While we’ve chatted before about red flags to watch for when screening potential buys or current holdings — including delaying filings and earnings misses — unfortunately, the list goes on.
There are a few distinct classes of investments that almost always are trouble for your portfolio, even though they may not be obvious trouble spots. I like to call these investments “pickpocket investments,” because oftentimes you don’t know you’ve been had until you go for your wallet … then realize it’s too late.
To help reduce your risk and protect your holdings, here’s a detailed description of five types of investments I think could cause serious damage to investors who aren’t on their guard: dividend cutters, low-volume stocks, dumpster dives, high-frequency trading targets and fashionable investments.
Let’s take a look at each group.
#1: Dividend Cutters
Dividend investing may not seem like a typical strategy for young investors, but it can still pay off over the long run. Unless, of course, the dividend stocks you’re holding cut back on their payouts.
If you ask most investors, the prime example they remember is General Electric (GE). The industrial conglomerate slashed its payday from 31 cents a quarter to 10 cents a quarter in 2009 — a 68% slash in dividends that has just started being bulked up again.
So, how do you protect your income? For starters, make sure you examine the distribution history of a stock carefully before even investing. And once you’re in, pay attention to cash flows and earnings history to prevent having your pocket picked by these dividend cutters.
I recommend a simple calculation involving the dividend payout ratio. In short, if a company starts to pay out significantly more in dividends than it does in earnings per share, warning bells should go off. After all, how can stock afford a $2.50 annual dividend per share when its earnings are only $1.50? The math just doesn’t work — and a cut could be looming.
#2: Low-Volume Stocks
Penny stocks and microcaps (the stocks most commonly characterized by low volume) can be rewarding if you buy them at the right time and make big profits. But they also can bankrupt you with their volatility.
The nature of these small stocks means a little buying pressure goes a long way, and simply placing a buy or sell order can cause these companies to soar or crash. That means they can move big on news — or move big on no news at all, which makes them prime targets for pump-and-dump artists trying to drive up the price through unscrupulous tactics.
I have written extensively on inherent problems to penny stocks and microcaps that trade over-the-counter and on the pink sheets (see this post about microcap risks, this post about low volume and this post about penny stock scammers).
I highly recommend never buying a stock with a volume of less than 100,000 shares daily or a market cap of under $500 million. There are exceptions, of course, but this is a good rule of thumb to avoid this ugly part of town and steer clear of pickpockets.
If you must trade low-volume stocks, always use a limit order to protect your entry price and sell price. And if you are buying a significant amount, consider distributing your transaction over a few days or weeks instead of moving the market with one big order.
#3: Dumpster Dives
I wrote at length about this kind of pickpocket investment last year in an article called “Buy Quality on Pullbacks, Not Stocks in Their Death Throes.” The idea is simple: There’s a big difference between a good stock that has had a bad run and an ugly stock that you’re hoping will just get less worse.
In a bear market or a sideways market, it’s tempting to talk yourself into why a downtrodden name is a good bargain based on a rock-bottom P/E ratio or a strong history of outperformance in the past. But never fool yourself into thinking that a stock that has gone down dramatically can’t go even lower.
Consider BlackBerry (BBRY) — previously Research in Motion. Shares peaked at $150 in 2008 and finished 2011 at around $15. Still, many investors remained convinced the company wasn’t dead. Well, pity on you if you were one of them. BBRY shed more than 30% in the last month alone thanks to ugly earnings, ugly sales of its hyped BB10 smartphone and an ugly tablet strategy — if you can even call it a strategy.
The moral of the story is that if sentiment is ugly and secular trends clearly are against a stock, don’t fool yourself into thinking that the market has somehow miscalculated the value of an investment. You’re better off buying a stock you believe in on a pullback.
Or, to turn a phrase, shop the sale rack at Neiman Marcus instead of dumpster-diving.
#4: High-Frequency Trading Targets
Unlike low-volume penny stocks that can be juiced by unscrupulous traders, equally troublesome are mega-volume companies that are the playground of Wall Street computers.
For those unfamiliar with the practice of “high-frequency trading,” it involves stocks that trade almost instantaneously when a sophisticated algorithm is identified by supercomputers. Some HFT positions are held for only a matter of seconds, and often there’s no net investment at the end of a given trading day. A report by the Tabb Group estimates that as many as 98% of orders placed by these computers are canceled before they become trades.
Until more regulations are put in place, you need to understand the risks to your portfolio to prevent getting your pocket picked.
For starters, be aware that HFT tactics work best on low-priced stocks with high volume. That would be companies like Bank of America (BAC), which some estimate makes up 5% to 10% of total U.S. stock market volume while the computers run wild with shares. Headlines and financial reform will play into how BAC performs, to be sure. But you can bet the HFT algorithms will have their say — even on a day with no news.
Secondly, be aware of the risks of placing stop-losses in HFT targets. Volatility can be par for the course despite the big size of these picks, and you easily could be stopped out of a position one day and see it bounce back the next.
#5: Fashionable Investments With False Pretenses
This category of investment can sometimes be of the criminal variety, but oftentimes can hide behind the idea of free speech in their “commentary” as they try to pump up a battered stock or push down a company unfairly for personal gain.
These Wall Street pickpockets prey on investors in the following ways:
- Offering opinion as fact: Fluffy marketing about your product is par for the course for any company. But phrases like “best-selling” or “industry leading” must be attributed to hard data (and time frames) to be meaningful.
- Masquerading as the “smart money”: There are some great minds in financial media. There are also some hucksters. Finding someone you can trust is not easy, but even when you believe you have found a real ally in the stock market, you always should be careful of folks looking to protect their own positions or to get ahead by making hyped-up claims. A prime example: Brian White, who tried to make a name for himself with headline-grabbing price targets for Apple (AAPL).
- Hiding their true track record: There are certain benchmarks for greatness in all industries. A perfect game in bowling is almost expected of the great players, but a perfect game in baseball is a holy and rare event. In the stock market, perfection isn’t even close to attainable. No stock goes up every day, and no stock picker is right every time. Particularly egregious are those hucksters who use “back-tested data” for their track records.
So how do you protect yourself from these kinds of pickpocket schemes? Simple: Demand consensus, and read voraciously. Never accept anything at face value and never rely on a single source no matter how trustworthy.
Jeff Reeves is the editor of InvestorPlace.com, and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at email@example.com or follow him on Twitter via @JeffReevesIP. As of this writing, Jeff Reeves owned a position in Apple.
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