How to look for investment red flags – that will save you a lot of pain and money (Part 2)

In our first part of looking for red flags, we touched on issues like management and the balance sheet for signs of corporate ills. This world is plagued with inefficient companies, the good ones are usually expensively priced, and the lousy ones are usually priced so cheap they actually look enticing to investors who aren’t discerning and careful enough.

Here are several more red flags to look out for to protect your neck in the investment world and these will be more qualitative than the first part in the red flags series.

Management part deux

Human behaviour is difficult to quantify and looking at numbers won’t give you the full picture of how management behaves. Results can be measured in numbers but it’s the words of the management that sets the tone and direction and their action for its execution.

Listen to conference calls or read earnings transcripts of companies; they’re public and widely available for all to listen or read. It pays to take note of the things they say, especially on a quarterly basis, there are some signs that after reading a company’s earnings calls for a few years or so, you can roughly hazard a guess on management’s attitude toward its shareholders. Here’re some signals you can look out for:

  1. Has the management constantly overpromised and under-delivered? One example is when management constantly fails to meet their key performance indicators (KPI) that they’ve set for themselves – they target 8% sales growth and a 1.5% increase in margins by the next fiscal year but they’ve continually missed their targets.
  1. Has the management been changing their KPIs suddenly without explanation or with weak arguments supporting their case for change?
  1. Have any management initiatives disappeared without mention? Annual reports are always at least a few hundred pages thick, and conference call transcripts can be long – it’s easy to make an initiative disappear without an alert person noticing.
  1. How is the management’s attitude to tough questions from analysts? A good and honest management team is always prepared for any question analysts might throw at them – giving realistic, rational, and sober answers rather than wildly optimistic words or avoiding questions. Avoiding questions doesn’t mean that they’re a fraudulent bunch but it sets off alarm bells in anyone’s honesty department. Hopefully, at least they don’t angrily throw out analysts for downgrading their company to a “sell” (that stock dropped like a rock after news emerged of the CFO throwing an analyst out).
  1. A study by accounting professors from Stanford University on detecting deceptive conference call discussions has shown that deceptive executives tend to have more references to general knowledge, fewer references to shareholder values, self-references, extreme negative emotions, hesitation and certainty words. In short, lying CEOs are most likely using the words “unquestionably”, “fantastic”, “marvellous” rather than simply “good” or “solid” results. It’s an art trying to detect lying CEOs or CFOs but actually listening in on the conference call where you can hear their tone of voice would alone speak volumes about their character.
  1. Heavy insider selling – is management or the board letting go of their vested options or direct stock holdings like there’s no tomorrow? They might know something that you don’t – and that can be worrying for a shareholder.
  1. If it’s possible, high employee turnover is also a key indicator that’s something’s wrong with the people on top. It’s tough to measure as they’re not legally obliged to disclose it, but ways like actually talking to their employees if it’s convenient for you, looking at company reviews on Glassdoor, hearing bad rumours at networking events of the company can be loosely used as signs of trouble. This, as I’ve said in my first article, only works for companies with no economic moats – a company that can be run by a monkey for ten straight years and still make the same margins won’t qualify as their moat is in place and the company itself is larger than the management to take it down.
  1. Do any of the directors or executive management personnel own stakes in companies where the company itself conducts business with? In some fraud cases, the errant company itself buys goods and services from a (usually) private company that’s owned by someone that’s also representing the company. It’s a related party transaction and it’s usually the most ominous sign that screams fraud.

Poor capital allocation

Great capital allocators allocate capital in assets that generate economic value over the long term or returns that are best suited for the future.

Look at companies that are acquiring assets that are completely different from their core business, like a soft drink manufacturer buying semiconductor assets – are you fully confident that the management is astute enough to run a business that is in a different universe from their current one?

Overpaying for acquisitions – this is very common, businesses tend to overpay for assets and incur large goodwill in their balance sheets. You must ask yourself this: Is the large debt load they’re undertaking to pay for the large premium worth it? Is the asset they’re buying going to yield higher returns over the company’s new cost of capital? Can that accounting goodwill be translated to economic goodwill?

In structurally deteriorating businesses (dinosaurs), management has moved from a position of strength to that of weakness. They may not be used to running a weak, declining company as opposed to when they were strong, and they might make ill-informed decisions that might bury the company in years to come. They might do things like:

  • Buy back stock at a rapid clip (no matter the price) to boost earnings per share.
  • Acquire other businesses that they don’t know how to run to make it seem that they’re growing.

