How To Avoid Investment Landmines

by: Alan Brochstein, CFA

One of the keys to successful investing is avoiding large capital losses. In many ways, investing is like baseball: Homeruns are great, but their pursuit often leads to striking out. In investing, you often have to assume a lot of risk in order to earn extremely high returns. Many investors hedge their bets through diversification, which serves to smooth out the variability of returns. If you do choose to invest in stocks, is it possible to spot the landmines before you step on them?

In the 1st quarter of 2007, over 1% of the Russell 3000 index (the top 3000 stocks in terms of market capitalization) declined in price by over 40%. Hopefully, you didn’t own any of them! Using StockVal, I took a look at an even sadder group: Stocks that lost more than ½ their value in the first quarter. As you can see from the table below, the list covers several economic sectors and includes some companies with which you are probably somewhat familiar:

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A few observations: First, several of these companies are burdened with debt. Second, there are many stocks that were below $10 before the sell-off commenced. Finally, the EPS estimate for this year was hammered in general.

How to avoid the landmines

One thing that can’t be ruled out is chance. Quite frequently, there are “shocks” to a stock that can’t necessarily be predicted: a rival drug receives approval, the company does a big acquisition that isn’t well received or a flood or natural disaster disrupts business activity. There is an almost unlimited number of unavoidable or quasi-unavoidable circumstances, but there are probably even more cases of landmines that could have been avoided.

There are several “tells” that potentially suggest trouble ahead for a stock. The presence of more than one especially signals the need for increased diligence. In the financial statements, one can often observe deteriorating working capital metrics, declining profitability despite rapid sales growth, and the presence of high levels of debt relative to equity or tangible equity. With respect to sentiment, often an insider can be “in the know” in advance of bad news: It pays to monitor for significant changes in their holdings.

Technicals are probably the best tool for avoiding landmines. Stocks in downtrends and/or stocks sitting on support levels with the next level significantly lower should raise yellow flags. Finally, a pattern of continual negative earnings estimate revisions can point to problems as well. In a similar vein, sometimes a hugely “accretive” merger fails to meet the lofty expectations: watch out for stocks that expand PE multiples after doing a big deal. While the presence of one or more of these factors shouldn’t necessarily trigger an automatic sell, it should alert the investor to the need to revalidate their buy thesis.