3♦ — Watch out for Red Flags

Watch out for Red Flags - and use them to build your Bargepole List

Red Flags

This post is part of the MoneyDeck series, a pack of 52 playing cards that describe 52 “golden rules” for Private Investors in the UK.

Watch out for Red Flags – and use them to create your Bargepole List.

One of the most important skills in stock investing is knowing when to sell. Just as important is knowing when not to buy in the first place.

You can’t rely on equity analysts. Only 10% of their recommendations say “Sell”, because their real customers are the companies themselves, not investors.

But you can make use of red flags.

A red flag is any characteristic that identifies a stock as being more likely to have problems in the future.

  • There is no universal standard for what constitutes a red flag. Each investor will have his own list, based on his approach to investment, and his experiences in the past.
  • It is even possible to imagine a characteristic of a stock that acts as a red flag for one investor, but is seen as an advantage to another investor. ((Within the relatively homogenous group of investors that we serve – UK Private Investors working towards financial independence – this is less likely to be the case ))

As we will see, a lot of red flags are found in a company’s accounts.

Looking for problems with companies – and in particular with their accounts – is a long-established tradition, ((Terry Smith’s seminal book Accounting for Growth was published in 1991 )) but it came back into fashion after the collapse on Enron in 2001.

Although accounting can be seen as a set of fixed rules, in practice there is a lot or wriggle room. Data can be presented in multiple ways, tempting a company’s management to use the approach that flatters their performance the most (and potentially triggers extra executive compensation).

  • The Cash Flow statement is the most difficult to manipulate. When sales are increasing, so should cashflow.

There are four main areas in which to look for red flags:

  1. valuation – this can be too high or too low
  2. low financial strength (weak balance sheet)
  3. bad management – particularly management excess
  4. company specifics – sector, structure, and strategy

Valuation is the most subject to interpretation, since it can be too high or too low.

Too high is the easiest to deal with – a ratio like price to sales (PS) can be used. A high PS often indicates a “story” stock that has been driven too high by investors keen to believe in a rosy future.

At the other end of the spectrum, one of the most common pitfalls to avoid in stock-picking is the value trap. Stocks are often cheap for a reason.

  • A value trap is a stock that looks like a bargain, based on valuation metrics like price to earnings (PE) or price to book (PB), but which fails to recover and potentially goes bust instead.
  • This is often because of structural / secular changes in the company’s business, rather than simple business cycle pressures – the “dying company in a dying business” scenario.

Value traps need to be separated from genuine value stocks by using the other three areas of investigation.

Financial strength is also relatively straightforward to assess. The Piotroski F-score is a nine-point checklist,  developed by Joseph Piotroski at the University of Chicago in  2000. The filter was the most successful stock screen during the 2008 crisis.

It was initially a filter for value (low PB) stocks that looks for companies that are profit-making, have improving margins, don’t employ any accounting tricks and have strengthening balance sheets.

Piotroski himself liked stocks which scored 8 or 9, and calculated they would outperform the universe of cheap (low PB) stocks by 7.5% pa in the US (1976-96). Shorting the worst stocks at the same time increased outperformance against the broad market to 12% pa.

Further work by Societe Generale analyst Andrew Lapthorne has shown that a higher F-Score predicts higher returns for stocks at all valuation levels.

The filter has been shown to improve the performance of income portfolios as well as value strategies, and has been used successfully in combination with Joel Greenblatt’s Magic Formula.

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The filter works best with small and medium-sized firms with poor analyst coverage and low trading volumes. It seems to exploit an information asymmetry.

In the context of red flags, a score of less than 4 is a bad sign. Those scoring 2 or less were five times more likely to go bankrupt or delist.

The nine measures in the F-score are split into three groups:

  1. Profitability
    • positive net income in the current year
    • positive cashflow from operations in the current year
    • return on assets higher than the previous year
    • cash flow from operations greater than net income before extraordinary items
  2. Leverage, Liquidity and Source of Funds
    • leverage – lower ratio of long-term debt to equity than in the previous year
    • liquidity ­ – higher current ratio than in the previous year
    • no dilution – no new shares issued in the preceding year
  3. Operating Efficiency
    • higher gross margin compared to the previous year
    • productivity – higher asset turnover ratio than previous year

Note that six of the nine measures look for positive change in the company’s fundamentals. In this sense it is a “fundamental momentum” measure.

Bad management can be a big problem if the firm operates in an industry with low barriers to entry or has no moat. Bad managers can be identified in several ways:

  • lack of industry experience
  • boardroom fallouts, indicating low tolerance of dissent – especially the FD
    • a change of auditors can indicate this – perhaps the old auditors wouldn’t go along with the way management wanted the accounts to look
  • big egos – those who want to be synonymous with the company in the mind of the public
  • boardroom extravagance and empire building
    • asset growth of more than 10% pa is an indicator here
  • too much M&A activity (leading to excessive goodwill in the balance sheet, followed by write-downs)
  • antagonistic with shareholders or even customers
  • excessive compensation and use of stock options

There are several indicators of a potentially bad company:

  • complicated structure and strategy, missed milestones
    • if you can’t understand how a company makes money after reading the financial statements, don’t buy it
  • industries in secular decline (usually because of technological innovation)
  • speculative industries such as energy and resources exploration, small-cap foreign agricultural firms, and blue-sky technologies (including biotechnology)
  • bad strategy
    • growth through acquisition to achieve scale (cost or demand advantages) in an industry with low barriers
    • diversification into adjacent markets with low barriers
    • rationalisation (cost-cutting) in a declining industry
  • excessive leverage (debt) for the industry (they may not survive the next recession)
    • ratios like the Quick Ratio, Current Ratio, Long Term Debt / Equity and Total Debt / Equity can be used here
  • dodgy accounting (lack of transparency, aggressive revenue recognition)
    • an increase in Accounts Receivable can indicate a change in revenue recognition polices, and that earnings are being padded with sales that will be delivered (and paid for) in the future
    • increase in Inventories, possibly from a change in valuation method, is also a bad sign

Apart from the F score we met earlier, there are two other defensive stock screens that can be used to identify red flags. One is the Altman Z score and the other is the Beneish M score – for some reason this area of investing is an alphabet soup.

