Avoid the Stupid Mistake I Made

Until far too recently, I was a General Motors shareholder. I owned the stock despite knowing, as far back as 2005, that the company was heading toward oblivion. Just about everything that the company could have been doing wrong, it was doing wrong, including:

• Having a management team more adept at shifting the blame than running the business.
• Hemorrhaging a ton of cash, even back then.
• Acceding to insane labor demands, such as a job bank that paid people to not work.
• Maintaining a sclerotic bureaucracy unwilling to make the changes necessary to survive.

That entire mess, along with the company's inevitable eventual stop in bankruptcy court, was blindingly obvious to anyone who bothered to pay attention. Yet I still owned the stock.

How could I have been so stupid?
My problem was simple. I had become anchored to General Motors' past greatness, to the point where I completely discounted the tremendous problems then facing it. The reality that the former titan of the roadway was failing was staring me straight in the face, yet I glossed over it as if it were a short-term blip that would soon pass.

Proper investing is a forward-looking endeavor, yet I was so busy looking through the rearview mirror that I drove myself straight into a brick wall. It was an expensive lesson to learn, especially now that what was once General Motors stock is absolutely worthless. Fortunately, the lesson has stuck. Instead of judging a company by how great it once was, I've relearned the importance of looking closely at what it has today and what it will likely do tomorrow.

What to look for
Most of what you need to know can be found on a company's "big three" accounting statements: its balance sheet, income statement, and cash flow statement. Together, they'll tell you how well a company manages its assets, how well it can convert its sales into profits, and how well it can convince its customers to pay cold, hard cash for its products.

A company's balance sheet will tell you what it has going for it today. If it limits its debt and keeps enough cash on hand to cover its expected near-term costs, it makes itself better able to handle a short-term economic downturn. A strong balance sheet stands in stark contrast to the old General Motors, which relied heavily on debt and using borrowed money to pay its bills.

Likewise, a company's income statement will tell you how well it's doing today. Profits are good; losses, unless they're due to the up-front costs of rapid expansion, are not. General Motors, unfortunately, had long-term trouble showing a profit from its automobile operations.

And perhaps most importantly of all, a company's cash-flow statement shows you how well the company generates cold, hard cash. The unfortunate reality is that a struggling company can juice its reported profits in the short term by offering deals like same-as-cash financing. (Sound like any failed car companies we know?) But if the cash never rolls in to support those "profits," all the accounting profits in the world won't save a company from bankruptcy.

Healthy companies look like this
When you have a financially healthy company, you get metrics like what you see in the table below, rather than what I saw while owning General Motors:

Healthy financials today are still no guarantee of long-term investing success. But your chances are significantly better when you own companies that are financially solid and have customers who are willing to part with real cash to buy their products.

If a formerly strong company does manage to permanently blow its chances at recovery, take it from me (and learn from my experience). It's far better to sell at a loss than sink to the bottom with the anchor of a company's past greatness tied around your neck.

Learn to get out in time
At Motley Fool Inside Value, the team constantly reevaluates its selected stocks based on their reported financials and their likely prospects for the future. If a company's business deteriorates, Inside Value is willing to sell at a loss, rather than tie a stock around its subscribers' necks as an anchor. That discipline has kept it ahead of the market, even through its recent turmoil.

If you'd like to jettison failed investments sooner, rather than let them sink your entire portfolio, join us today at Inside Value. If you'd rather first see how a disciplined selling strategy helped protect us from the worst of the market's recent chaos, click here to start your 30-day no obligation free trial. You'll have access to our scorecard, updates, and buy and sell selections, and you'll be able to see how knowing when to cut your losses can be a huge difference.

At the time of publication, Fool contributor Chuck Saletta did not own shares of any company mentioned in this article. He did manage to wake up in time to get about $1 a stub for his General Motors shares. Markel is an Inside Value pick. Coach is a Motley Fool Stock Advisor selection. The Fool owns shares of Markel. The Fool's disclosure policy is proud of Chuck for 'fessing up to his idiocy.