How to look for investment red flags – that will save you a lot of pain and money (Part 1)

There have been endless articles around talking about how best to screen and analyze for a wonderful company and/or a company that’s trading below its intrinsic value that’s worth buying. From the very best like Buffett to the average retail investor – there have been many times we have invested in things that we thought were good but ended up disappointing us and, perhaps, losing us money. Worse, many retail investors who think they know enough or are overconfident in their limited ability to thoroughly analyze something tend to buy horrible stocks that look good at first glance.

So instead of giving you signs, metrics or indicators that lead you to hunt for good companies, here’re some that will hopefully allow you to avoid the bad companies. This is by no means an article about short-selling horrible companies, as short-selling in itself is an entirely different skillset of investing and takes incredible discipline, timing and stomach to pull off.

Charlie Munger once said about short selling:

“It would be one of the most irritating experiences in the world to do a lot of work to uncover a fraud and then watch it go from 1x to 3x and watch the crooks happily partying with your money while you’re meeting margin calls. Why would you want to go within hailing distance of that?”

Short-selling is for specialists; we’re at best hundreds of miles behind specialists like that and should stay within our circle of competence. Instead of trying to identify frauds, we simply identify companies which seem obviously bad, bad enough for us to exclude them from putting our money in. This article isn’t going to teach you how to spot fraud, but hopefully it will help save your wealth in the future.

Management

Management is almost always the key reason for companies doing badly. However, in wonderful companies with huge economic moats, even bad management can’t sink it.

Take Moody’s for example, they, S&P, and Fitch were heavily criticized for exacerbating the financial crisis by rating toxic subprime loans AAA. One would imagine the banks, insurance companies and general public would no longer trust them at all and not give them any business, right? Wrong. Moody’s margins further expanded and as of late (YTD2016), their operating margins are at a fat 40%.

Another gleaming example would be Microsoft. Steve Ballmer was made a billionaire for simply being Microsoft’s CEO and perhaps also being one of the tech industry’s worst CEOs. His decade-long tenure was fraught with failures and yet Microsoft made tons of money. A wonderful company with a wide economic moat with an oligopolistic position in its industry will survive even if a monkey were in charge.

On the other hand, if you’re looking for smaller companies with no moats but hoping to identify growth companies – it pays to pay attention to management actions.

Salary, Bonus and Director’s Fees

Is the management/board overpaying themselves? Dive into the income statements — usually it’s stated in the profit & loss statement or hidden in the notes, LOOK for it. We have an earlier article on management red flags but here’s a slight expansion on it.

1. Use a basic Excel sheet and calculate as a percentage, how much is management paying themselves as a percentage of revenue, gross profit, EBITDA, or operating income.

2. How is their compensation structured? How much of their pay is variable and fixed? How much of their compensation is delivered in equity?

3. If it’s variable, what metric is used to calculate their compensation? Is it some arcane metric that you don’t understand or something simple like ‘variable pay is based on year-on-year EBITDA growth’?

4. Stock options – are there any clauses that prevent the company from re-pricing any outstanding options without shareholder approval?

5. Are there any clawback clauses if directors or executive officers are caught in illegal or bad behavior that will tarnish the company’s image?

6. How much of the company does the management or board own? Some companies have policies where executives are subject to a mandatory minimum stock ownership that’s monitored on a quarterly or annual basis. If they own little of the company they run, there’s a serious misalignment of interests with shareholders.

7. If they own a controlling stake, how have they treated minority shareholders over the years? Too many local companies in Singapore have families dominating their companies’ outstanding shares and we’ve seen enough minority shareholders being taken for a ride especially during management buy-outs/privatizations.

8. Take at least three companies that are the company’s competitors and do the exact same thing, and then compare how much, in general, managements and boards in that industry are compensating themselves.

Track your company’s executives’ compensation and compare it with competitors. If they’re grossly overpaid at first glance, maybe take a look at their compensation structure and compare it against how well the company has been performing. Company A with a CEO earning $10 million may be a better buy than Company B with a CEO earning $100,000 simply because Company A has been a stellar outperformer compared to Company B — and its prudent to pay a CEO well to retain his/her talent.

Company A with a CEO earning $10 million may be a better buy than Company B with a CEO earning $100,000 simply because Company A has been a stellar outperformer compared to Company B — and its prudent to pay a CEO well to retain his/her talent. Not all highly-paid executives should be vilified, so don’t grab your pitchforks the moment you see a seven-figure salary, there could be a good reason why.