The Altman Z-Score – created by US finance Professor Edward Altman in 1968 – is a checklist of five weighted ratios to identify stocks that might be at risk of bankruptcy.

The five measures look at:

  • liquid assets
  • cumulative profitability
  • earnings productivity
  • solvency
  • asset turnover

Over 31 years to 1999 found the Z-Score was 80-90% accurate in predicting bankruptcy in the following year.

Here is the Z-score calculation:

Z = 1.2 * A + 1.4 * B + 3.3 * C + 0.6 * D + 1 * E
 A = Working Capital / Total Assets
 B = Retained Earnings / Total Assets
 C = Earnings Before Interest and Taxes / Total Assets
 D = Market Value of Equity / Book Value of Total Liabilities
 E = Sales / Total Assets

A Z-Score of 3 or more is considered safe, and one of less than 1.8 indicates that the company is likely to go bankrupt in the next 2 years.

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Note that the Z-Score doesn’t work for financial companies. The original work was done on manufacturing companies, and an alternative calculation can be used for non-manufacturers.

The third defensive stock screen that can be used to find red flags is the Beniesh M-score.

This is a checklist created by finance professor Daniel Beneish to identify stocks that are manipulating  their reported earnings. It was used to identify Enron as an earnings manipulator.

It uses eight accounting numbers to produce a single output:

  1. DSRI = Days’ Sales in Receivables compared to previous year (revenue inflation)
  2. GMI = Gross Margin compared to previous year
  3. AQI = Asset Quality Index – ratio of non-current assets other than plant, property and equipment to total assets, compared to previous year
  4. SGI = Sales Growth Index – sales compared to previous year
  5. DEPI = Depreciation – rate of depreciation compared to previous year; slower depreciation means the firm is revising useful asset life assumptions upwards, which is income friendly
  6. SGAI = Sales, General and Administrative expenses compared to previous year
  7. LVGI = Leverage – total debt to total assets compared to previous year
  8. TATA – Total Accruals to Total Assets – this looks at discretionary accounting choices to alter
    earnings; accruals are calculated as the change in working capital other than cash less, depreciation.

The calculation is as follows:

 M = -4.84 + 0.92*DSRI + 0.528*GMI + 0.404*AQI + 0.892*SGI + 0.115*DEPI – 0.172*SGAI + 4.679*TATA – 0.327*LVGI

A M-score greater than -1.78 indicates a high likelihood of overstated future earnings, and lower future returns.

Many investors use red flags to create a Bargepole list of stocks that they would never buy.

Two UK investors who make their bargepole lists public are Paul Scott – who writes the excellent daily SmallCap value report for Stockopedia – and WheelieDealer (with his Wheelie Bin).

Paul presents his list as a Google SpreadSheet, with only one introductory cell. This contains the following red flags:

  1. excessive debtors
  2. too much debt
  3. cash running out (if loss-making)
  4. over-hyped story stocks
  5. weak balance sheets – Paul has three key tests
    • net tangible assets are positive
    • current ratio greater than 1.2
    • net debt is “modest”

In addition, Paul is currently steering clear of the oil and gas sector following the oil price crash a year ago.

He also doesn’t like “serial disappointers” – companies that have been promising jam tomorrow for several years – or director greed.

Wheelie lays out his principles before the list of companies.

  • He starts with general industry exclusions (small-cap mining and energy stocks, biotech and pharma, small cap agriculture) as well as a catch-all “don’t invest in anything that you don’t understand”.
  • He also excludes on a country basis: China, Russia, Africa, Malaysia, war zones, most of Middle East.
  • He doesn’t like industries in structural decline, or Next Big Thing stocks.
  • He doesn’t like companies with a small number of big customers, or those who rely on large one-off projects, or a single product, as they will have lumpy revenues and profits.
  • He won’t buy stocks after a recent profit warning, or those with ongoing corporate governance issues, legal battles, shorting attacks, egomaniac directors or share overhangs.
  • He doesn’t like stocks with no control over the price of their product (commodities companies, distributors, suppliers to retailers etc).
  • Director sales after a run-up in the share price are a Red Flag.

He also has quantitative measures:

  1. market cap below £20M
  2. share price below 20p
  3. forward PE > 20
  4. cash flow significantly lower than reported profits
  5. debt > 3 times reported after-tax profits
  6. value traps: PE below 10, yield more than 5%

For most investors, it’s easier to avoid a bad stock than it is to sell it once you have bought it.

So use the techniques discussed above to find red flags, and use red flags to build your bargepole list of stocks to avoid.

Until next time.

Mike is the owner of 7 Circles, and a private investor living in London. He has been managing his own money for 39 years, with some success.

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3♦ — Watch out for Red Flags

by Mike Rawson time to read: 7 min