Investors: Avoid These 5 Red Flags
Contributed Opinion

1. As of the date of this article, officers, contractors, shareholders, and/or employees of Streetwise Reports LLC (including members of their household) own securities of Apple Inc. and Tesla Inc.
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Martial conflict in Iran persists in propelling equities downward.

The S&P 500 hovers on the precipice of an acknowledged rectification zone, having plunged 9% from its pinnacle.

Myriad tech equities are faring considerably worse.

The "Magnificent Seven"—Apple Inc. (AAPL:NASDAQ), Microsoft Corp. (MSFT:NASDAQ), Alphabet Inc. Class A (GOOGL:NASDAQ), Amazon.com Inc. (AMZN:NASDAQ), Meta Platforms Inc. (META:NASDAQ), Nvidia Corp. (NVDA:NASDAQ), and Tesla Inc. (TSLA:NASDAQ)—have nosedived an average of 18%.

As our habitual readers comprehend, rectifications of this nature provide superb opportunities to procure world-class disruptors at bargain valuations.

But refrain from pursuing them recklessly.

The preponderance of purported "disruptors" are duds.

They flaunt dazzling marketing and futuristic pledges ..., but underneath the veneer, there's no bona fide enterprise, no enduring growth, and no prospect of long-term triumph.

Over 20+ years immersed in markets has imbued my collaborator Chris Wood and me with the wisdom that sidestepping the immense losers is just as pivotal as identifying the immense victors.

That's why we crafted a paradigm for discerning the crimson indicators that nearly invariably portend disaster.

It's the identical checklist we employ before advocating any equity in Disruption_X—our advisory that zeros in on more diminutive, "dark horse" disruptors capable of surging 1,000% or more courtesy of the disruptive technologies and sectors they're molding.

Now, allow me to unveil the five crimson indicators...

Red Flag #1: Naught to exhibit but a captivating narrative

Every eminent disruptor boasts a riveting narrative. But a riveting narrative alone doesn't forge a superb investment.

Many are merely "story stocks." All sizzle, no steak.

Succumbing to hyperbole is one of the most ubiquitous pitfalls in investing. Investors become entranced by a vision of the future without examining the scoreboard today.

The quintessential exemplar is the 3D printing frenzy of 2012. The narrative was irresistible: a "factory in every domicile" that would revolutionize manufacturing. I recollect pessimists clamoring for 3D printing prohibitions, as it would empower everyone to print their own firearms.

Equities like 3D Systems Corp. (DDD:NYSE) catapulted over 6,000% on the sizzle. The actuality? The apparatuses cost six figures and were predominantly employed to print plastic baubles. The hyperbole was a decade (or two) ahead of the enterprise.

When Wall Street ultimately took heed, 3D printing equities plummeted 90% and never rebounded, eradicating countless investors.

Chris and I seek out a track record of rapid, enduring revenue growth (ideally 20% or more) over multiple quarters. Revenue is the ultimate reality check. It's evidence that bona fide customers are disbursing bona fide money for a product because it resolves a bona fide pain point.

I'd much prefer to invest in a company with tangible sales at a more elevated valuation than a startup with naught to exhibit but a captivating narrative.

Decades of collective investing experience has imbued Chris and me with the wisdom that the upside for a proven disruptor is essentially boundless.

Red Flag #2: Valuation in the stratosphere

Sometimes, even an eminent company can be a dreadful stock.

This transpires when the stock price becomes utterly detached from any reasonable projection of future profits. When the price already reflects a decade of flawless success, you're left with all the risk and none of the reward.

In Disruption_X, we employ our proprietary GARP Quotient to sidestep stocks with valuations residing on planet Mars. We built it to supplant the old price-to-earnings filter because many great disruptors reinvest every nickel into growth.

The simple GARP Quotient formula is (Price-to-Sales Ratio) ÷ (Revenue Growth Rate).

Just divide the P/S ratio by the company's growth rate (as a whole number). If a stock trades at 20X sales and is growing at 40%, its GARP Quotient is 20 ÷ 40 = 0.5.

We look for a score below 1.0, and ideally below 0.5. This simple formula is our guardrail. It keeps us disciplined and prevents us from chasing a stock to the moon.

Red Flag #3: A feature, not an enterprise

Some of the most seductive disruptors are built around a clever new feature, not a defensible enterprise. The innovation is real, but it can be readily copied by a larger player.

