Warren Buffett says there are only two rules in investing:
1. Avoid losing money.
2. Don’t forget rule number 1.
It sounds so simple.
But how do you avoid losing money?
The most important thing is not to invest in companies that go bankrupt.
In a recession, there will be more companies that go bankrupt, and this means that you have to be extra vigilant on the edge of a recession.
So what is it that you need to avoid?
Here are five types of companies that you have to steer clear of.
1. Companies without a 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.
A great many private investors flirt or invest in biotech companies without opening the accounts because they are seduced by the idea that the company might one day be able to cure the type of cancer that Aunt Anna died off in 1989.
It can be some of the most hyped things that become hot IPOs – without having any product on the market. Here I am thinking, for example, of some of the cannabis companies that previously went public without having a product yet.
If the company has no revenue, they have no product on the market yet. You go bankrupt if you don’t start selling something within a relatively short time, so that money comes into the coffers.
2. Companies without profits
Then there are all the companies that might sell something, but lose money selling their product. They simply do not yet have any profit on the bottom line.
There are many of them.
Some may defer profits by investing heavily in new business parts (as Amazon did for many years), but as a private investor, it can be difficult to discern whether they are deferring profits or just being lousy at making money.
If the company is continuously losing money, you have to manage around them.
3. Cyclical companies
Cyclical companies experience drastic dips in sales and stock prices when we enter a recession. It is e.g. all companies within transport and property development. This means car manufacturers, 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 correct – if they survived the recession, that is.
4. Companies with excessive debt
Companies with high debt are also at extra risk of going bankrupt during a crisis because they are weighed down by their debt.
As a rule of thumb, the company should be able to repay the long-term debt within three years with its free cash flow.
You will find the long-term debt on the balance sheet. Free cash flow is often calculated in the accounts.
5. Companies whose products you do not understand
You must be able to understand and perhaps even test the company’s product.
If you don’t understand the company and what it sells, you are in danger of investing in something that is a pure sham – or that might cheat here and there.
There are of course other things that you should keep an eye on before you invest. You should investigate 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 have to find out whether you believe that the company will have growth in the future, which you, among other things, investigate by finding out if they have competitive advantages and invest in something that is the future.