Welcome to the Investing for Beginners podcast. In today’s show we discuss:
- How to spot red flags in financial statements
- Investing with margin and some of the dangers
- Assessing Intel and other Semiconductor ETFs
- What are SPACs and how to invest in them?
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All right, folks, we’ll welcome you to the Investing for Beginners podcast. Tonight. We have episode 187 tonight. We’re going to answer some listener questions that have a bit of a theme to them. We’re going to talk a little bit about red flags. We’re going to talk about things that maybe give you pause or holding off on investing in a company or different ideas. So I’m going to go ahead and read the first question, and Andrew and I will go ahead and do our usual give and take. Let’s go ahead and read the first question. This is from Louis. I am from the UK and have been tuning into your podcast. That’s the start of the pandemic in March. Thanks for your podcast. I have significantly improved my financial literacy. I have been reading a few annual reports, but I can’t seem to make a judgment about which companies not to invest in.
I can make such a judgment when working at metrics because it is black and white. However, with the annual report, everything seems positive, and I could never find a reason not to invest in a company after reading an annual report. What makes you decide not to invest in a company, red flags, et cetera, Andrew, what are your thoughts on his excellent question?
Thanks for that question list. It’s a good one. So I’ll think back to one I did recently with a company I was looking at; it was a medical distribution company. And so I didn’t at the time know how a medical distribution company worked. And so from the start, when you start to hear from management, they’ll tell you how the business works, and that can give you, you know, start to get the gears turning. And then you have to try to do some hard thinking from there and make your conclusions after that.
As you said, no black and white answer makes it difficult, but hopefully, as you get exposed to more businesses, you can start to see things that you like and things that you don’t like. For me, looking at this company that was a medical distributor, they talked about some of the things that affected their revenues. As an example, they said that when drug prices go up, that tends to be good for our business. When drug prices go down, that tends to drag on our revenues. This was around the same time when Amazon announced that they had essentially opened a type of pharmacy. And so knowing Amazon’s background, knowing the way that they built a business, starting with the Kindle, and they drove prices for books in general, down quite a bit. And they’ve driven prices down for shipping and other things within retail.
So I looked at this company because I’m trying to look for the same term, and I’m trying to ideally get something that I can hold for maybe five to 10 years. At least that would be nice. And so I know that when Amazon comes in, and there’s such a big player, they’re going to start to drive prices down. While that’s probably going to be good for the consumer, it’s probably going to be good for insurance companies not to have to pay such high prices on these drugs. Still, many other companies involved in this kind of value chain will probably see some issues. What I did just taking that little was just maybe a sentence or two, but that helped me understand that, yeah, this is what drives the business.
That drives a big part of the business. And we know that because management’s telling us that. From there, we can try to think, do we feel bullish about this part of the business, or do we feel bearish now? That’s not to say that this company won’t be a great investment. It’s not to say that this company won’t do very, very well. It’s just for me and for what I’m comfortable with and knowing what I know about Amazon; it was something that it’s not necessarily about a flag with. It’s just something that gave me a reason not to want to buy this company. Dave, do you have any examples like that?
I sure do. I have two. So the first one I will mention. It’s a company that is in a kind of a defensive type of business. It’s not glamorous. It’s not exciting. It’s not sexy by any stretch of the imagination. But as I was reading through the business description, which made a lot of sense, I got to the management discussion section, and I noticed as I was reading through there that they kept mentioning that they had special situations, improving their income. And at first, I was like, eh, it didn’t register. And I just, I kind of kept reading through it. And when I got to the income statement, I noticed that they had a section where they had an extraordinary income addition to their income, making their income work better than it probably really was. And so then I looked at the next year and the same thing and the next year, the same thing.
And so I thought to myself, three years of a one-time exception for income, that seems a little fishy. So then I thought, huh, how far back does this go? So I started looking, it went back ten years, and I thought, okay, something’s going on here? And that’s just a little bit too fishy for me. And the reason why I say that is because when you have a one-time exception or an extraordinary situation, those words in and of themselves indicate to you that this is a kind of a one-off; this is an odd thing. This isn’t something that happens on a normal basis. And we, you start seeing that every single year, then now all of a sudden, it’s not a one-time exception and it’s not an abnormal situation. This is a normal part of their business, but for whatever reason, they’re choosing not to label it as such.
