Stock picking is not just about identifying strong companies. You should also be wary of red flags that signal that a company should be avoided.
Picking the right stocks can be a fun and rewarding activity as long as the investor is committed to being pro-active and diligent. It’s not always a clear-cut case of a company being investment-worthy, as certain factors may make you smile while other aspects may make you cringe.
It would be much easier if there was a cookie-cutter list of exactly what to avoid in lousy investments.
But in the real world, things aren’t always painted in either black or white. Most of the time, investors are dealing with varying shades of grey.
Therefore, having a mental checklist of what to be wary of could help. With that in mind, I would like to share four red flags that should alert investors to potential trouble at a company.
Low or declining gross margins
Gross margins are an important aspect of any company as it demonstrates the business’ ability to price its products and services.
If a company has a low gross margin to begin with, that probably says something about how easy it is to increase prices without causing a sharp fall in demand. Hint: it’s hard.
Investors also need to watch out for companies that demonstrate declining gross margins, as that may signal that the business is losing its competitive edge.
An example of a business with low gross margins is Serial System Limited (SGX: S69). In its 2021 half-year earnings, the business reported gross margins of just 8%, though this was up from the 6.1% chalked up a year ago.
Crippling debt levels
Having some debt is normal for any business and may even be a positive thing as loans can be a cheap form of financing for a more profitable venture.
However, if debt levels are too high, they could start to drain a company’s cash flow and become a crippling weight to shoulder.
Many businesses, regardless of size, have been brought to their knees by excessive amounts of debt which end up being unserviceable as the business runs into problems with cash flow.
A recent example would be Hyflux Limited (SGX: 600). The company has been suspended due to insolvency and its latest financial statements ended 30 September 2018 show a cash balance of S$193.7 million and total gross debt of S$1.568 billion.
Lack of free cash flow
Another clear red flag is the absence of free cash flow (FCF).
FCF, in a nutshell, is defined as operating cash flow minus a company’s capital expenditures.
Operating cash flow that is positive implies that the company is generating cash from its core business instead of relying on cash from loans and borrowings (defined as “financing cash flows”).
The presence of operating cash flow reduces its reliance on external parties such as banks and investors to fund its expansion and daily operations.
Companies that consistently generate negative FCF are a big red flag. In this case, investors need to delve into the reasons for the company’s inability to generate FCF.
Some companies may enjoy an extended run without positive FCF if there are tailwinds driving the industry. However, when tough economic conditions arrive, the lack of FCF may cause the business to spiral into the depths of an abyss that it could never climb out of.
When it comes to the human aspects of a business, one clear warning sign for me is what I would term “lousy management”.
There are several angles to this, of course.
It could involve management over-promising yet under-delivering, being consistently poor capital allocators, squandering valuable shareholder funds on poorly-chosen acquisitions, or simply sweeping problems under the carpet without property addressing them.
And the list goes on.
It may be surprising for investors to learn that poor management can run a strong business into the ground if their behaviour is not called out for what it is and nipped in the bud.
Put another way, would you trust a bunch of incompetent or inept people with your hard-earned money?
I think the answer would be very clear and obvious. So, steer clear of management that stinks and instead, seek out quality, top-notch management teams.
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Disclaimer: Royston Yang does not own any of the companies mentioned.