A single bad investment can set you back a good number of years. So before you invest your hard-earned money, learn to identify and avoid them. With this in mind, we have outlined ten warning signs that can help you with the process.
High or rising levels of debt
Debt can be a useful tool for boosting earnings and profit margins. But when debt surpasses the value of assets or equity, it may mean the company is funding its operation via debt, further implying the business is unable to sustain itself. Now, this raises a lot of questions on sustainability over the long-term.
A good test is to look at the debt to equity ratio. The lower the debt to equity ratio, the better it is. A high debt to equity ratio, over a prolonged period, eventually increases the cost of debt, creating an unsustainable cycle that is difficult for the company to break. There have been several cases of companies drowning trying to service their high levels of debt. The more recent IL&FS and Jet Airways case highlights the same problem, alarming investors about companies with high levels of debt.
Reporting consistently poor ROEs, ROCEs
Return on equity and return on capital employed is perhaps, one of the most meaningful indicators of a company's profitability. It tells you whether a company is generating more than a low-risk investment, like a fixed deposit. They are also a valuable tool for comparison purposes. You can compare the ROE of an investment with its peers and the industry to understand how the company ranks.
A good range for this ratio, in a growing economy like Indian, is around 15-25%. Anything lower means capital can be better employed elsewhere. And while sometimes companies may take time to get there, consistent levels of low returns over prolonged periods is worrisome and raises a big red flag.
But keep in mind, these ratios cannot be looked at in isolation. They have to be studied over time or in comparison with other companies. Mainly as companies behave differently in different cycles. A new company, generating strong returns might be loaded with debt. But if it uses that leverage well, the company has the potential to become a multi-bagger.
Stocks trading at lower valuations are tempting as the age-old adage goes 'buy low, sell high'. And so, buying an undervalued stock makes sense, correct? Not necessarily. This is a classic example of what I like to call, a half-truth.
Stocks trading at dismally low valuations, particularly under normal market conditions are an investment warning sign. There is no guarantee that stocks that have fallen spectacularly over time will someday recover. And while it might appear cheap based on its past earnings potential, its future potential might be much lower.
So, before you invest in such stocks, understand all reasons behind the fall and study its true potential. A turnaround story is highly speculative and should be treated with utmost caution. You can lose your shirt off your back investing in a stock, on the bare assumption that it will someday recover.
Look at India Cements, a large cement player in the southern region. Even though the company has always traded at a discount to its peers, it is not necessarily a good investment. The owners have a long history of investing money from its core operations into other non-core ventures.
Lack of transparency
Company managers must be approachable and transparent about all its operations and corporate actions. Minority investors are part owner and have every right to know about all affairs of the company regularly.
But sometimes, companies in trouble try to hide their incompetence. And usually, their very first step in this direction is to cut all communication with investors to spare themselves from any explanations. So if you notice that an actively corresponding company has suddenly shut down all lines of communication, beware.
Incompetent board structure
The law requires publicly listed companies to develop an independent board of directors. It states that 50% of the directors must be independent, i.e., not related to the management or the founder of the company.
Now, most companies abide by this, but unfortunately, no law requires board members to be competent. And this must alarm investors. The skillset the board members bring to the table is of great importance. They should be well-qualified with relevant business expertise in different fields, like accounting legal etc. that can benefit the company.
The Board members are not just the face of a company. They are responsible for questioning the management and protecting the interest of the minority shareholders. And must, therefore, be well-equipped to act in the best interest of investors.
Numerous third party transactions
The annual report highlights many loopholes which, when stumbled upon, must not be ignored. Related-party transactions are one such item, which helps identify if the founder is using the company’s funds for his benefit.
Sometimes founders create bogus companies or fictitious transactions to siphon money out of the company. Now, this falls under third-party transactions, large amounts of which reported consistently, raise a huge red flag.
What usually happens is, that founders establish multiple businesses. And then use the money from their profitable ventures to fund the loss-making ones. They issue zero-interest loans or supply materials at a loss etc. The problem is here that this money isn't entirely theirs. The minority shareholders also have a stake in it, and so, they cannot use it for any non-core activities.
Changing accounting policies
Another method troubled companies adopt is that they try to change their accounting policies. When things take a bad turn, companies try to mask bad performances by adopting creative accounting methods. They inflate their asset base or their earning numbers to portrait a different picture. For instance, commodity companies change their inventory accounting policies from Last in First out to First in Last out (FIFO) and vice versa as per the market scenario.
Companies changing their accounting policies regularly is a big red flag. Investors must read all the auditor reports and ask the management for clarification. Furthermore, keep a tab on such investments and be on the lookout for any other suspicious activities.
Companies only distribute dividends once they are fairly confident about the business and its earnings. They understand the prospects well and set a payout ratio they know they can honour. So, if they decide to lower the payout significantly without any reasonable explanation, it's a big warning sign. A warning that the company's current profitability might be under pressure, unsustainable even.
Furthermore, lowering the dividend distribution will affect the dividend yield of the stock. And combined with reduced profitability, it can adversely affect the market value of the company.
Now, we are not saying that a liberal dividend policy always makes for great investments or vice versa. As a dividend policy alone does not make an investment good or bad. And most high growth companies seldom pay dividends, using their profits to grow their business. We are just saying that a company shrinking its dividend payments abruptly, is a cause for concern.
Moving the goalposts
Most companies have a vision of what they will look like in the future, what they want to achieve. Some want to increase capacity, they want to venture into another country etc. Generally, company managers tend to set targets for the next 5 to 10 years. And this is all good, a great sign even. The company has a vision for the future. They know where they want to be and have devised a strategy to achieve the same within a set timeframe. But some companies always miss their goalposts constantly, making excuses and extending their timelines. And what's worse is that rather than acknowledging their mistake, they set new benchmarks, which they fail to achieve. Now, this raises a red flag such companies are not confident about their business or are always changing their strategies.
And hence, investors must be wary of such investments.
Asset write-downs are common. Sometimes companies overpay for assets they have either bought or acquired. And so, when it is apparent that its real value is much lower, they re-adjust it, i.e., write it down to its current market value.
As a result, the company's equity and consequently, it's market value falls. While a small one-time write-down or a write-off doesn't necessarily indicate the company is in trouble, regular ones surely raise several concerns.
Other than affecting the reserves and equity, write-downs also affect the quality of earnings. They make them erratic and highly unpredictable. Furthermore, it poses a big question on the management's decision-making ability and competence.