Red Flags in Stocks: Warning Signs Organised by the Five Criteria

Red flags in stocks are warning signs in a company’s numbers, disclosures or behaviour that raise the chance of a permanent loss. The most important ones are falling returns on capital, profits that do not turn into cash, shrinking margins, rising share counts, too much debt and a price that assumes perfection. One flag means dig deeper; several at once usually mean walk away.

Most investors spend their time building the case for a stock. The best spend just as much time trying to prove themselves wrong. Charlie Munger borrowed a motto from the mathematician Carl Jacobi, “invert, always invert,” and this article applies it: instead of asking what could go right, we ask what could go wrong.

Where this fits: red flags are the inverse of the Five Criteria framework. Below, each flag is organised by the criterion it fails, starting with Criterion 1 and our hub on return on invested capital.

Why Red Flags Matter More Than Good News

Almost every famous investing disaster had visible warning signs. Enron’s accounts were famously hard to understand long before its 2001 collapse. Luckin Coffee admitted in 2020 that a large part of its reported 2019 sales had been fabricated.

Most investors who lost money were not fooled by hidden information. They ignored information that was there, because the growth story was more exciting than the footnotes.

Think of red flags like the warning lights on a car dashboard. One light might be minor. Three or four at once, and a sensible driver pulls over.

Red Flags at a Glance, by Criterion

Criterion	What it tests	Key red flags
1. Great business	High, consistent returns	Falling ROIC, weak cash conversion, shrinking gross margin
2. Durable moat	Protection from rivals	Customer concentration, price cuts, share loss
3. Aligned management	Owner-like capital allocation	Dilution, poor acquisitions, related-party deals
4. Sound balance sheet	Survival in a bad year	High leverage, weak interest coverage, debt-funded dividends
5. Reasonable price	Margin of safety	Low FCF yield, valuation needs perfection

Criterion 1 Red Flags: Is It Really a Great Business?

Declining return on invested capital

ROIC measures how much after-tax operating profit a company earns on each dollar of capital. Our house standard for a great business is 15% or more for five years.

The flag is the trend, not one weak year. A company that earned 25% five years ago and earns 12% today is telling you something: competition is biting, or management is investing in lower-return projects. When ROIC falls below the cost of capital, roughly 8–10% for most companies, growth starts destroying value.

Profits that do not turn into cash

Net income depends on many accounting judgements. Free cash flow, cash from operations minus capital spending, is much harder to dress up.

Our house standard is free cash flow of at least 90% of net income on average. If it averages below 70% over five years, find out why. Common causes are receivables growing faster than sales, inventory piling up or aggressive revenue recognition.

Gross margin erosion

Gross margin is the first place pricing power shows up. A steady decline over three or more years usually means the company is cutting prices to hold customers, or cannot pass on rising costs.

Recurring “one-off” charges

If a company reports restructuring charges every year, they are not one-off. They are ongoing costs being kept out of “adjusted” profit. Always compare adjusted earnings with reported earnings over several years.

Criterion 2 Red Flags: Is the Moat Real and Lasting?

Customer concentration

When one customer accounts for a large share of revenue, that customer holds the power. Annual reports usually disclose any customer above 10% of revenue. A supplier that depends on one large retailer for a third of its sales is not in a partnership; it is dependent.

Price cuts and rising promotion spending

A company with a moat raises prices over time. A company that needs discounts, bigger promotions or more marketing just to keep sales flat is losing its grip on customers.

Market share loss to a new kind of rival

Losing a point of share to a familiar competitor is normal. Losing share steadily to a new technology or business model is how moats disappear. Review the signs in our moat hub, how to spot a competitive advantage.

ROIC collapsed in the last downturn

Our Criterion 2 test asks whether ROIC held up through a recession. If it fell to single digits and took years to recover, the high returns were likely cyclical, not protected.

Criterion 3 Red Flags: Is Management Working for You?

A rising share count

If the number of shares grows every year through stock options, share-based pay or acquisitions paid in stock, your slice of the company shrinks. Our house standard is a share count that is flat or falling over five years. Learn more in stock dilution explained.

Serial acquisitions and rising goodwill

Acquisitions can hide a weak core business. Watch for goodwill growing faster than revenue, frequent write-downs and organic growth that fades while total revenue holds up.

Pay tied to the wrong targets

If executive bonuses depend on adjusted earnings per share or revenue growth rather than returns on capital or cash flow, management has a reason to grow at any cost. The proxy circular or remuneration report shows how pay is set.

