Five traps to avoid when choosing shares

Rather than ask ''what characteristics should I look for when investing in a company?'' it is often better to ask the reverse question ''what characteristics should I avoid?''. This can help to avoid the losers and increases the chances of picking winners.

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Below I highlight five common company characteristics which, I believe, investors are invariably best to avoid.

1. Weak cash flows

There is a well-known saying in business: ''revenue is vanity, profit is sanity but cash is king''. Cash flow is the lifeblood of businesses and a company that fails to produce enough of it is destined to fail.

Cash flow and earnings are not the same thing. The latter can easily be manipulated by creative accounting. For this reason investors should look at a company's cash flow statement (usually found towards the back of the annual report) to establish how much cash a company actually generates. As a bare minimum, companies should be avoided that consistently fail to generate enough cash to cover the interest on their debts and required capital expenditure.

Instead, look for companies that generate more than enough cash to service the business. Consumer goods companies such as Unilever, Diageo and Reckitt Benckiser, and tobacco companies such as Imperial Tobacco and British American Tobacco; for example, tend to generate very strong cash flows. This gives them the opportunity to reward shareholders with dividends and share buybacks.

2. Excessive debt levels

Generally, too much debt is a bad thing for companies and shareholders. All debt must eventually be repaid and this drains cash from a business, as does the interest on this debt. In order to establish whether a company's debt is too high you could ask the following questions:

• How long might it take to repay the debt? By comparing a company's debt levels with the amount of cash it generates you can get a reasonable approximation.
• Can the company afford the interest on its debts? The interest coverage ratio, calculated by dividing earnings before interest and taxes (EBIT) by the company's interest expenses in the same period, can shed light on this. The higher the interest coverage ratio the better, with a ratio below one signalling that a company cannot afford the interest it owes.
• How economically-sensitive is the business? Companies that provide an essential good or service such as gas, water and utilities tend to benefit from predictable revenues and cheap borrowing costs. They can usually afford to service higher debts. However, if a business provides a discretionary good or service (a clothes retailer for example) and also has very high debts, this can be a worrying sign. Many companies over-extended themselves in the years leading up to the financial crisis and debt levels rose to unsustainable levels. When the crisis hit they had to resort to rescue rights issues to shore up their balance sheets, and some were forced out of business.

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3. Highly complex business models

As Warren Buffett says, if you don't understand a business, you shouldn't be investing in it. This is why he avoided technology shares in the late 1990's and why his investment company, Berkshire Hathaway, tends to invest in simple, relatively stable businesses such as Coca Cola, Procter & Gamble and Walmart. The great economist and successful investor, John Maynard Keynes, also stresses this point:

As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about...

JM Keynes

You do not need to become an expert on a company's products or services to be a successful investor, but you should understand how it makes money, and have a reasonable understanding of its future prospects.

4. Rapidly declining market or industry

A declining market is not necessarily a bad thing, provided the decline is manageable. A good example is the tobacco industry – falling smoking rates in the West and rising legislation mean there is little or no threat of new entrants and results in strong pricing power. This enables existing market participants to generate high returns.

However, sometimes the market for a company's products evaporates almost overnight, often due to changes in technology, regulation or consumer preferences. This can spell disaster. The internet, for example, has forced many of the traditional high street retailers out of business (HMV, Comet and Blockbuster to name just a few) and is presenting huge challenges for others.

It is always worth considering how the demand for a product or service might change over time. Consumer goods companies such as Diageo (owner of Guinness) and Coca Cola, for example, own brands that have been around for years. They are unlikely to see demand for their products fall off a cliff overnight.

Technology companies, on the other hand, need to constantly innovate to stay ahead of the game and so are generally much more susceptible to changing consumer tastes and preferences. Both Sony and Nokia led their respective industries for years before succumbing to competition from more innovative rivals.

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5. Expensive valuation

High valuations can be a great destroyer of shareholder wealth. This was particularly evident in the late 1990's dot-com bubble. Investors piled in to technology and media companies, despite the fact that many were making little or no profit. Share prices and valuations rose to meteoric levels. Eventually, reality set in and the bubble inevitably burst.

More often than not it is best to avoid shares attracting a lot of hype and excitement, trading on stratospheric valuations. You may miss out on the odd Apple or Google, but you will also avoid a lot of disasters.

How to choose shares like the experts

Now we've helped explain what not to do, could you unearth shares with good potential? Our free "How to select shares" guide reveals six common sense strategies, used by successful investors, to select shares. The guide also explains simple analytical tools you can use to assess the health of a company and identify share price trends.