A Pig with Lipstick is Still a Pig.

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  1. 1 — Your granny has asked you if you have heard of the stock.
  2. 2— The company burns more cash than your sixteen-year-old daughter.
  3. 3 — You cannot explain to your dumbest friend how the company makes money.
photo by Pascal Debrunner on Unsplash

When I started investing, like many more fools before me, I was obsessed with an ultimate goal: make money, make lots of it, and make it fast!

At the time did not seem like such a big deal. After all, everyone seemed to be making money in stocks, even Carl, my moronic neighbour.

I wanted in. I scrambled together a decent stake, downloaded an investing app (duly recommended by Carl), and I was ready to make millions. As soon as tickers started flashing green and red on the screen, I realised I didn’t know how to pick a stock. I began selecting them randomly just because they seemed to be going go up. No spoilers, but as you can probably imagine, my plan of piling up riches didn’t work out.

I will share an unrefutable truth: investing is simple but is not easy. I wish I knew this back then, but I know it now, and so do you.

Over the years, I developed a process for picking stocks through a bumpy road of crazy bets, countless books and bitter tears. My perception of investing has completely reversed. My ultimate goal is now: protect capital, expect reasonable returns and don’t be in a rush!

One of the essential aspects of my process is being able to dismiss a stock quickly. A considerable skill in investing is the ability to say no. It is easier to say no if you know what to avoid.

I distilled three characteristics of an uninvestable stock.

1 — Your granny has asked you if you have heard of the stock.

Being famous might be good if you are Justin Bieber, but it is not great for stocks. If a stock is popular and everyone is talking about it, it is probably overrated and overpriced. Markets are supply and demand mechanisms feeding on people's fears and desires. If demand is super high, the price will be too.

The goal of investing is capital appreciation. If you pay a very high price for an asset, you are limiting your upside potential while increasing the risks of the downside. Overpaying is the number one enemy of a successful investor.

It’s not what you buy; it’s what you pay. (Howard Marks)

We all want to own trendy stocks but paying high prices is not the way to make consistent superior returns. You need to demand quality at a reasonable price. You want value. Value tends to be elusive and rare. It is certainly not popular.

Avoid overpriced stocks!

2— The company burns more cash than your sixteen-year-old daughter.

The lifeline of a company is cash. Cash is king and an excellent place to start valuing a company!

When researching a company, forget about what CNBC is saying and instead look at the cash flow statement. You want to see capital expenditure lower than cash from operating activities. That means that the company makes money and has free cash flow. That “free” cash can be reinvested in the business to keep growing (and earn more cash, hopefully) or can return to you, the friendly shareholder. Beautiful!

When we buy a company, we buy a future stream of cash flows.

You also want to ensure that management knows what to do with the disposable cash in hand. Look for companies with a consistent double-digit return on invested capital (roic).

A business without disposable cash it’s not a good investment. They need money to finance growth. They will issue more debt or shares. Both scenarios are not suitable for you.

Avoid cashless companies!

3 — You cannot explain to your dumbest friend how the company makes money.

Warren Buffet calls this a “circle of competence”. Buy a stock only if you truly understand how the business makes money.

How can you create an opinion on the company's future revenues if you don’t understand the product or service sold by the business? If you don’t understand it, avoid it at all costs.

You can learn about a business by reading its annual reports, but I suggest sticking to areas of the market that you are familiar with. You are buying partial ownership of a company, not a lottery ticket.

Know what you are buying!

In conclusion, always remember that investing is a process. Stick to these three rules to reject stocks. Stay invested for the long run, remember that corporate accounting is black magic, and buckle up as it will be a wild ride.

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