It's all well and good to decide to buy ASX shares. But so often, investors think they know a company and its associated risks well, only to be caught short later on. Of course, we can't account for all possible outcomes – you can't blame anyone investing in Qantas Airways Limited (ASX: QAN) in January 2020 for not seeing the full impacts of the coronavirus pandemic, for instance. But we can take steps to mitigate the possible risks of investing in a business by putting the company under the microscope.
So here are 3 'checks' I like to go through in a business before I decide if an investment is worthwhile and risk-averse enough.
1) Debt
One thing you can't take with a pinch of salt when investing is a company's debt levels. Debt is a major catalyst for companies going into bankruptcy, so it pays to consider how much debt a company has before buying its ASX share. Now, some businesses need debt in order to function in its chosen market. It would be almost impossible for a mining company or a real estate investment trust (REIT) to operate without debt, for instance.
But if a company has a mountain of debt that it doesn't really need, it's a massive red flag in my books. So when you're assessing your next potential investment, have a look to see how much debt its carrying and think about how it might manage to service this debt if there was a major economic crisis. A good place to start is the debt-to-equity ratio (D/E) where more debt than equity is a bad thing.
2) How does it sit with its competitors
Ideally, I like to buy shares of a business that dominates its field. The market leader will usually have several advantages going for it, such as brand loyalty and pricing power that stems from this loyalty. In contrast, a lesser competitor will often be throwing money at discounting its products to try and compete, which ends up weakening the business's long-term strength. I usually try and buy the ASX share with the biggest advantage in an industry. There's nothing wrong with backing a winner in investing.
3) Are its shares cheap?
This one seems obvious, but too often investors will want to own a company so much that they will pay a price that doesn't make sense from an investing perspective. Warren Buffett's right-hand man Charlie Munger once said, "no company, no matter how wonderful, is worth an infinite price". Wise words from a wise man.
Buying ASX shares in a great company doesn't equate to a good investment on its own. You also have to make sure there's a reasonable chance your investment will give you a decent return over the long run, and buying something that's overvalued greatly reduced the chances of this. So always be careful about how much growth you're paying for in a share price. If you're paying a price that is assuming 20 years of high-octane growth, the chances of something going wrong are high.
