Only buy stocks that make money. Seems like a pretty straight forward and common sense rule. So why do so many investors break it?
Every quarter, a publicly traded stock must report its most recent quarterly financial reports. These financial statements are put together by the company and audited by a third party accounting firm. These statements must be "approved" through the audit and judged to be truthfully and faithfully representative of the company's financial position to the best of management's knowledge. Then, a company will set an earnings release date where it will publicly announce the performance of the company over the last quarter (or year if they are publishing results for a full fiscal year).
Analysts working at investing or other financial institutions will predict what is "expected" for earnings per share of the company for the quarter (as well as revenue forecasts), either based on past trends that are extrapolated into the future, or based on predictions set by the company earlier in the year. If a company reports earnings and "beats expectations", typically the stock price will experience a modest climb after earnings are reported. Of course, earnings are not the only factor that go into decision making for choosing a stock to invest in, so earnings beats or misses compared to expectations are not always the culprit of a stock climb or decent. However, it typically plays a large factor into the direction of a stock price over the long term. If a company consistently produces positive and increasing earnings quarter after quarter, the stock chart will typically reflect that in an upward movement. The opposite is also true. If analysts consistently downgrade earnings and companies miss earnings compared to expectations, stock prices will trend down.
Seems pretty simple right?
The general golden rule is that a stock price trend will reflect its earnings performance over the long term. Time and time again this is proven to be true. LONG TERM is the key word... not weeks, not months, not even quarters typically...we are talking years. The problem is that many individuals who self direct their investments do not have the patience or wherewithal to hold a stock for years on end, and be able to ignore their emotions when their stock holding goes through volatile cycles.
There are many companies that are publicly traded that don't net a dime. They might make positive revenue, but after all expenses are considered, net negative earnings. This is quite common for small or micro cap companies who are in their infancy and trying to attract capital to grow their business and eventually become profitable. Many exciting tech stocks attract hungry investors looking to own a piece of the latest and greatest hot stock. However, the majority of these so called "exciting stocks" produce negative earnings and burn cash like there is no tomorrow. Not to mention that such excitement drives up stock price because of the heightened "buy volume" which creates ridiculously high stock valuations (valuations in terms of comparing stock price to its earnings per share, or P/E ratio). My good friend over at YWealth produced an article recently that spoke to the "Demise of Snapchat" (US:SNAP) and why it is such a terrible investment. The main reason is because it has always has and continues to not make money and produces negative earnings every quarter while eating up cash and investor's capital faster than you can blink an eye.
So ask yourself.... why would you own an investment that doesn't produce positive net income (positive earnings)? If you knew your local neighborhood pub was getting no clientele and losing money every month, how comfortable would you feel giving the owner a large sum of money to help invest in the business?
How about overpriced hype stocks like Amazon and Netflix that are good companies but way too expensive in relation to their earnings. You go buy a Big Mac and the teller asks for $100. Sure the burger is tasty and you like it, but is it worth $100? Buying Snapchat would be like going to the goodwill store, buying a holey moth eaten t shirt for $100. The t-shirt is expensive AND it sucks.
In the end, remember the Golden Rule: only buy stocks that make money. This will right off the bat save you the trouble of even considering 10% to 15% of stocks listed on the TSX. Don't let negative earnings get you down... literally.