What is really going on in this situation is a form of the psychological concept of social proof. Much like the popular clique in high school, a large percentage of the population has a fundamental need to feel like they are part of a group. From an investing standpoint, this can be fatal. Some general (although necessarily flawed) ways to tell if there is wipeout risk:
- The company sells or sold products that have enormous potential liabilities such as asbestos
- The price-to-earnings ratio is over 40 or 50
- The debt-to-equity ratio is astronomically high (for one notable exception caused by share repurchases, read the article Looking Past the Numbers – The Limitation of the Debt to Equity Ratio.)
- Never invest in something you don’t understand. A good test is your ability to write out, in one short paragraph, how the company makes its money, the sources of its profits, its most important customers, the competitive landscape of the industry in which is competes, the honesty and competency of management, and your expectation for company earnings in the next five to ten years.
- Although profitable, the cash flow is barely exceeding fixed expenses such as operating leases. It has happened in the past that otherwise good companies have been forced into bankruptcy because they couldn’t make their lease payments; the debt for which does not show up on the balance sheet but is instead buried in the financial statements.
