- Stock investing is largely about researching and understanding a company.
- Knowing when to invest, hold or buy is what makes an investor successful.
- Hence it is critical to understand various warning signs in order to differentiate a good stock investment from a bad one.
Stock investing is one part gambling and nine parts research and understanding of the market. Successful investors know when to hold a stock, understand the signs signifying that it's time to sell, and recognize the warning signs that a certain stock is probably a bad investment at a given time. Some warning signs are obvious – steering clear of a company with billions in pending lawsuits, for example. Others signs, such as cash flow or profit trends, take some additional investigation.
Numerous Lawsuits Pending Against the Company
Lawsuits – even of the class action variety – aren't an automatic death knoll on the stock market. Medical device company C.R. Bard Inc., which trades as BCR, saw its shares rise 2.9 percent after agreeing to settle only a portion of lawsuits involving its vaginal-mesh product. Companies that are publicly taking action regarding lawsuits – and have the bankroll to back those actions – aren't necessarily a bad investment. When lawsuits are piling up and companies are visibly scrambling, investing may be riskier.
Controversial Turnover in Executive Management
Any turnover in executive management can drive sudden changes in stock value. When Arctic Cat fired its CEO in June, stock value dropped 12 percent in a single day. Ultimately, the stock recovered some, but still closed over 8 percent down. When watching for leadership warning signs, consider the full picture. Companies that are transparent about the change and have a strong plan for the future are likely to recover, which may make them a good short-term gain investment. Companies with scandalous firings or constant leadership turnover may be poor investments.
No Engagement between Company and Audience
Business is a two-sided street, and companies that clearly ignore their target audience may be headed for trouble. Companies that fail to engage online or respond to ongoing customer complaints don't usually fair well, which means stock investments are likely to see the same fate.
Known Product or Service Reliability Issues
The stock market often reacts to public opinion, and known service or product issues can drive down stock value. Investors don't want to back the lame horse – just ask General Motors (GM), which has experienced an ongoing downward trend in stock prices throughout the recall issues of the past few years.
Source: General Motors stock price chart by Amigobulls
Evidence of Regulatory Compliance Issues
Nothing sends consumers and investors running faster than a whiff of regulatory problems. Companies that can't keep their own books straight – or that have possible criminal activity between the balance sheets – are never a good investment. Even if stocks soar temporarily, the fall is hard for these companies. The Enron fraud illustrates that such companies rarely fall alone.
Large or Very Public Employee Layoffs
Layoffs are a mixed bag as a stock warning. Sudden unexplained layoffs without a publicly communicated plan for business growth panic the market, often resulting in poor stock performance. Layoffs can also signal that a company is in its death throes. In some cases, stocks recover quickly after layoffs, especially amid mergers, acquisitions, or other company structure changes. Hewlett Packard (HPQ) announced layoffs as part of a restructuring that split its printer and PC divisions into two companies; following that announcement, the stocks gained 4.7 percent.
Source: Hewlett Packard stock price chart by Amigobulls
Known Cash Flow Problems
From equity investment to stock purchases, investments are rarely a good idea when the company in question is experiencing severe and prolonged cash flow issues. Stock investors may want to approach purchases with the eye of a creditor. Buying into an entity with severe debt problems rarely pays off. The exception to that rule is a company that has a strong plan for recovery or is undergoing restructuring to create a more successful future.
As with anything in the stock market, these warning signs aren't the same in every situation. The examples prove that what is a bad sign for one company is a good sign for another, so it's important to consider the signs in context with a company's history, plan, and current performance.