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5 Red Flags to spot while picking stocks!

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Key Takeaways

1. Companies losing money might struggle to grow and maintain their stock value.

2. Companies with too much debt may find it hard to grow and could face financial problems, affecting their stock value.

3. Confusing or incomplete reports may hide company performance problems.

4. Significant leadership changes can mean uncertainty.

5. If the company's promoters sell many of their shares, it could mean they're unsure about its future. Keep an eye on this, as it might affect the stock's value.

Are you curious about how to spot the good and bad stocks in the market? To answer the query “how to invest for beginners,” initially, it's like being in a giant store with a wide selection of choices—exciting but tricky. Unfortunately, not all stocks are winners. Getting into share market trading offers the thrill of being part of the success stories of companies like Reliance, TCS, and HDFC Bank. However, it also tells a cautionary tale of being extra sure and informed before making any trade.

History teaches us that losses are part of the game. Moreover, the financial landscape isn't free from scams and scandals. From the Satyam scandal to the recent issues around IL&FS, Indian investors have seen firsthand that high returns can come with high risks. These events serve as stark reminders that in the stock market, guarantees are a myth. A methodological approach and keeping away red flags is thus the only solution. Let's see how this can be done.

Your Approach To Picking Stocks

When choosing stocks, there are a few fundamental decisions to make, such as these:

Understanding Your Goals: Decide what you want from your investment—quick profits, steady income through dividends, or long-term growth. Your goal will influence the kind of stocks you should consider.

Starting with What You Know: Invest in companies or sectors you understand. For example, if you’re familiar with the IT sector, you might be more comfortable evaluating companies in that space.

Researching the Company: Look into the company’s financial health by reviewing its balance sheet, profit and loss statement, and cash flow statement. Check its revenue, profit margins, and debt levels. Companies with strong financials are generally considered safer investments.

Knowing the Market Position and Competition: Understand the company’s position in the industry. A leading company in a growing sector is often a good pick. Also, consider how it stands up to competition.

Reviewing Regularly: Investing in stocks is not a set-and-forget strategy. Regularly review your investments to ensure they are on track to meet your goals.

Diversification: Don’t put all your money in one stock or sector. Spreading your investment across different stocks or sectors can reduce risk.

Wise investors tread carefully, recognizing the importance of vigilance. They know that education is the key to protecting their financial future against the market's darker undercurrents. Awareness of red flags is crucial to understanding how to invest in stocks. If you notice too much debt, confusing financial reports, or investment offers that seem too good to be true, it's worth looking closer. 

Let's explore five key warning signs that can help you make informed investment decisions and avoid potential pitfalls.

The 5 Red Flags to spot while picking stocks

1.   Constantly Losing Money: If a company keeps losing money year after year, be cautious. It's like a shop that never sells enough; eventually, it might have to close. A company that doesn't profit might struggle to grow, affecting its stock value. 

One example is Jet Airways. Despite being a prominent player in the Indian aviation industry, Jet Airways faced continuous losses due to stiff competition, rising fuel costs, and mismanagement. The airline eventually ceased operations in 2019, leading to a significant decline in its stock value.

 2.   Too Much Debt: Companies with a lot of debt have to pay back more money, making it harder for them to grow. Excessive debt can be a red flag for investors. Companies burdened with high levels of debt may struggle to meet their financial obligations, hindering their ability to invest in growth opportunities. Monitoring a company's debt levels is crucial; a significant increase could signal financial distress and potential risks for investors. Assess the company's ability to service its debt obligations, considering cash flow, asset quality, and debt covenants.

For example, Videocon, a diversified corporation, expanded rapidly but accumulated substantial debt. Too much debt, economic problems, and issues with running the company caused big financial problems. The company had to declare bankruptcy, and its stock price dropped significantly.

3.   Odd Financial Reports: Financial reports should be clear and easy to understand. If a company's reports are confusing or there is some missing information, it's a red flag. If a company's financial reports are confusing or lack critical information, it raises concerns similar to a story that doesn't add up. Investors should be cautious with companies that aren't clear about their finances, as this could signal problems or efforts to hide bad results. 

Satyam, once a leading IT services company, faced a massive accounting scandal in 2009 when its founder confessed to inflating its profits for years. The discovery of fake financial reports significantly reduced investors' trust and caused a significant drop in Satyam's stock price.

  4.   Change in Leadership—Significant changes in company leadership can signal uncertainty and potential challenges ahead. While new leadership can bring fresh perspectives, frequent turnovers or abrupt changes may indicate instability within the company. Investors should assess the new leadership's qualifications and track record to accurately gauge the company's prospects.

In 2017, Vishal Sikka resigned as the CEO of Infosys amid clashes with the company's founders over corporate governance issues and strategic direction. The leadership change created uncertainty among investors, contributing to a temporary decline in Infosys's stock value until stability was restored under new leadership.

 5.   Promoter Reducing Stake- When considering investing in a company, it's essential to watch for significant changes in how much of the company the founders or primary owners hold. If they start owning less, it could be a warning sign that they're worried about the company's future or management. Consider why they're selling their shares if you're new to trading. Reasons could be personal financial needs, wanting to spread their investments, or not agreeing with where the company is going. But if the principal owners keep selling off their shares often or in large amounts, it might point to serious problems like the company not doing well, issues with how it's run, or financial troubles ahead.

Check the company's announcements, official documents, and news to understand why the owners are selling. Also, getting opinions from financial experts or people who know the industry well can help you determine how this could affect the company's stock and future.

An example of this is that of Yes Bank. Yes Bank, once considered one of India's fastest-growing private sector banks, faced significant challenges in 2020, leading to a sharp decline in its stock price. During this period of turmoil, the bank's promoters, led by Rana Kapoor, reduced their stake in the company. Rana Kapoor, who co-founded Yes Bank and served as its CEO, had gradually reduced his stake in the bank over the years. However, in the wake of increasing concerns over the bank's financial health, governance issues, and regulatory scrutiny, the rate at which ownership was being sold increased quickly.

The decrease in the owners' share in the bank made investors and analysts worry about whether the owners still believed in the bank's future. This also led to guesses about why the shares were sold, like needing cash or doubting the bank's ability to handle its problems. The big sell-off by the owners, along with other warning signs like worsening finances and regulatory issues, caused Yes Bank's stock price to fall sharply and shook investors' trust. This situation warns new traders to keep an eye on changes in how much of the company the principal owners hold and think about how it could affect the company's future and its stock price.

To Summarise

Investing in stocks comes with risks, but knowing what to look for can protect your money. The warnings we've discussed are just the basics for new beginners. “How to invest in stocks” comes from experience.

Today, investors have tools like the CubePlus app to help sort out suitable investments from bad ones. The app offers detailed analysis and up-to-the-minute information. Keeping an eye out and using common sense in your investment choices is vital to doing well in the stock market. Enter the share market trading with confidence.

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