In investment, picking the winners is as important as avoiding the losers: that is one reason why hedge fund managers make so much money. While a healthy, steady stock could make you 25 per cent returns over, say, three or four years, a business going sour can lose that much before lunch.
Spotting problems that will lead to the collapse of a share price is not easy, but there are tell-tale signs that can indicate that a business may be heading into choppy waters. There are plenty of places to look for clues: real-world changes; changes in the income statement/profit-and-loss account; the balance sheet, usually buried in the ‘notes’ that accompany the accounts.
Below and in subsequent weeks we look at the tell-tell signs in a company’s trading environment and its own performance. We are not looking to spot frauds; that is a whole different ball game and comes with a very different set of signs. We are just looking here at ways that investors might be able to stay one step ahead of a share price decline.
Keeping score
It is rare that just one thing will badly trip a company up, so it can be helpful to run health checks on stocks owned or of interest over a longer period because problems tend not to appear overnight, but rather come as expanding cracks that can be visible weeks or months before they break into the open.
Plotting how key measures and facets of a company are changing (ideally quarterly if they report that frequently or at least twice a year) may be time-consuming but can be worth the time investment. It is never 100 per cent safe to assume any stock is buy-and-forget.
Real-world clues
The best place to start is in the real world, looking at the marketplace in which the business operates. Are retail sales dropping, house prices falling, the steel price in reverse or a correction occurring in a commodity price? Has a new competitor arrived (eg Lidl/Aldi in the grocery market) or has government regulation changed (such as ending a VAT exemption)? Where a business operates in a single geography and/or a single market channel then the impact on profitability from such change is almost inevitable without palpable management action. While it is possible to trim costs and adapt, few businesses can paddle against the flow for that long without intervention.
Margins – look at the gross
When external pressures begin to bear on operations, margins are clearly at risk. Profits are reported at a number of levels: gross; earnings before interest, tax, depreciation and amortisation (Ebitda); Ebit; pre-tax and post-tax.
Which is most important to track? Gross profit. This is the raw difference between sales and the cost of goods used to make those sales. This is where actions such as price reductions or other actions to keep up appearances will exhibit themselves. Gross is perhaps the most important as all other costs (rent, staff, interest), a large amount of which might be fixed or inflexible, must be met. The higher the gross margin, the more capability a business generally has to cope with difficulties, and vice versa, but dwindling margins here are rarely a good sign.
Other P&L issues to watch
There are many accounting practices that are fine when all is well, but when revenues and margins come under pressure they can rapidly bite and easily lead to a business struggling and being devalued. Some prominent examples:
- Capitalised costs. This only applies to a few sectors, but this is where costs (such as interest or R&D) are not expensed, but rather ‘capitalised’ and treated as an asset. This flatters both the profits and the asset value and can lead to a mismatch between trading results and cash flow.
- Adjustments. Many companies today present, in effect, two sets of accounts: ‘statutory’ and ‘adjusted’. Adjustments allow management to show results in the way that they feel best reflect ‘true’ trading patterns and can be radically different between competitor companies, giving a misleading appearance of success. This encompasses the likes of share-based, R&D costs, rationalisation/reorganisation charges, gains/losses on disposals, goodwill write-offs, abnormal pension costs etc. Cynically, these are often called ‘excluding bad staff’ profits and are especially a problem if they repeat year after year.
- Interest costs. Debt servicing has not been an issue for more than a decade with interest rates close to zero. Using debt funding was very affordable but many businesses have floating interest rates, expensive debt margins or upcoming debt refinancing. Some companies face interest charges that will be multiples of those in prior years.
- Long-term contracts. With building or other long-running contracts, there is a risk that matching of profits (often more art than science) and cash flows are misaligned, which can open up black holes in the accounts. Always treat this area with care.
Share price momentum
It is important not only to track a stock’s performance per se, but also to track how well it is doing against its immediate peers – even in seemingly homogenous market sectors trading patterns can diverge. Also, look at whether share price momentum is changing – track performance across a range of periods (such as one week, one, three, six, nine and 12 months) and check both absolute changes and changes relative to the market benchmark index. Getting more technical, consider share price moving averages (50 days and 200 days typically) versus the current share to see if the share price is gaining, sustaining or losing momentum.
