Real Estate
New Century Financial
Pilgrims Pride Corporation
Real Mex Rest
Stone & Webster
Trans World Air
This list contains companies from every business sector in America. But you won’t find one company on this list whose liquid assets were greater than their total debts. 42 years in the business: lesson learned.