Brad’s Note: The recent blow-up in crypto surrounding the FTX exchange and its CEO, Sam Bankman-Fried, has been taking over headlines.
It reminds me of a few other times in history: The 1980s Japanese real estate and stock market bubble… The 1998-2000 U.S. internet stock bubble… And the 2006-2008 real estate bubble.
In hindsight, the hype and craze surrounding those bubbles were a dead giveaway that they couldn’t last. But in the moment… It was hard for people to sit out. And the results proved disastrous.
What it comes down to is this: Predicting crises isn’t easy.
That’s why today, analyst Stephen Hester is going to share the three rules to avoiding investment catastrophes.
Stephen has been a due diligence officer for multiple firms with over $100 billion in assets under management. Thousands of investment deals crossed his desk. Real estate, hedge funds, private equity, oil and gas, even specialty tax plays… You name it, he’s probably analyzed it.
Learning from his experience professionally managing risk is a great way for you to help protect your own portfolio today… and for the future.
We’ve all heard the quotes about not losing money being the key to investing success.
That’s easy for billionaires to say. They don’t need to worry about retirement. Regular people, on the other hand, are tempted by high-risk, high-reward investments to reach their financial dreams.
I get it. I’m not a billionaire, either. But I have been analyzing investments professionally for a long time. And with a lot of accountability.
Regular investors are known for going all-in during bubbles. For example…
I know people who bought the top of bitcoin and the recent tech bubble. It’s not that I asked. They never stopped talking about it… Until recently, that is.
The losses many crypto and tech stock investors have experienced are no laughing matter. Many technology and crypto stocks are down 80%, 90%, and even more.
I’m not here to kick anyone while they’re down. I’ve made plenty of mistakes. Especially as an investor in my 20s. The point is to be better prepared for the next bubble. And there’s always one on the horizon…
That’s why today, I’m going to tell you three of the rules I lived by as a professional due diligence officer. It was my job to analyze and select complex investments for institutional investors like banks and endowments.
I had billions of retirement savings on my back. And a small oversight could result in big losses. So learning and implementing them was crucial to carrying out my job.
By following these rules, you can sidestep the most dangerous investments for your own retirement portfolio.
Rule No. 1: Don’t Invest in What You Don’t Understand
This simple rule isn’t always easy to follow. But deep down, most investors know if they understand what a company does.
Look at the “organizational” chart below…
Source: Twitter, @GRDecter
This is the org chart for FTX. Does it make sense to you? Can you tell who owns what?
FTX isn’t alone. Alibaba (BABA) is the same way. Carvana (CVNA) – my biggest short in recent years, which I’ll tell you more about below – isn’t far off.
Look through your portfolio using this lens. Be honest with yourself. Can you explain what a company owns and how it makes money to a 12-year-old? If you can’t, it’s a warning sign.
Rule No. 2: Cash Flow Is King
A company doesn’t have to generate large cash flow to be a good investment. But it sure helps. And if it doesn’t, you’d better know how and when those profits will arrive.
Amazon (AMZN), for example, reinvested cash in its early years. So it wasn’t always easy to see cash flows outside of research and development. But by doing this, it avoided debt, and its investments paid off year after year.
Amazon could turn on the cash flow machine if it wanted or needed to. Many tech darlings of the most recent bubble, however, can’t say the same.
Without a way to generate cash, it isn’t a business. It’s just an experiment. And the funders of that experiment? Shareholders.
That’s one reason we at Wide Moat Research focus exclusively on companies that generate strong cash flows.
Rule No. 3: The Valuation Must Make Sense
Carvana was worth just over $30 billion at its peak in August 2021.
Meanwhile, since its founding in 2014, it never had a year with positive operating income. Plus, it never had positive earnings before interest, taxes, depreciation, and amortization (EBITDA).
EBITDA multiples are often used instead of a price-to-earnings (P/E) ratio for companies that aren’t profitable. And in 2021, Carvana’s EBITDA was negative $1.12 billion. That’s three times greater losses than any other year in the company’s history.
Yet investors continued to pile into Carvana as its stock price rose from $35 in 2019 to $370 in 2021. It’s below $10 today. That’s a 97% decline in the past year.
These situations almost always have another warning sign in common. The company had 15.2 million shares outstanding at the end of 2017. By the end of 2021, that number was 82.8 million. That’s five times more shares.
Instead of making a profit, Carvana was plugging the huge hole in its business by issuing more shares. It had been doing it for years. But investors pretended like it was no big deal. It was.
So the lesson here is: Not sure if something is fairly priced? Don’t buy it.
Invest Like a Due Diligence Officer
A great thing about these rules is anyone can follow them. The recent popping of the crypto and tech stock bubbles is yet another reminder of how important they are. And how easy it is to fall for the latest fad…
At Wide Moat Research, we don’t consider these as just rules – they’re laws. And making them core principles of your own investment strategy can help you avoid falling for hyped-up stocks and trends.
Luckily, you have us and our experience to guide you toward the companies that have what it takes to help you sleep well at night. And we’ve put together a portfolio of companies that passes these rules with flying colors.
To learn more about them, click here.
Happy investing,
Stephen Hester
Analyst, Intelligent Income Daily