Points where these chart lines intersect on a chart are known as ‘crosses’, and are designated as ‘golden’ (positive) when the 50-day line rises to cross the 200-day, or ‘lead/death’ crosses (negative) where the 50-day crosses from above to below the 200-day. In the chart below for Union Jack Oil (UJO), there is an example of a lead/death cross occurring right now. Some investors swear by such charting indicators while others see them as hokum, but it can be useful when used alongside other indicators. It is more useful, in practice, for indicating whether an existing downtrend will continue rather than predicting that one will commence.
Shorting
This is where (typically) hedge funds sell shares they do not own in anticipation of a drop in the price. This can be a useful indication of future price movement. Short positions are far from 100 per cent reliable, but in some they can actually precipitate a fall as actual sellers are tempted to exit. Click here to find out which companies’ shares are the most shorted in London right now.
Insiders trading shares
Some investors like to follow management into a stock on the basis that they would not be risking their own money if the outlook was poor. However, there are plenty of traps here. Directors may have unjustified faith in their products, markets or even their own capabilities; there may be pressure around the boardroom table to show support through personal investment; the business may have very narrow windows when directors can buy stock so their timing may be prescribed rather than sensible.
On the flipside, it is more significant if directors are selling shares. Again, there are plenty of legitimate reasons for doing so and it is OK for a director to be selling once, but not frequently. The same is true for larger institutional investors, but again there can be plenty of reasons why a fund is selling down – heavy redemptions or a new investment strategy, for example. Again, this should not really be used in isolation, but always justifies a closer look.
Profit warnings
This is where management is obliged to publish a formal notification that expected profits (ie the consensus of analysts’ forecasts) will not be achieved. These often occur outside of normal communication schedules (ie results and trading updates) because the board must disclose as soon as it becomes aware of the risk. Historically, a profit warning was likely only to dent a share price (say a 5-10 per cent drop), but today the market is far less forgiving and falls of 25 to 50 per cent are not uncommon. Often, it is possible to see that a profit warning is likely from real-world events, but even with all of the signs visible, when the warning comes the shares are still likely to be hit hard. Warnings published at times other than 7am are normally more worrying.
Also, it is pretty common for there to be more than one profit warning (look at ITM Power (ITM)). Management, when issuing a warning, is often only taking a view on its prospects, and human nature is usually to err on the side of positive outcomes rather than caution. Is Dr Martens (DOCS), for example, impacted just by warehousing problems or have its products passed peak popularity? So, even after the initial shock to the share price, it may be wise still to think about selling, especially if there has been a so-called ‘dead cat bounce’.
Management change
This is really only a problem when the change comes out of the blue, when the departure of a director takes place with ‘immediate effect’ or when there is no indication that they are leaving to take up a similar position elsewhere. This can, of course, be fully legitimate – a sudden illness or personal tragedy, for example. If investors believe the director is the wind beneath the company’s wings, their departure for whatever reason risks harm. If a business seemingly relies heavily on a single character, that can in itself be a warning sign. The same holds true for management defections, especially if they are leaving to join a key rival – the market’s balance of power is likely to shift.
Change of advisers
When a company suddenly changes its accountant or lawyers, especially after a longstanding relationship, it can be a sign of problems. There could have been a disagreement about handling of contracts, banking arrangements, an acquisition or items in the accounts. This is rarely a positive sign. There may also be a change of broker or financial adviser, but such changes are less serious and are not typically an indication of more serious problems.
Shareholder activism
This is where (usually) a single investor (often a US hedge fund) buys a sizable stake in a business and seeks to effect change, often significant, such as selling off a division or breaking up a company. Is this a positive or negative development? It can be both, but more often it is likely that the changes being sought will enhance shareholder value and sometimes unseat poor management. It can, however, become a massive distraction for management if the activism is ill-focused or frivolous and can harm the running of the rest of the business.
The balance sheet tells more tales
Spotting problems can be difficult but there are often bigger and earlier warning signs to be found in the balance sheet and cash flow statements. We will take a look at what to watch out for there in our next article.