Envision a startup building a fantastic photo-filter app that goes viral. This is a feature.

What's to stop Apple from building the same functionality into the iPhone? Or Instagram from rolling out a similar filter set? The company in question has no moat. It's a tenant in someone else's ecosystem.

Remember GoPro?

It spawned a whole new category with its tough, mountable cameras that captured incredible action shots. The stock was a Wall Street darling.

But as smartphone cameras became astonishingly adept and more durable, the need for a dedicated action camera shrank. The "feature" of a great portable camera was absorbed by the ultimate platform: the smartphone in your pocket. Drone companies like DJI also started building incredible cameras directly into their products.

The result was GoPro's stock collapsing 98% from its zeniths.

That's why Chris and I hunt for platform technologies.

A platform technology is the foundation of an industry or a whole new way of doing things. It often provides the infrastructure or ecosystem that enables other entities (such as developers, businesses, or users) to create and grow.

Take Nvidia, for example. It doesn't just make a cool chip; its CUDA system is the platform for the entire AI revolution. Amazon Web Services provides the cloud infrastructure half the internet runs on. These companies have deep, wide moats.

That's why we eschew the companies that just have cool features... and invest in those building platform technologies.

Red Flag #4: A money-shredding business model

The company has a great idea, a real market, and a product that works. But the underlying economics of the enterprise are flawed.

The poster child is Webvan from the dot-com bust. The idea was visionary: order groceries online and have them delivered to your door.

The problem? The business model was a disaster. The cost of the refrigerated trucks, drivers, fuel, and complex logistics meant Webvan lost money on every single order.

Blue Apron is a more recent exemplar. It pioneered the meal-kit delivery service, sending boxes of pre-portioned ingredients and recipes to people's domiciles.

Great idea, lousy enterprise. It had to spend a fortune on marketing to get folks to try its service. The company was spending, for example, $100 in marketing to acquire a new customer. But that customer would only generate $80 in profit before canceling.

Think about that. It was a machine designed to destroy capital. The more it "succeeded" by growing sales, the faster it incinerated cash!

Blue Apron IPO'd at a $2 billion valuation in 2017. It went down in a straight line before being bought out for $100 million in 2023.

Chris and I take great care to look at the unit economics. Does the company make money on one transaction? If they sell a product for $10, how much does it cost them to make and deliver it?

If a company cannot make money on its core transaction, it has a hobby, not an enterprise. A crimson indicator of the highest order.

This is why we make sure the companies we recommend in Disruption_X are either profitable or "intentionally unprofitable."

An intentionally unprofitable company—like Amazon for its first decade—has a profitable core business but chooses to reinvest every penny of gross profit back into growth. That's a sign of strength and a hallmark of some of the best disruptors in history.

A company that is unintentionally unprofitable because its business model is flawed is a sign of fatal weakness.

Red Flag #5: The "SBC" scam

This is a critical crimson indicator many investors miss because it's hidden in the financials.

A company's management team often pays itself and its employees with massive amounts of stock. This is called stock-based compensation (SBC).

Problem is, under standard accounting, this isn't treated as a real cash expense. But it's a very real cost to you, the shareholder, because it dilutes your ownership stake. A company can look profitable on paper while its shareholders are getting diluted into oblivion.

As Warren Buffett says, "If compensation isn't an expense, what is it? And, if real and recurring expenses don't belong in the calculation of earnings, where in the world do they belong?"

When we see glossy slide decks full of alphabet soup like "community-adjusted EBITDA" while the actual cash in the bank is vanishing, we know there's a problem.

Take Snowflake (SNOW:NYSE).

To attract the best engineers in a hyper-competitive industry, Snowflake pays them huge amounts of stock. In 2024, it awarded $1.48 billion worth of stock to employees. That wiped out Snowflake's supposed $913 million "profit" it recorded that year.

Investors only looking at Snowflake's numbers on the surface have a completely misleading view of its true profitability.

You can't fake cash. This is why we created our own metric: Real Cash Flow (RCF). We simply take a company's cash flow and subtract the cost of stock-based compensation to see the true money left over for owners.

A company generating strong RCF is truly profitable. A company with huge cash flow that evaporates after accounting for SBC is playing a shell game with your money.

Remember, in markets like this, picking winning stocks is only half the battle. It's just as important to sidestep the losers that could detonate your portfolio.

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