And that made me wonder, well, what else are they, I guess, stretching in their valuation of the company. And so I thought, okay, this is a no, so that just immediately, I just, I stopped what I was doing. And I moved on to the next company because that, to me, was just a big, big red flag. After all, if they’re going to, I don’t want to say lie, but maybe stretch the truth a little bit about their income. Then what else are they going to search for two thoughts the truth on. So there’s that. And then the other one that I came across was the use of a metric. So when you read through reports, whether it’s a quarterly or an annual report, your time to see terms like adjusted earnings or a situation where maybe they have EBITDA is the focus. And sometimes the companies are doing that to maybe throw you off from the fact that maybe performance wasn’t as good as maybe they projected or ho or they had hoped, or things were not going as well as they overall would hope.
And sometimes, it’s just the nature of the business. The insurance industry has many adjustments to earnings, especially quarterly, because of the way that accounting works for insurance companies. So that’s in and of itself not that unusual, but when you start seeing things like adjusted EBITDA, because EBITDA is already kind of, in essence, an adjusted metric. And when they start adjusting EBITDA and adding a lot of other things back into the income to make it look better than it is, then that starts sending up a red flag to me, because that to me is they’re trying to tell you that things aren’t that good, but here’s how we’re going to spin it. It’s okay because EBITDA is a terminology that we use, which stands for earnings before interest taxes and depreciation and amortization. And it’s a, it’s a non-gap financial metric, which means that it’s a, not a, an accounting accepted metric that companies will use in finance to help
Showcase how the company’s doing. And it’s a great metric to use when you’re comparing across industries. It’s not necessarily always maybe the best to tell you exactly how the company is doing. Still, in and of itself, when companies start adjusting a metric that’s not already accepted by the accounting community as a financially relevant metric, then that to me starts sending out alarm bells, especially when they’re using lots of very iffy line items to add back to their revenue. It just makes; it just gives me the heebie-jeebies. And so when I see stuff like that, I’m out, I’m done. It’s just, that’s too much of a red flag for me. So those are, I guess, are a couple of companies that kind of sprung to mind more talking about this one other example I could give, which might not necessarily be a red flag, but can help unders like give another opinion on, on the numbers that you’re looking at.
And so if you go to the management discussion section, the MD and a, you can look and they will generally explain why revenue moved or why earnings moved. So they might say, Hey, you know, profits were up 20% this year because we just bought a new company and, you know, rolled that acquisition into our financials. And so if you seem like a big jump like that, from something like an acquisition, being able to read the words like that kind of helps you to picture why a company was able to grow and understand whether that’s probably sustainable or not. So like another example, I know a lot of the computer companies like computer hardware, like HP or Lenovo or Dell, they mentioned in their management discussion sections how the pandemic had created all of this crazy demand. And so obviously their profits and revenues were high over the past year because of that.
And so they’ll, they’ll just type that out for you and you can, and you can read about it. So not only will you hopefully find good things to take away from about the businesses themselves, but also as they develop over time through what management says from year to year, one other tip I will give. Hopefully, you’ll take this one to the heart is I think it’s very hard to come up with a red flag or a negative opinion on the business when you just read their annual report when you start to read the annual reports of their competitors, that’s where you can start to see discrepancies between Oh, okay. What this company is doing, which sounds good. Really? Isn’t that good? Because here’s another company who’s doing it probably in a better way. So I guess another example of that would be like, let’s say, a shipping company where one company owns all of their planes.
And that sounds very nice. Then you compare that to a competitor who doesn’t have to own any aircraft. And they mentioned how that could save them on all these costs. You can then see why their numbers are potentially so much better than the competitors because they don’t have all this capital-intensive stuff they have to maintain. If you try to add, you know, research on the competitors and make some comparisons in that way, it might not get you there all the time. And the answer is not always going to be the same all the time, but hopefully, that helps you move in that direction and then start to come up with some good judgments as you move forward.
Great advice. All right. So I’m going to read this next question. I’m going to leave some of the stuff out because it’s a little bit personal. I talked to this listener and reached out to her personally because it was a sad story. So I’m not going to mention her name or anything. But basically, it’s an investor from Madrid, and she saw an ad that said that she could make a bunch of money investing in Amazon. She got on a platform called Forex TB, and she said it went very well initially, but then I lost it all. And she had 7,000 euros, and now she has four, the seven euros. She asked if she could reinvest those four, the seven euros, in my VTI product. And if it would help her make money back. And so I think, and anybody who’s been listening to the show for a while?