In normal businesses, is the company constantly loading itself up on debt or issuing shares (rights, convertibles, secondary offerings, etc.) to overpay for businesses they have no expertise in? Some companies constantly dilute shareholders by issuing shares en masse almost every year, taking new shareholders’ money to finance risky adventures or simply pay off debt – one can easily calculate on an annualised basis how much of the firm’s shareholders were diluted throughout the years.

Sometimes it is obvious…

Read the company’s IPO prospectus (if it’s relatively new), and view it as you would a business person. Does the business make sense to you? If it doesn’t, you have one of two choices – study the industry widely and try to understand its business, or move on to another stock.

In all prospectuses, they will list the risks inherent in the business and its environment, sometimes in detail. I’m not talking about the usual terrorism, apocalypse, nuclear winter type of template risks that all companies inject in there, but more of the business itself – some will even list out risks that have a high probability of occurrence such as key personnel risk or ongoing/potential litigation that might have a huge financial impact on the company. It’s quite common for average investors to skim through the risk section of a prospectus or a 10K as they might think it’s always the non-issue type of template companies around the world use. But it’s common that companies do add in, with detail, risks inherent in their businesses that actually will happen over the course of time.

Key client/supplier risk

One of the risks that can be inherent with some businesses that have a high probability of occurrence is key customer or supplier risk.

Some companies may have customers that constitute a major portion (or sometimes all) of its revenue. The term in annual reports can sometimes be “off-taker”, and sometimes it’s a contractual agreement (offtake agreement) with a time period of a few years. Even an offtake agreement doesn’t mean anything if the customer hits financial trouble and simply tears up their contract and risks legal fees or declares bankruptcy – the loser would be that of the company that supplies them the products.

Never take an offtake agreement for granted, nor assume that the company’s customer will remain solvent forever. Let’s say Company A is a minor OCTG (oil country tubular goods) manufacturer that sells to drillers in the O&G industry, and your two major customers are Swiber and Keppel, sharing 50% of your revenue equally. Swiber goes under, your offtake agreement doesn’t count for anything and you’ve just incurred a 50% hit permanently, with inventory levels stocked to the brim with no other customers willing to buy when the industry is in the doldrums. It’s a dangerous situation to be in.

Same goes for a company on the opposite side of the value chain, a key supplier that provides a critical component or service to your company’s goods suddenly goes under or decides to raise prices as and when it likes – you’re completely at mercy of your suppliers, and sometimes suppliers can be major MNCs that dictate terms of agreements in their favor which their customers have to abide with due to the highly specialized nature of their products.

These can be red flags for investors as it’s always better for your company to be in a position of strength within its value chain – look through the annual reports and see how large their customers’ revenue contribution are.

Non-recurring items

Most financial news headlines can be misleading, they simply report what the company puts as their bolded, underlined, italicised titles for earnings press releases. They rarely say something like “Company X announces record earnings of $1 billion, but mostly from one-time gain of $999 million of sale of property”. It’s not their fault as it can crowd the headline text and it’s more important to grab readers’ eyes with just “Company X earns record $1 billion”.

It’s your job as an investor to pore through the results release documents itself and see what truly comprises a company’s earnings.

  1. Are most of their gains from one-time (non-recurring) items?
  1. If so, on a quarterly or annual basis, strip out their non-recurring earnings and see if there has been any organic growth. If it’s worsening and the company’s simply selling assets to prop up earnings, it’s a red flag.
  1. Property developers are an exception as they’re in the business of “lumpy”, one-time gains or losses. It’s normal to see three to five straight quarters of “meh” earnings and one quarter of insane triple digit percentage earnings gains. It’s nothing to be excited about, it’s simply their business model.

The fifth perspective

This is by no means an exhaustive list as there can be endless ways to look at companies to spot fraud or simply avoid investing in. Use these points to aid in your avoidance of structurally weak companies or potentially fraudulent ones – there are too many around!

Matthew Lim is an equities and fixed income investor. He has a great curiosity of how markets, economics, and human behavior influence each other. He believes that an understanding of human irrationality and solid fundamental analysis allows an investor to seize opportunities and ultimately profit from the market.

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