If you are reading my blogs for the first time and are a novice in the field on investement, I recommend you read the blog on Accounting Ratios before starting this blog so that you can evaluate if a stock is a great investment or not. If you already now about ratios it’s time to do some second order thinking and dig deeper. Companies manipulate their financial records to paint a rosy picture for investors who boost their stock prices. Therefore, it’s imperative for us to not take a stock screener’s data for granted and learn to read between the lines. The details are often hidden inside their annual report. Unscrupulous behavior is also a sign that something is wrong. When it comes to investing, it’s better to err on the side of caution as it can take a long time for frauds to be discovered before all hell breaks loose.
Red flags do not necessarily mean that investors shouldn’t buy a particular stock. They serve as warnings that something is amiss, unusual and requires deeper analysis to understand the cause and implications. Investors should watch out for 5-10 year trends and try to identify patterns because a one-off activity might just be one-off due to various reasons and not represent anything sinister.
Below is a useful list which is a mix of forensic & corporate governance checks:
Source of Funds & Application of Funds
We need to identify and understand the source of funds raised by the company – equity dilution, debt, cash flow from operations and how these funds are used – capex, investments, working capital, giving loans.
Tax Payment
Is the company paying its fair share of taxes? Is the provision for taxes increasing very rapidly? How is the Cash tax to PBT over the long term?
KMP remuneration
Is the compensation fair? Is the gap between KMP remuneration and average wages significant and widening? How qualified are they for the job?
Auditor remuneration, change and observations
Has there been a substantial hike in remuneration or change from a good auditor firm to a lower quality one? Has the auditor made some adverse observations?
Contingent Liabilities
How large/small/hidden are contingent liabilities? What is the disclosure policy?
Related Party Transactions
Related Party transactions need to be checked as a % of Sales and Net Profits.
Promoter background
Any history of corruption, crime, or wrongdoing? How big or small is their stake in the business? Is their attention divided due to other ventures? Are those ventures in the same industry?
Acquisitions
Is the company very acquisitive? How does it treat goodwill? What is goodwill as a % of net worth?
Revenue Recognition
When does the company recognize revenue – after physical transfer of goods or simply minimum advance booking amount or upon shipment etc?
Ratings report
Reports by credit rating agencies can offer us rich insights into the company’s operations and ailments (if any).
CFO/EBITDA
This should ideally be above 75% for B2C and above 60% for B2B companies. A poor low number is not a good sign as it could mean money is stuck in account’s receivables or inventory. Comparison with peers can also give insights about the company’s ability as well as the wider industry.
One-off charges/income and past write-offs
Are there recurring one-off charges or income? Have there been large write-offs in the past?
Miscellaneous
Depreciation policy, pension assumptions, ESOP policy, unusually low salary to employees, unaudited subsidiaries, boastful management, negative publicity on online forums are some more details to be looked into and carefully examined.
The list above is not conclusive but a strong preliminary filter to help you avoid companies who take minority investors for granted. Remember, when it comes to investing, better to have errors of omission than commission. Skepticism can be advantageous for investors. Often the details are cryptically buried deep inside annual reports which most people don’t bother to read. Pay attention to changes and their reasoning.
You might miss a few good companies, but your portfolio overall will be better for it. A good book to read on the subject is Financial Shenanigans by Howard Schilit. It’s filled with interesting case studies of companies employing innovative techniques to manipulate their books and fool investors.
Along with accounting ratios and red flags there are also some qualitative attributes which investors should check before committing like:
Awards/recognition
Has the company won some award from a prestigious organization or have their efforts been recognized by some marquee customer?
Environmental compliances
How environmentally friendly and sustainable are the company’s operations? Are they following all the pollution norms and have applied for green certification or using renewables to meet their requirements?
Category of customers
Does the company serve small unknown customers, or does it deal with large established names or global giants? Large well-known companies don’t generally default on their payments.
Competitor’s opinions
Do the competitors in the industry look up to the company or have some grievances about unscrupulous practices? Not all competitors will be forthright in their opinions but could be helpful to be aware of their thoughts.
Public advertising
Does the company do a lot of advertising? This is especially important if the company is not B2C, then one needs to understand the reasoning behind this.
Media coverage
Does the management appear frequently on tv channels and give interviews or guidance? This could appear as red flag unless the company in question is very large. Everybody loves attention but one needs to be watchful of too much attention and then determine if the company has other motives.
Interaction with shareholders
Does the company arrange con-calls after every quarter and share updated presentations? If a company doesn’t do so, then that’s not necessarily a bad thing – think of it more like the icing on a cake. Communication transparency or lack thereof can often say a lot about the company’s attitude towards minority shareholders.
Dividend policy
Again, not a must have, but does the company have a dividend policy in place? We are not concerned with the yield but want to know how the company plans to reward minority shareholders for riding along the journey. The management could also reward with buybacks or bonus issues.
Ambition and Actions
The company might have grand ambitions, but we need to see if their actions match their words. This can be done by checking past capex plans and matching them with actual time taken to execute, cost overruns and asset turnover. It will give us a broad idea of what to make of new announcements.
Institutional holding
For any company to give massive returns, it needs to attract institutional buyers. Thus, when institutional holding is increasing in a company, that is a validation of the company’s efforts and a positive sign for us.
We should avoid investing in companies where there are a lot of red flags and poor governance. Having said that one should also note that, Benjamin Graham and Warren Buffet have done their fair share of ‘cigar-butt’ investing. Cigar-butts are basically worn out decaying/failing companies which are available at such throwaway prices, that one can still make some money (last few drags of before the cigar burns out). At a great price, even a bad company can be a good investment. However, this particular style of investing requires a lot of research and agility, and is not recommended for beginners.
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