Well, no, it’s not reasonable to think that you can make 7,000 euros back with, for the seven euros. That’s just not how the stock market works. There’s not a good, reliable way to do that, but I thought we would address it because one, it’s a good example of what to look for in a red flag. There might be people who come across something like this and their investing journey, and hopefully, you can steer away from it cause this is pretty bad. So what I did is I went on this Forex TB website, and mind you, it’s not available for US investors. It’s not regulated in any way. And so if you scroll down to the bottom of this brokerage website, it says on here, and it’s in bold, and it says 77.8% of retail investor accounts lose money when trading CFDs with this provider.
So a CFD is something. I think that investors should just not do. It stands for contract for differences, and it’s something that’s, again, not regulated whatsoever. It’s traded in certain countries, like parts of Europe, pretty heavy, and parts of Europe, but it’s completely banned in the US, and its problem is several problems. There are high commissions. There’s a spread that you lose on it. So you’re losing in that sense. And that also puts you on leverage too. And, you know, we would never recommend anybody try to invest money on leverage. It’s just not a good way to go. And so I think, look, look out for CFDs, those are definite red flags. Do you not try the trade CFDs? It says right there on the bottom, but you know, I know a lot of us don’t go down to the bottom of webpages and try to read those things.
But in this particular case, it’s, it’s, it’s out there in bold. And so, you know, a brokerage operating in Cyprus that that’s kind of a red flag just on its own. And then if you learn about what CFDs are, the fact that you have to trade on leverage and now, you know, you could be losing more money than you put in. And that’s if you know anything about the stock market, you, you don’t, there are very few times when you lose all your money in the stock market. And it’s, it’s not, you can’t lose more money than you put into it yet when you have these, these weird, exotic financial instruments, like options or CFDs or anything to do with margin, you can lose money very, very fast. You can lose more money than you put in. And it’s just not a good spot to be in, especially if you’re first starting in the stock market.
Yeah, That’s great stuff. It’s you know, when we read through this, it was really sad. And when you told me the story about what she had gone through, I felt really bad for her. And maybe you could take a moment and explain leverage and margin a little bit.
So people can kind of understand what that kind of is. Yeah. It’s borrowing money from a broker. So they will, you know, let’s say you put a hundred dollars in, but you want to start investing like a thousand or 2000, a broker might let you do that. And it’s like, you’re putting in a small down payment, and you’re paying fees to be able to trade on borrowed money. The problem with doing that is, you know, at least with a house, you get to stay in the house as long as you pay the bills. If you’re trading on margin, if your trade starts to go the opposite way, they’re going to give you what’s called a margin call. What you have to do now is you have to put up more money to keep your account active and keep that trade open.
And so you could be right on the trade but be wrong on the timing and not have the margin call filled in at the right time and still lose. And so, you know, outside of all of that, I mean, it’s just everything about it’s bad. You’re not compounding money. You are losing money as time goes on, and you have the potential for it to blow up in your face and the whole, the whole issue with the game stop thing that was several weeks ago when something like that gets a short squeeze that’s from a margin call. It’s because many different trailers needed to put up a lot of, a lot of money. So there’s just a lot of problems with margin is very risky. And it’s not something that I think the average investors should look at. I would agree with that. Thank you for explaining
Let’s move on to the next question. So I have, hello, Andrew. I recently started listening to your podcast; I appreciate you and your knowledge and how you break things down. So simply and thoroughly and spec, I was reading up on it, but still not clear what and how to research on our preferable ones to invest in. Also not very clear what’s the big attraction in investing in a spec IPO. I tried to go through your past episodes and see if you had already talked about this, but I didn’t find any; if you have already talked about these topics, would you kindly direct me to the episode numbers? Well, we haven’t, Ellie. So Ellie was the person who wrote us this. So Andrew, I know, you know, a little bit about specs, we’d like to, I guess, drop some knowledge on us, please. Yes.
So she doesn’t understand the big attraction. Neither do I it’s, it’s you’re giving it’s a blank check thing, and you’re giving somebody else the ability to invest for you. And so, okay. There, there are some attractive features of it, but basically what it is. If, if I try to lay it out in, let’s say a story. Let’s say that we all thought Michael Jordan was a great investor, and we just all wanted to give him some money so he could invest for us. So this is basically what the spec is. So let’s say I would give him a hundred bucks. Dave, you give them a hundred bucks. Some people from the audience give them a hundred bucks, and we tell them, Hey, go, find us a company to invest in. And so some of the money goes to fees. Some of it goes to like a management fee.