Related-party transactions

The annual report or proxy lists deals between the company and its directors or executives. Leases from a director’s property, consulting fees to an executive’s firm or loans to insiders are not always illegal, but they tell you about the culture.

Clustered insider selling

Executives sell for many innocent reasons. But when several senior insiders sell large portions of their holdings in the same period, pay attention. In the United States these trades are reported on SEC Form 4 within two business days; in Canada they are filed on SEDI. See insider buying and selling.

Auditor or CFO changes

A sudden change of auditor or chief financial officer, especially with a vague explanation, deserves a closer look. Having worked in investor relations, I know that experienced analysts always ask about this, and a smooth, specific answer matters.

Criterion 4 Red Flags: Can It Survive a Bad Year?

Too much debt

Our house limit is net debt of no more than 2x EBITDA. Above 2x, the company fails Criterion 4. Above 4x, a modest drop in profits can threaten covenants and force asset sales or share issues. Read more in how much debt is too much.

Weak interest coverage

Interest coverage is operating profit (EBIT) divided by interest expense. We want at least 5x. Below 3x there is little cushion. Below 1.5x the company is one bad year from serious trouble.

Dividends funded by borrowing

If free cash flow does not cover the dividend for several years, the payout is being funded with debt or asset sales. That usually ends with a dividend cut.

Large debt maturities with no clear plan

Check the debt maturity schedule in the notes. A big repayment due within two years, with limited cash and weak credit markets, is a real risk.

Criterion 5 Red Flags: Are You Overpaying?

A price that assumes perfection

If the current share price only makes sense with many years of rapid growth and rising margins, there is no room for error. Our house test is a free cash flow yield of at least 5%, or a price at least 25% below a conservative estimate of intrinsic value.

Valuing on “adjusted” or future metrics only

When a company, or its supporters, justify the price with adjusted earnings, a multiple of revenue or profits several years away, be careful. These make expensive stocks look reasonable.

Buying because the price is rising

Momentum is not a reason. Overpaying is the most avoidable way to lose money, as explained in the largest risk to your wallet: overpaying for stocks.

Worked Example: Spotting Several Flags at Once

Here is a hypothetical company, Company X, over three years.

Metric	Year 1	Year 2	Year 3
Revenue	$500m	$580m	$660m
Net income	$50m	$60m	$70m
Free cash flow	$45m	$30m	$15m
Receivables	$80m	$120m	$170m
Share count	100m	106m	113m

At first glance, Company X looks like a growth story. Revenue is up 32% and net income is up 40%.

Now look underneath. FCF conversion fell from 90% to about 21%. Receivables more than doubled while revenue rose by about a third, which suggests sales are being booked before customers pay. The share count rose 13%, so each owner’s share of profit grew far less than headline net income.

That is three flags touching Criteria 1 and 3 at the same time. None proves wrongdoing, but together they shift the burden of proof. Under the Five Criteria, Company X does not pass until those questions have convincing answers.

How We Use This in the Five Criteria

Red flags are the Five Criteria run in reverse. When I score a company, I note every flag next to the criterion it touches:

• One flag: investigate. Read the annual report notes and management’s explanation.
• Two flags: demand a clear, specific explanation and a larger margin of safety.
• Three or more flags, or any fail on the house thresholds: the stock does not pass. Move on.

This matters most for Criteria 1 and 4. A business that fails the ROIC and cash conversion tests, or breaches the debt limits, carries the highest risk of permanent loss, however cheap it looks.

Common Mistakes

• Explaining each flag away one by one. Each may have an innocent reason. Together they tell a story.
• Only reading the headlines. Most flags sit in the cash flow statement and the notes, not the press release.
• Trusting adjusted numbers. Compare them with reported figures every time.
• Ignoring flags in companies you already own. Commitment bias is strong. Review your holdings as if you were buying today.
• Waiting for proof. By the time a problem is proven, the price has usually already fallen.

Your Next Step

Take one stock you own and check it for every flag in the table above. Start with the Criterion 1 numbers in our ROIC guide, then record your findings with the Five Criteria Checklist.

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About the author: Cameron Hayes is a senior investor relations and finance professional who has worked in IR at Nasdaq Copenhagen-listed companies including Nilfisk and Maersk Drilling. He holds an MSc from Copenhagen Business School and a BCom from the University of Ottawa, and founded Gingernomics to teach individual investors the Five Criteria framework. More about Gingernomics.

The content on Gingernomics is for educational and informational purposes only and does not constitute financial advice. Always do your own research and consult a licensed financial advisor before making any investment decisions. Past performance is not indicative of future results.