Balance Sheet

Many investors usually skim through the balance sheet without much thought. They look at cash, properties and debt and simply stop there. Worse still, some simply use the Current Ratio and stop there without thinking twice.

Assets

Not all assets are created equal. A company with few tangible assets is potentially dangerous.

Intangible assets & goodwill

Sure, we’re in a “New Economy” now where most value is from intangible assets. Alphabet can get away with it, that’s for sure, and you know it. How about companies that aren’t the biggest search engine in the world that doubles as the world’s largest advertising firm?

Can their intangible assets/goodwill be trusted? Moreover, intangible assets have to be amortized and treated as a non-cash charge. Goodwill can’t be amortized but has to be actually written down and companies consider it as a non-cash event as well. Goodwill is when you pay $10 for something that’s worth (net assets) $8. The remaining $2 sits in the balance sheet as an asset. Sooner or later there has to be a write-down on it and the company’s earnings will take a $2 hit.

How much of that intangible asset is actually generating economic value to the company? If it isn’t much and it’s just because the company went full Valeant-mode gobbling up everything paying premium prices, it will soon come to a head and the market will eventually punish the stock for it.

Receivables & Inventories

Receivables and inventories should be good assets right? They’re tangible and it turns into them gleaming Yusof Ishaks (or Benjamin Franklins) after a while, don’t they?

Peg accounts receivables to sales over quarters or years, and watch its relationship. If receivables balloon whilst sales growth remains paltry, something is not right. A metric that is used is Days Sales Outstanding, and in complement with Days Inventory Outstanding and Days Payable Outstanding (for payables), it’s calculated as Cash Conversion Cycle (CCC) and the metric is a time frame measured in days.

If the company takes longer and longer to receive cash, something isn’t right. Think the opposite of crazy retailers like Amazon with negative CCCs because they pay suppliers after they get paid by their customers – if a company pays $1 to a supplier now, but its customer takes 90 days or more to pay them the $1, how will the company survive on those 90 days as operating costs won’t wait for 90 days?

Many fraudulent Chinese companies have been known to conduct fraud through their receivables and related-party transactions, but that’s an entire article within itself and it’s far beyond an average investor’s competence to sniff it out.

Liabilities

Liability seems like a bad word and its connotation is full of negativity. Buffett managed to make liabilities an asset for Berkshire but liability in itself isn’t a bad thing as most companies tend to have some.

Debt

Not all debt is bad. Many companies make their billions using debt as it provides leveraged returns on investments. However, when over-levered, it’s a double-edged sword.

Look at the recent oil & gas bond wipeouts in Singapore, for example. Hindsight is 20/20 and I won’t delve into Swiber or any of its smaller cousins’ financial statements and go, “Hah! Isn’t this obvious?” But there are signs that should be a fair warning to investors.

If the industry is in a secular downturn and a company is bleeding millions every quarter with a balance sheet loaded up with debt, it’s fairly obvious to say that unless it can refinance its debt by finding new willing-enough investors, they’re headed for trouble. Simple ratios like the Interest Coverage Ratio (it can be modified from EBITDA to any other metric you might prefer) to looking at the debt schedule of the company would give ample warning signs to investors.

Company A has lost $10 last year and they only have $20 of cash left. They have $50 in debt, of which $30 is due to mature this year. Its industry is in the doldrums and you don’t know where the bottom is. Distressed debt hedge funds will salivate over something like this, but not these poor folks. If you don’t really know whether you can get an asset for pennies on the dollar with confidence of it being redeemed at intrinsic or fair value in the future, stay out.

Shareholder’s Equity

What can go wrong here? It’s just retained earnings and shares!

Buybacks can be great, it concentrates your ownership of the company, and it’s usually a signal that the management thinks that the company is undervalued and it’s a better investment to buy back shares instead of investing in assets outside. Until it isn’t.

Some companies use buybacks as a publicity stunt to support their stock – boost EPS for example. Sometimes the buybacks don’t technically happen: the company does not retire the stock and place it in the corporate treasury, which is of zero use to shareholders. Watch out for that!

Linking to management above, buybacks materially benefit executives who’re paid in stock options. When those options are exercised, deviously timed buybacks can absorb the excess stock and offset the dilution. It’s an opportunistic buyback program for sure, but it’s to management’s benefit, not shareholders. Look at the company’s announcements and filings, watch for when the buybacks occur and when the stock options get exercised.

The Fifth Perspective

These are just some red flags that investors can take note of when scouring the world for investments. Great investments are not just about picking the right stocks, but also the ones you avoid.

Read part 2 here.