You get shares diluted. But at the end of the day, after all this stuff gets netted out, out of that, a hundred dollars, you have maybe $80 of value. That’s yours that is represented in whatever the new company is. Now, if you’re like one of the first people to get Michael Jordan money, you might have like a, like a warrant, which gives you some additional claims and some additional options, but not all investors are getting into specs are doing that early. And they’re not all getting these warrants, which was kind of the whole financial point of having some sort of an advantage with it. But, you know, you’re, you’re putting a lot of trust in somebody else to go out and buy a company. It’s attractive because a lot of IPO’s that you could think of name some, some recent ones like Oh gosh door dash Airbnb are two that spring to mind recently.
And those are, I mean, those are hugely popular, right? Because I feel like everybody uses those. Those are some hot apps, and everybody wanted to get in on them. And so IPO, there’s some problems there because it’s expensive. You got to pay the investment bankers. You don’t always get early access, as an average investor. So the spec is, is a little bit different than that. It’s a little bit more direct. You don’t have to deal with the IPOs, but you’re; still running into this problem where for one, you don’t know what company that Michael Jordan is going to pick for us. So that’s, that’s kind of, that’s kind of scary. Number two, once he picks the company, they don’t have to follow the same rules that somebody like a door dash or Airbnb would have had to follow to disclose financial information and go through crossing their T’s and dotting their I’s.
So that’s kind of scary. And then you have the fact that in 2020, a lot of them didn’t do well. I think of it almost like small businesses, you know, we, we kind of all know that many small businesses don’t do well, but you don’t hear about the small businesses that don’t do well; they go away. Right. We always hear stories about the most successful ones and the biggest ones that got so massive, right. And then had such great success. You don’t hear the stories are the ones that fade away and SPACs are very similar. IPO’s are similar to that too. And it’s just because capitalism is just very, a very intense place. And a lot of it takes a lot of failures to bring out the best of companies. And so it’s not a good deal. In my opinion, I don’t like the fee structure. I don’t like the incentives. I don’t like the fact that you don’t know what you’re putting your money into other than it’s a person. And so those are some of the things that I think make backs scary. And the reason why we don’t recommend them,
Speaker 5 (22:58):
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Yeah. Amen to that. I, I know almost nothing about them, and I don’t care too. So call me, that’s fine. But it’s outside of my circle of competence, and I have a hard enough time figuring out the different companies to invest in. And that’s knowing the ones that I can learn about. So putting my money into, although I’ll be it, I do love Michael Jordan as much as the next person, but know that I want to give them my hard-earned money to buy whatever he wants. So yeah, not for me. He’s not; I don’t think he has a spec.
She seems like I wouldn’t be surprised if he did, though. It seems like everybody is. Yeah. True. True. Very good point. So let’s wrap it up at this last question. And this one, Dave is going to take it out of the park for us. So this was another part, the first part of Allie’s question she says I’m interested in, in tagging on the semiconductor train. That’s been speeding up. However, I’m afraid it’s already faster than I can catch on. What do you think of Intel? It seems like things have been a bit tough for it, and its stock price is still a reasonable range for me to consider. Also, can semiconductor ETFs be a good alternative to buying into one particular stock, even though they’re all pretty high up there.
All right. Ellie, this is a really good question. And so here are some thoughts on how you can latch onto the semiconductor train. Yes, by and large, many of the companies you look at in this field are expensive. They have all got very high metrics. They are very rich. Suppose you want to try to buy onto that train AMD, TSMC Nvidia, all great companies. So when I say that these companies are expensive or I don’t air quote recommend them, it has nothing to do with the actual product they’re making or the company’s performance. All fantastic. It’s just a matter of thinking about it this way. When you buy an iPhone and say that the iPhone is, is selling for $800, most of us are willing to pay $800 for it. And if we can find it for 600 and it’s still the same great quality as the $800 one, we’re going to jump all over it.
