One of the best things about value investing is the evergreen nature of its principles.
A great company is great and worth investing in because several core elements that, when met, gives the investors a peace of mind, knowing that his/her funds are well deployed.
These principles are evergreen plainly because they withstand the test of time; no matter when, no matter what the “flavour of the month” is, no matter which hot new instrument people are talking about, if you apply value investing principles diligently, you can’t help but grow your money and have a healthy, sizeable investment portfolio.
Now, these principles aren’t just for pointing out what’s good about a company you’re investigating; it’s great for flagging out potential pitfalls and traps which can lead to a severe dent in your investment portfolio if you aren’t careful.
If you’re already experienced in this field, here are investment 3 red flags you can take note of, both for companies you are already investing in, and for companies you are doing your research on:
1. Turnover of CFO
How long has the current CFO been around? Did the company’s CFO quit recently? Why?
Does there seem to be a pattern of CFO’s quitting the company?
If so, that’s not usually a good sign.
For example, in the retail industry in the U.S., the CFO turnover rate was 17.4%, compared to 15.4% for all industries in 2016, according to a Bloomberg tally. And in 2017, about one-fifth new finance chiefs were appointed (U.S. retailers) compared to 15% for all industries. This turnover rate is definitely a cause for concern.
The CFO, more so than others in the company, literally has first-hand information about how the finances of the company is panning out.
He/she sees where revenues are generated, where the outflows are, what the ROI is, and what the plans for funds consist of.
If the CFO quits, why? Was there something amiss in the company beyond the superficial “difference in opinion”?
Is the company headed for disaster, or doing something behind the scenes that deserve some scrutiny?
Now, staff leaving is part and parcel of every company’s legacy. But if CFO’s are coming and going … especially frequently, that’s a red flag right there.
Do your scuttlebutt, dig deep, attend the AGM’s and start asking questions.
It could turn out you’ve been worrying for nothing, or it could have saved you a lot of heartache.
2. High profits, low cashflow
Oh, who wouldn’t love a profitable company? I mean, profitable means the company is making money, right?
Well, that is a common misconception and you should dive straight into their cashflow statement and read between the lines.
A profitable business with insufficient cashflow can put the company at risk of bankruptcy.
What? Bankruptcy for a profitable business? Yes, it’s a common oversight.
Take Toys “R” Us for example where they were initially a profitable business. However, in 2016, the staggering debt became an issue. On a yearly basis, $450 million cash outflow was needed to service its interest payments. It became a huge source of burden. As a result, the company did not have the necessary resources to remain competitive. The landscape was changing with eCommerce. The shift was rapid and Toys “R” Us simply could not keep up. Faced with lower sales but huge interest payments, Toys “R” Us was forced into bankruptcy.
If your cash isn’t coming in in time to pay off your suppliers, meet payroll and other operating expenses, your creditors may force you into bankruptcy at a period when sales are growing rapidly.
So don’t jump for joy just because sales are up. See where the money is flowing.
3. Frequent, non-recurring gains (or losses)
Non-recurring gains & losses are, well, by its very nature not supposed to occur frequently.
These occur because they do not relate to normal business operations.
What types of one-off events is the company posting? How frequently do they engage in such transactions?
If it seems habitual, then the company may be regularly finding ways to write off or write down transactions to make the business look a certain way. Or, the management doesn’t really know what it’s doing.
It’s your responsibility
Yes, the law provides a set of guidelines companies are supposed to operate within. And we, as investors, have no control whether they do so with integrity or not.
Having said that, it is
to do our research before deciding to invest in a company.
Stay within your circle of competence, educate yourself, avoid shiny objects and stay the course.
Value investing has proven to be a sustainable, profitable investment strategy that has withstood the test of time. The rewards
are yours to reap if you learn, apply and remain diligent.
So what are you waiting for? Come and join our free investing workshop to learn how you can invest safely with positive returns!