What Makes A Risky Stock? It’s a good question. And getting to the bottom of what makes stocks risky can save you a ton of money. So what should you be on the lookout for when you’re trying to find stocks to buy?
In this short article you’ll learn to spot the major red flags that define risky stocks. With this knowledge you’ll be well on your way to improving your confidence in your stock picks and protecting your bottom line. Sound good? Great. So…
In no particular order here are…
Factors That Make A Stock Risky:
Really Low Volume: Volume is like a proxy for stock demand. It gives you an idea of how many people are interested in buying and selling the stock in question. Practically speaking: If there are less than 150,000 shares traded you will have trouble getting in and out of a stock. This is particularly problematic if you have a large position because you won’t be able to sell your stock without driving the price down. This is how a lot of penny stock scams happen. To be safe, look for stocks with an average of over 500,000 shares traded daily.
Micro Market Cap: This isn’t a deal breaker for risk. But you should know that stocks with really low market caps (under $300 million give or take) have a tendency of being volatile. They’re also usually low priced stocks, so you can suffer big % gains which look terrible on paper and will turn your stomach in knots. While low market cap stocks are often under-watched and may very-well be mispriced, this can be a bumpy road to ride. So be prepared.
High Price to Earnings: While some growth stocks warrant their high price to earnings multiples, most of the time this is a sign of risky hype. And when hype runs out you can be left holding the bag. The risk with overpaying for earnings is that if the expectations aren’t met the stock will collapse and there are no hard assets to prop up the value. It can be a long way to fall. To avoid risk I ideally I look for stocks with P/E ratios under 15, and I almost never buy stocks with P/Es over 30.
Negative Operating and Free Cash Flow: Sometimes companies have negative free cash flow because they are making big investments to support growth. But companies that have negative operating cash flow and consistent negative free cash flow can be very risky investments. While it’s tempting to bet on turnaround stories, it is also risky. The risk of a company running out of cash (and having to raise debt or dilute current shareholders) is very real. Free cash flow is a great measure because it’s much harder to manipulate than earnings.
High Price To Book Value: The price-to-book value of a company gives you (rough) insight into the intrinsic worth of the company. If a company is trading much much higher than the assets of the company are worth, it’s risky. On the other hand, the margin of safety philosophy is designed explicitly to find stocks trading below book value, precisely because it’s less risky. While book value isn’t a perfect metric it definitely helps to know your stock price is supported by real assets.
Low Current Ratio: One of the risks companies face is solvency. And while keeping an eye on cash flow is one way to avoid the risk of a cash crunch, current ratio is another easy way to get an idea of the risk a company won’t meet it’s liabilities. Stocks with a current ratio above 2 are a much less risky than those laden with current liabilities (indicated by a current ratio below 1).
If you want a more in-depth look at how to avoid these risky stock characteristics, check out the short video below about “what makes a stock risky.”
What Makes a Stock Risky [VIDEO]:
Watch Out For Risky Stocks:
As you can see, there are a number of factors that make a stock risky. And the risks to investors aren’t always easy to see. But by keeping your eyes on the indicators above you can get a pretty good measure of risk in your stock ideas.
And By The Way: If you’re looking for more ways to avoid risky stocks, sign up for the free mini e-book below. You’ll learn how I evaluate stocks and use swing trading strategy to reduce risk.