Red Flags

High payout ratios

 

Any company that has been sustaining a payout ratio exceeding 85-90% for a few years should avoided/investigated. A high payout ratio may mean one of the following:

  • Low ROE: if the company isn't retaining any earnings, it's likely they believe investors can get better returns elsewhere. 

  • No growth prospects: retaining no profits means no growth opportunities are pursued by the company (or they are funded by debt, added debt is a no-no)

Payout ratios that exceed 100%: this usually occurs when a company has had a poor year, or a year filled with statutory costs (one-off). They exceed 100% so companies don't have to cut the dividend (dividend cuts piss off a lot of people). One year of this is okay, given a good explanation however more than one year, or consecutive years is an immediate red flag. 

 

Revenue dependant on conditions

We don’t like companies that can only thrive under good conditions. Management saying: ‘conditions we expect to improve’ highlights to me that they have no concrete plan of action.

 

Creative accounting

Creative accounting can be extremely difficult to identify, as it's very existence is designed to deceive onlookers from gaining a clear perspective of the numbers.

Some things to look out for: 

  • Excessive statutory highlighting: underlying earnings is always more important, as statutory involves one-off costs and transactions. You will see many companies in earnings season broadcast their fantastic statutory profits, yet mention nothing of underlying profits.

  • Excessive goodwill on the balance sheet: goodwill is an intangible asset that's associated with company takeovers, it's is equal to the amount paid over the tangible & intangible assets purchased in an acquisition. Too much goodwill on a balance sheet usually means an overpriced acquisition, as well as over inflated asset values. Write-downs in goodwill are value destroyers, so be wary of this phenomena. 

Employee remuneration

It's crucial that management's incentives are aligned with the shareholders. The ultimate red flag occurs when management don't have shares, or are selling shares in the company the manage. 

If management remuneration is mainly through end of year bonuses, this encourages short termism, which is a red flag. 

If they are remunerated on EPS growth, which is very easily manipulated through buybacks and cost cutting, this is another red flag. 

e.g. the craziest employee remuneration scheme I've ever seen was Tesla agreeing to pay Elon Musk money for growing the market cap of Tesla. Growing market cap is the easiest thing in the world to, all you need to do is acquire business's, no matter their fundamentals. 

 

Industry red flags

There are no set rules for this red flag, you need to be a little creative and apply a little logical analysis. 

Think of the underlying product or service the company your analysing offers. Is it a poor service that you believe can be easily improved? If so, it's likely others feel the same way; when there is a glaring need for an improved product/service usually that need will be addressed by someone quickly.

E.g. 

 

However you mustn't believe in unicorns though, meaning that you shouldn't believe in a product or service that is going to be invented that will making an existing industry obsolete. 

e.g. I've heard commentary about not investing in Sydney Airport because self driving cars will be fully integrated into society within 5 years. This time-frame is absurd, yet it's holding some back from investing in a company that is growing earnings and has impenetrable barriers to entry. 

When industries are under threat due to hype around new technologies that are yet to be invented, this is an opportunity. Humans have an abysmal track record in predicting future technologies, so when a companies share price is under pressure due to the threat of a 'unicorn', it is worth a second look. 

That’s not to say you need to believe in unicorns though. The service/products need to be cheaper, or more efficient. You can’t not invest in a car company per say because you believe flying cars will change the future. Only avoid if the disruption is grounded in technology we only have today.

 

Capital raising

Depending on the reason, capital raising can destroy shareholder value. Fundamentally it reduces the profits per share, as there are more shares on issue. 

If capital is being raised to pay down debt, run for the hills (check out the Nufarm share price in late 2018). 

The best business's don't require external capital to be raised; they are able to grow organically through reinvestment of their own profits. 

 

There are many red flags to look out for; If your unsure about something please feel free to post any questions in the members forum. 

NBSInvesting