1. Structural weakness
Without innovation, companies can get left behind in the modern world of business, leaving them vulnerable to losing market share. A prime example of this, covered in more detail below, is Yell Group. The directories business has been undermined by the growth of the internet, making its physical directories products look increasingly anachronistic.
2. Low barriers to entry
Market share can be rapidly compromised if a market is easy to enter. A competitor with deep pockets can snatch market share, either with a superior product or through competitive pricing. Overstretching and compromising margins in a bid to maintain market share has been the undoing of many and last year's collapse of Connaught is a prime example.
| Beware valuation traps |
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Only a select few brands exert supreme brand power over a sustained period of time, especially in fickle consumer markets. Hence the current high rating of 32 times earnings afforded to clothes retailer SuperGroup should set the alarm bells ringing. True, the company has a long way to go before it becomes overexposed but French Connection and its once ubiquitous FCUK branding should be a stark warning of what can happen when a brand becomes effectively 'too successful'. Elsewhere in the world of fashion, luxury brand Mulberry has soared to 75 times its forecast full-year earnings, which is too rich even for a quality operation. Online retailer Asos has been a huge success story but its share price has also run away with itself somewhat, racing to an eye-watering 70 times this year's forecast full-year earnings. Asos will be a success in the long term, but its short-term valuation is just too hot. And even pre-revenue companies can provide a value trap for investors. Online retailer Ocado is a prime example. The company, which operates in a fiendishly competitive sector and is only barely profitable, is already valued at north of £1bn. |
3. Weak end markets
Is the company you hold operating in a strong and resilient market or one on the wane as new technologies emerge? Is it exposed to forces outside the company's control? Over the past two-and-a-half years, consumer-facing companies have struggled in economically tough times. Two very different examples are nightclubs operator Luminar and high-street sports retailer JJB, both of which suffered as consumers reined in their spending habits.
| Recovery or ruin? |
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Companies can and do come back from the brink of disaster. Shares in steelmaker Corus once slumped as low as 3p, but the company was turned around and eventually sold to Indian industrial group Tata for 60p a share (adjusted for a consolidation). Brian Souter returned to the helm at transport group Stagecoach when its shares languished at 15p – they're now 215p. Wm Morrison made a hash of integrating Safeway, but is once again one of the UK's fastest-growing supermarkets. How do you know whether a company's troubles are terminal, or surmountable? There is no easy answer but, as a rule of thumb, look at whether the problem is structural – such as end markets in long-term decline – or a one-off, such as a botched or over-priced acquisition, or a cash crunch. The support of creditors is also key. If banks, insurers and suppliers are still prepared to cut a business some slack, there is a chance it will pull through. It was the withdrawal of credit insurance that banged the final nails into Woolworths' coffin, for example. |
4. Debt
Many companies thrive on a reasonable level of gearing, but they need to be solid, growing, cash-generative operations in expanding markets. If a business is running a hefty debt position but is struggling to generate the cash to service that debt, at some point it will become unsustainable.
5. High valuation
A company valued at a premium to its rivals needs to justify that through the strength of its market position, its pricing power, its balance sheet strength and also its prospects for continued and accelerating growth.
