3 Investing Rules To Avoid Buying Shares In A Lemon

Show me a seasoned share market investor who’s never made a loss and I’ll show you a liar.

Investing mistakes and plain bad luck is inevitable given enough time in the sharemarket. Below, I’ve listed three rules to help us all avoid buying a dud/lemon stock.

2 Decades Of Investing Have Taught Me…

After nearly two decades spent constantly trying to unearth the next ‘best buy’ to add to my portfolio, I have learned a few shortcuts along the way, made countless mistakes and discovered a few rules to help protect me from financial ruin.

By no means are these hard-and-fast rules. Everyone brings a slightly different approach to investing in the share market and there is no absolute correct way to go about it. Ultimately, we are all hoping to buy low and sell high, but the methodology of how we get there can diverge greatly.

Rule 1: Avoid companies with high levels of debt.

What constitutes a high level of debt is up for debate and will depend upon the nature of the business. However, as a general rule, I will filter out any company that has a net debt to equity (D/E) ratio of greater than 50%. By doing this, I drastically decrease the chances of investing in a business that goes bankrupt — which causes a 100% loss of capital.

The best companies don’t require outside funding, they produce excess free cash flow from their business operations which is then used to fuel further growth. A couple of current examples include Jumbo Interactive Ltd (ASX: JIN) and Infomedia Limited (ASX: IFM).

Rule 2: Buy companies which are run by managers with skin in the game.

This is not to say that just because a CEO owns a large parcel of shares the company is a sure-fire winner. Of course, this isn’t the case but I’ve learned that it helps as an investor to know that the people charged with running your company are incentivised to act in the best interests of owners.

For me, two companies that immediately spring to mind are Frontier Digital Ventures Ltd (ASX: FDV) and Flight Centre Travel Group (ASX: FLT). Both companies have CEOs with significant skin in the game (that is, shareholdings in the company they run), which gives me confidence that decisions will be made with the long-term best interests of the business front of mind.

Rule 3: Avoid IPO’s spun out of Private Equity.

Just like the previous two rules, following this religiously will mean that you’ll miss the occasional superstar performer. But I think it’s a small price to pay for the number of IPO lemons you’ll also avoid.

When it comes to business transactions, as the potential buyer it’s important to be mindful of who the seller is, what their incentives are and what sort of informational advantage they have over you. In the case of an ASX IPO coming via a private equity firm the odds are firmly stacked against you.

The above rule would ring true to anyone who invested in the IPO of Myer Holdings Ltd (ASX: MYR) when it listed for $4.10 back in 2009.

These are just some of my investing rules to live by. Obviously there are many other things you must consider — hopefully before you invest. Nevertheless, they are worthy rules to consider adding your existing process or checklist.

At the time of publishing, Luke owns shares in Jumbo Interactive and Frontier Digital Ventures.

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