Eight signs of a rotten stock

Had you been unfortunate enough to have had the likes of ABC Learning Centres, Babcock & Brown or, more recently, Timbercorp in your portfolio, a little homework could alert you to the signs to help you steer clear of doomed stocks in the future.

Clearly no one likes to do their homework, but it’s better than the alternative of having an investment in tatters and being one of thousands of investors lining up to salvage what (if any) is left of your capital.

Few people seem to know what these signs are. In fact, with so many individual, institutional and “professional” shareholders seemingly caught completely off-guard, it has become apparent that few investors seem to be able to spot the signs of a poor quality investment, a stretched balance sheet or a business in stress.

This doesn’t need to be. Because businesses rarely collapse overnight, the signs are generally there well in advance for all to see. Despite the rosy outlook touted by the media, by management and by anyone recommending you purchase the stock, you just need to roll up your sleeves and look for the signs.

With a little knowhow and the use of what I have coined the “Eight signs of a doomed stock”, you should be able to avoid having any of your future capital invested in a basket case. Here are the eight signs, using the recently collapsed Timbercorp as an illustrative case study.

1: Watch those negative cash flows

The best advice I was ever given when I was an analyst for two publicly listed businesses is that the truth is often found on the balance sheet and in the cash flow statement. Instead of focusing on earnings, investors need to learn to look beyond the widely touted and analysed profit and loss statement to the cash generation of the business.

Why so? The simple truth is that even if a business is reporting accrual accounting profits, it might be losing cash. If it is losing cash on a continual basis, this is a serious cause for concern.

This is why the cash flow statement reported by all businesses is so important. I rarely focus my attention on the profit and loss statement.

Its importance is demonstrated below with two screenshots from Timbercorp’s 2008 annual report. Instantly you can see the large disparity between the healthy accounting profits being reported by the business and the unhealthy negative operating cash flows the business was producing.

Put simply, Timbercorp was continuously paying out more cash than it was receiving; it had negative operating cash flows: it was losing cash at an impressive clip.

If this situation occurs over a number of financial periods, the outflow will need to be supported by drawing down any available cash at the bank. When the bank account runs out, the only choice available to a business is fresh injections of equity (capital raisings) and debt.

Timbercorp’s negative cash flows gave investors early warning that something was wrong. In fact, going back over the previous four years, the business never produced positive operating cash flows despite significant levels of investing in the future, it always spent more than it earned. Something was wrong for a very long time.

This outflow of cash was supported/financed by shareholders tipping in more funds (capital raisings) and by bankers with debt financing … well, for a time, at least.

2: Cap those net debt to equity ratios at 50%

The second sign can be found by doing a simple calculation. From a balance sheet, take the total short-term and long-term debt financing employed, subtract available cash and measure this against the shareholder equity supporting that debt. This calculation produces one of the most powerful ratios available when an investor wishes to avoid doomed stocks.

If you were aware that Timbercorp had net-debt to equity ratio well in excess of 100% in 2006, 2007 and 2008 – that its net debt easily exceeded the businesses assets – you would have stayed well clear. In fact, this simple ratio would have steered you clear of almost all of recent corporate failures.

As a guide, I take a strong look at businesses with net debt to equity ratios exceeding 50%.

Anything above a conservative level of gearing can put significant strain on the company’s all-important lifeline: cash flow. This will likely be more pronounced for highly geared businesses or businesses in stress.

3: Don’t let the interest coverage ratio go below 1.0

Combing the interest coverage ratio with the net debt to equity ratio provides a powerful stress test. By comparing how geared a business is to how easily a business can pay its interest expense bill, a clearer picture emerges as to how stretched the cash flow and balance sheet has become.

The ratio simply divides a company’s earnings before interest and tax (EBIT) by the net interest expense associated with carrying debt. A lower ratio indicates a business is highly burdened by debt expense and is likely to be suffering, and vice versa.

If you perform this ratio and find a business with an interest coverage ratio of 2.0 or lower, serious questions should arise as to its ongoing ability to meet interest expenses. It would only take a small fall in profitability or an increase in financing costs to put the business under real stress. Should the ratio fall below 1.0, your business is simply not generating sufficient levels of profitability to satisfy the cost of its debt.

Alarmingly for shareholders, Timbercorp’s interest coverage ratio fell substantially over the three year period to a worrying 1.7 in 2008. Note that while the company’s debt levels actually fell by 5.3% in 2008 (from $818 million to $775), interest expenses actually increased by 28.1%, from $64 million to $82 million. As before, pressure will likely be more pronounced for highly geared businesses or businesses in stress. Banks or banking syndicates will generally charge a higher level of interest for businesses that have an elevated level of default risk.

4: Return on equity must be at least 8%

The fourth sign is a negative return on equity (ROE) as this suggests the business is making a loss. It’s pretty safe to say that businesses that make losses over sustained periods of time generally do not make great long-term investments.

While loss making entities should generally be avoided, businesses with a history of low ROE figures (less than 8% – the current cost of debt) should also be avoided.