But if you were going to buy that iPhone and now it’s selling for $2,700, you might not be so enthusiastic about getting to that $800 phone three times; that price kind of the same deal when you’re buying some of these stocks. So when you think about a company like AMD, which is the up-and-coming kid in the semiconductor world, it’s a great company, and they’re doing fantastic things. They’re growing their revenues like a weed. And they’re doing well. So Intel has been stepping on their own feet, or recently they’ve gone through a management change. Recently they brought in a new CEO. So the old guy had been their old guy; the person that had been there roughly a couple of years frankly had no background in tech. He was more of a number cruncher, and he wasn’t a designer or had worked in the semiconductor field before working as a CEO for a teller.
So I think many people felt like he was driving the train to use alleys; Ella, Ella allegory there that he was driving the train in the wrong direction. So the company has been a market leader for decades, and recently they have kind of stumbled in the race to get a quicker, faster semiconductor chip. And they have kind of dropped the ball on some of those things. And so that has allowed AMD in particular to kind of start to take some market share away from them. So the company is still huge, and they still dwarf a company like AMD. AMD did more in R and D research last year than an I’m sorry. Intel did more in R and D research as far as an expense than AMD. It did in revenues for the whole year. So it’s a massive company and, they have a lot going for them.
They are one of the few companies here in the United States that make chips here in the United States. And I’ll come back to that here in just a second. They have also been a leader in working with various realms, as far as the tech world goes. It also has the advantage of, on a relative basis, as far as stock price and any other metric, New York ad it’s cheap, but you could argue that it’s cheap because of some of the stumbles that they’ve had. So they’ve lost out on the race to be the smallest, fastest ship. I think AMD and TSMC, who are other big players in this field, are producing chips around the five and in, if I’m correct. And I think it tells us still playing around the ten or eight. So they’re a little bit behind doesn’t mean they can’t catch up, but they are behind.
So here’s where some of the strengths that Intel has. Number one, they have size number one, number two, they have a lot of advantages. As far as market share goes working with laptops and other producers, they have a legacy tech that allows them to stay in the game. The other advantage they have is they make their semiconductor chips. They have their Foundry. They produce quite a bit of their product in-house, which saves them a lot of money and time. And it also allows them to control the production. Whereas AMD, for example, has to outsource all the production of their chips, which means that once the design is done, it’s kind of out of their hands, and they don’t have any control over how much they can supply the people that are demanding their chips.
So recently, the United States and all our parts of the world have been going through a semiconductor crunch and chips. In other words, we’re running out. So this has been big news in the auto industry GM, Ford Tesla, all these companies are struggling to find enough chips to put in their cars because even though a lot of these cars are not electric outside of Tesla, they still need semiconductor chips for the computers that are in there in their cars. And because of COVID-19 and other things that have gone on, there has been a shortage of semiconductor chips. So one of the things that I heard the pres recently the new president, Joe Biden, was mentioning that he thinks that the United States needs to step up its game and propose adding more money to encourage the development of semiconductor production here in the United States.
Well, that is music to anybody that is investing in tell because as one of the leaders in Intel, I’m sorry, in the semiconductor world, that is going to probably lead to them being able to tap into that money to grow their expertise in producing these chips. And we’ll want them to a bigger portion of the market share. Those are all things that I think bode well for Intel now and into the near future, at least for the next three to five years. As far as the second part of your question, the semiconductor ETFs, I’m going, being honest with you. I’m not as up on those as I probably should be, but I would imagine that there were probably be some options out there. If you don’t want to pick one particular company, if you don’t want to pick a company like Intel, for example, for whatever reason you think they’re too far behind, or you don’t think that there’s an opportunity for them to catch up or they’ve lost too much market share.
And the momentum is not with them, whatever it may be. And those are all valid concerns for sure, but whatever that may be, if you want to switch to using an ETF, which would allow you to kind of get your hands into all of those companies like Nvidia and AMD TSMC and so on, then that would be a great way to go as well. So I, I, I hope that helps answer your question or give you some, some guidance on that. Andrew, did you have anything else you’d like to take onto my little rant there?
That’s a good one.
All right, folks, we’ll that is going to wrap up our conversation for this evening. I wanted to thank everybody for reaching out to us and sending us those great questions. Please keep them coming, guys. This is awesome. You guys are sending us some great stuff. It gives us a chance to dive into some things and help you guys work on a thing or two. So without any further ado, I’m going to go ahead and sign this off. You guys, go out there and invest with a margin of safety emphasis on safety. Have a great week, and we’ll talk to you all next week.
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