As the calendar gets set to turn to 2024, beginner investors might want to up their game and take a stab at trying to pick individual stocks for their portfolios. After all, the goal is probably to beat the market over the long term.
There are some things to watch out for, though. I think they could seriously help improve your chances of success.
If you're new to investing in 2024, avoid stocks that have these three red flags. Let's take a closer look.
1. Excessive debt creates problems
This first red flag should go without saying, but maybe all investors should listen up. It's best to stay away from companies that have lots of debt on their balance sheet. There are a number of reasons for this.
A business that has a huge debt load is very sensitive to macroeconomic factors. Should sales start declining for whatever reason, it may not be able to make interest payments to its creditors, leading to a potential bankruptcy. In other words, there is no financial buffer. In an adverse scenario, shareholders could get completely wiped out.
As we've seen recently, these types of companies are in a terrible position when interest rates rise. More capital needs to go toward paying off lenders and not toward growth initiatives, which isn't in the best interest of long-term value creation.
Just look at Carvana. Due to major macro headwinds, like inflation and rising borrowing costs, its financials took a huge hit. More importantly, the business had to restructure its debt, which currently represents 47% of its entire market cap.
To be fair, shares have absolutely skyrocketed in 2023, but they're still 84% off their all-time high. And there's still a very real possibility that Carvana will run into more financial problems in the future.
Image source: Getty Images.
2. Profitability should be prioritized
It's also a really good idea to only look at companies that have produced consistent profitability. I'm not talking about those funky metrics you might see, like earnings before interest, taxes, depreciation, and amortization (EBITDA), or non-GAAP (adjusted) numbers. I mean positive net income, as reported, as well as the ability to generate free cash flow.
Over most of the past decade, companies that were losing money each year received the benefit of the doubt from investors. Ultra-low interest rates meant these businesses could constantly sell the message that foregoing profits today in the name of growth was a smart strategy. Of course, many of these companies have gotten crushed in the past couple of years.
As the macro tides have shifted, owning financially sound enterprises should be a priority. In fact, this should be the case in all economic situations.
Profitable companies have proven that their business models are sustainable. Just like not having a lot of debt, this limits their financial risk. This should be important for long-term investors.
3. Avoid paying an expensive valuation
Besides focusing on key fundamental factors, new investors will want to make sure they don't overpay for the stock that they are looking at. It really doesn't matter how wonderful you think a particular company is. If the valuation is expensive, it creates a big headwind to achieving adequate returns, as these situations might be priced to perfection.
I think Tesla fits the description here. It's hard to deny its dominance as the leader in its industry, with an innovative and disruptive culture. But the stock's ridiculous gains in the past, and even in 2023, have resulted in a price-to-earnings ratio of 82. That current valuation is excessive, in my opinion, and leaves no margin of safety.
New investors should pay attention and try to avoid these major red flags. They will surely increase the chances of producing strong market returns in the long term.