Low ROE levels are generally a good indicator of uneconomical businesses: destroyers rather than creators of wealth. Clearly an 8% return is undesirable given the risks and effort associated with owning and operating a business. Given this return is only slightly higher than what can be achieved in relatively less risky bank bills (using long-term rates), why would an investor take on the extra risk?

By being an investor in a low return on equity business, if the business retains any capital, shareholders are forsaking potentially higher returns elsewhere. Businesses with a low ROE should therefore pay out all of their earnings as a dividend and investors should invest them into businesses that are able to generate good returns on incremental capital.

Timbercorp’s ROE fell substantially from 2006 to a mere 7.1% in 2008. Given the amount of debt and the costs associated with servicing that debt, the return on the business’ assets employed was not economical and represented a poor-quality investment.

5: Profit warnings are warning bells

Under ASX listing rules, if a business anticipates a 15% change in after-tax profits or is aware of a material item that will impact the profit result, it is required to report this to the market.

If a business has ticked any one of the warning signs 1-4, a profit warning should be taken very, very seriously. Lower levels of accounting profits may also indicate that cash flows are set to come under further stress, stress that may translate into worried banking syndicates and shareholders who may cease offering an important lifeline to an unsustainable business.

On July 1, 2008, Timbercorp announced that it expected a net profit after tax of $53-$57 million. Numerous revisions post this announcement soon followed.

6: Share price graphs tell a story

Over short periods of time, share prices can be volatile and can move for reasons that have no connection to the underlying (less-volatile) business which has value. Over long-periods of time, however, by plotting share prices on a chart, we can form a picture that tells us plenty. Particularly, look out for a steadily declining share price.

Why? Almost all listed corporate failures are preceded by a sustained decline in their share price. Timbercorp’s share price gave investors a warning sign three years before the company collapsed.

Of course, a declining share price may also indicate a potential buying opportunity. But this only holds true if the business has solid fundamentals and is just out-of-favour – if it has none of the additional factors we have discussed here.

7: Insider trading should trigger alerts

When substantial shareholders or business directors and executives buy or sell shares, they are required by the ASX to announce movements in their holdings to the stockmarket.

These parties, also known as insiders, usually have an in-depth knowledge of the business and its prospects. Increased selling pressure can therefore be a signal that insiders believe the outlook for the business is less than desirable.

Interestingly, in the year prior to Timbercorp collapsing, even with the above warning signs, many of Timbercorp’s directors actually bought more shares as the share price declined. The use of the “Eight signs of a doomed stock” may have prevented them doing so.

8: Resignations and sign-offs are bad news

The final sign that may indicate a business is in trouble and that insiders are well aware of the issues, is if a board undergoes significant restructuring or it is announced that a director suddenly departs. Be suspicious. This also goes for the businesses auditors.

A sudden departure may well be completely innocent (each case should be investigated further), but warning bells are the loudest when long-term directors with a track record of good management up and leave.

Auditors replaced by another firm who are not that familiar with the business should also trigger investigation. Such a departure may indicate a deteriorating relationship and reluctance on the auditor’s part to sign off on the accounts due to fundamental difficulties with the business. While an auditor may not necessarily be replaced just before a business collapses, their refusal to sign off on the business’ financials gives further clues as to the state of the underlying financials.

According to the 2008 annual report, “Timbercorp experienced a number of changes at the senior management and board level”. This included the retirement of the businesses long-serving chief executive and the stepping down of the chairman. The firm’s auditors also issued the following summary of the business affairs:

Material Uncertainty Regarding Continuation as a Going Concern??
Without qualifying our opinion, we draw your attention to Note 1 in the financial report which indicates that the consolidated entity, in the absence of waivers, would have breached certain bank covenants at balance date. The consolidated entity has, subsequent to year end, obtained waivers for the breach of covenants as at September 30, 2008, and varied future covenants and terms. This includes an undertaking to sell selected assets and apply a portion of the proceeds to reduce debt. These factors, along with other mitigating factors being relied on by management to address these issues, are as set forth in Note 1 “Going Concern”. In the event that the mitigating factors as disclosed in Note 1 do not eventuate as management anticipate, there exists a material uncertainty about the company’s and the consolidated entity’s ability to continue as going concerns and whether they will realise their assets and extinguish their liabilities in the normal course of business and at the amounts stated in the financial report.

While all the signs may be a lot to initially digest, if used correctly and continuously, they will not let you down. What I find alarming is while we have just uncovered that Timbercorp had seven of the eight signs, several well known tip-sheets, analysts and fund mangers were lured into making an investment decision simply because of a low share price – what is termed in the industry as a value trap. Don’t be fooled.

A final note: While many poorly managed businesses with the above signs can collapse, the instalment of a fresh management team with an ability to turn around the business from disaster and install sustainable business practices is possible.

If you have a business with two or more signs, then at the very least, you should investigate whether or not your business is suffering from stress. Ask yourself if the risk of being invested in the business outweighs the potential reward. If not, the appropriate actions should be taken; that is, replace poor quality businesses with those that have attractive and sustainable underlying fundamentals.

Russell Muldoon is an independent investor. He can be contacted at healthcheck@live.com

This article was first published in Eureka Report. To start a 21 day Free Trial please visit www.eurekareport.com.au