Warren Buffett says there are only two rules in investing:
- Never lose money.
- Never forget rule number 1.
It sounds so simple.
But how do you avoid losing money?
The most important thing is to avoid investing in companies that go bankrupt.
In a recession, more companies will fold. This means you have to be extra careful on the edge of a recession.
So what should you avoid?
There are five types of companies that you have to steer clear of.
1. Companies Without Turnover
Avoiding companies that don’t sell anything at all might sound like a no-brainer to most… but you’d be surprised how many people throw their money at companies that don’t even have a product yet.
Those could be biotech, fintech or even blockchain companies. A lot of private investors hear the story about what the company wants to change in the world, they get seduced by the idea of eradicating bone cancer or revolutionizing banking in the third world – and they never look at the numbers or the annual report to see that it’s a fantasy or a product that doesn’t exist yet.
Some of the things that get the most hype turn into hot IPOs without revenue. If the company has no revenue, they have no product on the market yet.
The hard truth is that credit lines dry up really quickly in a recession, and you need to get something on the market to survive that.
2. Companies That Lose Money
Then there are all the companies that might sell something, but actually lose money on selling their product.
They simply don’t make any profit yet.
There are plenty of companies like that.
Some may defer profits by investing heavily in new business ventures (as Amazon did for many years), but as a private investor it’s difficult to discern whether they are deferring profits as a strategy or if they’re just plain lousy at making money.
If the company is continuously losing money, you have to steer away from them.
3. Cyclical Companies
Cyclical companies experience drastic dips in sales – and stock prices – when we enter a recession.
What is a typical cyclical company?
It’s all the companies in transport and property development.
This means car manufacturers (and anything related to the mobility industry – batteries, tires, you name it), airlines, logistics companies, construction, and property development.
Avoid these companies before a recession, but feel free to buy them when we are on our way out of a recession. At this point, their share price will begin to bounce back – if they survived the recession, that is.
4. Companies With a Lot of Debt
Companies burdened by a high level of debt are also at a high risk of folding during a crisis because they are weighed down by their debt. Maybe they can’t honor their creditors as the market and sales dip.
It makes sense, right? It’s the same with people. Let’s say two people lose all or part of their income. Maybe they or a spouse get fired. The one with a lot of debt – car debt, credit card debt, a mortgage on the house and the country cottage, some old student loans – is at a higher risk of having to sell their house to avoid foreclosure than the one who has no debt.
As a rule of thumb, the company should be able to repay the long-term debt within three years with their free cash flow.
You will find the long-term debt on the balance sheet. Free cash flow is often calculated in the 10K too.
5. Companies Whose Product You Don’t Understand
You need to be able to understand and perhaps even test the company’s product.
If you don’t know what the company sells, you’re in danger of investing in something that, in the worst-case scenario, turns out to be a pure sham.
This happened in Denmark with a company called IT Factory. The CEO was making everything up, and intelligent people invested with him. Afterwards, everyone asked how the investors could be so stupid. It’s simple. Did they ever look at the product or test it? Of course not. They took his word for it.
Warren Buffett says always to invest inside your zone of competence – and you should. Only if you really understand the product – and test it – can you evaluate whether it has a competitive edge… and a future.
Obviously, there are other things that you should keep an eye out for before you invest.
You should research the company in detail and find out whether you believe in the product, trust the management, and can vouch for the company’s values.
Then you figure out whether you believe that the company will be bigger in 10 years. You can only estimate the growth if you analyze their competitive advantages.
If you want to learn more about the road forward – how to actually invest, you should attend my free webinar that takes place oct. 25th and 26th. You can sign up right here.
You can also read more about how to find good companies in my free e-book that you can get here.