When considering investments, many investors concentrate on the things that make a stock a good candidate. But what about the potential danger signs?
Understand your motivation for investing in a particular stock
When a highway ramp leads into oncoming traffic, warning signs keep drivers from going the wrong way. That usually gets the job done.
But when a particular stock poses danger, the signals aren’t always so evident. What might you consider to help avoid the stock market equivalent of two semitrucks bearing down on your portfolio?
First, find out whether the company you’re considering has issued any recent earnings warnings or failed to meet analysts’ earnings expectations more than once in recent quarters. Either may be a red flag.
Although no company can always perfectly predict how a quarter might go, it’s important to see that the firm has a decent track record of conforming with both its own and analysts’ expectations. Failure to do that might indicate either disorganization within the company or failure by company leaders to respond to changes in industry dynamics. You may not want that.
The other possibility is that the company might be in a very volatile industry that no firm could have much control over. That’s not always a bad scenario, because sometimes volatility can mean the chance for greater returns, but if you don’t like a roller coaster ride, it might be better to stay away.
How can you check if a given company delivered on financial estimates over the last few quarters? Login to your account at tdameritrade.com, then click on Research and Ideas > Stocks > Profile. Type in the company’s stock symbol, and from there choose the company’s profile page and hit the Earnings tab*. That tab gives an overview of the company’s recent earnings results, including how it performed versus analysts’ expectations. There’s even a red mark on any quarter where the company delivered a negative earnings surprise, which will tell you by how much it missed expectations.
You might also want to check the Analyst Reports tab for the company, which can tell you how analysts are viewing quarterly performance, what issues the company faces, and whether analysts believe it’s on the right path to resolve them.
Another important tab on the TD Ameritrade stock profiles page is one called Peer Comparison. When you scroll down in this tab, it shows your chosen stock versus key peers in the industry, comparing them on the basis of important metrics such as earnings growth, price-to-earnings (P/E) ratio, and profit margin, among other factors. This data can help you smoke out possible danger signs in a stock.
“I always like to compare stocks to others,” said Kevin Hincks, manager, trader contributor and host, TD Ameritrade. “Compare a stock to its sector and see how it’s doing compared to other stocks. Case in point: the P/E ratio. If the stock you pick has the highest P/E, maybe it’s not the best choice.”
“If you’re looking for value, a stock that has a P/E of 15 or higher or a dividend lower than 2.5% might present reasons for skepticism,” said Ryan Campbell, education content manager, TD Ameritrade.
Other warning signs might include lower profit margins than a company’s peers, a falling dividend yield, and earnings growth below the industry average. There could be benign explanations for any of these, but you need to do a bit more research and make sure they don’t point to any red alerts that might mean future share weakness.
Some danger signs might not be with the stock, but with you. The company may be doing nothing wrong, but if you invest hoping for major sales and earnings growth and accidentally choose a mature company in a mature industry, you’d own that mistake. The same is true if you buy shares in a company but don’t take time to really figure out what it does.
“If you don’t understand how a company makes money, you might want to re-think investing in it,” said JJ Kinahan, chief market strategist, TD Ameritrade. “You should understand how it makes money.”
Additionally, it helps to evaluate possible outside risks that even a solid company might face. Look into the industry a bit, read some recent news articles and analyst reports, and see if you sense danger signs. Even if a company seems to be dominating its industry, you wouldn’t want to invest if it’s the equivalent of buying the best horse and buggy maker. Again, the Analyst Reports tab on tdameritrade.com can help give you a sense of what’s driving the company and its industry.
It’s also important to understand your motivation for investing in a particular stock, because sometimes you may be letting emotions and perceptions get in the way of figuring out if it’s a good investment. This often happens when a stock is in a high-flying industry that’s getting a lot of attention and drawing excited investors. There’s often a sense of not wanting to miss out. But that’s another danger sign.
One example of investors investing emotionally was the so-called “dot.com” boom, when many investors threw caution to the wind and leaped into Internet stocks without really figuring out how or whether these companies could ever generate cash flow or profit. In some cases, investors loved the product they were using and may have decided the rest would naturally follow, but that’s a common fallacy.
“Just because they have a great product doesn’t mean it’s a great investment,” Kinahan said. “You have to do some research. As with anything worthwhile, you have to put in some work.”
There are also some danger signs of a more technical nature that you might be able to see on charts, also available on the TD Ameritrade site.
For instance, experts often tell investors to try to buy a stock when it’s relatively cheap, although picking a bottom is never really possible. But it sometimes pays to be patient and watch the charts carefully before swooping in.
“People try to pick a bottom, but if a stock is on a bad decline, you don’t have to buy the bottom,” Kinahan said. “You can wait for a little trend. Wait for it to rally a few days in a row, because often there’s what’s called a dead cat bounce, meaning it bounces for a day and then gets plastered. You may want to make sure [the initial rally from lows] isn’t just short-covering.”
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