Watch Out For Tell-Tale Signs

Foreword from ShareInvestor

This article “Watch Out For Tell-Tale Signs” by Daniel Buenas was first published in The Business Times on 28 May 2007 and is reproduced in this blog in its entirety.

Daniel Buenas takes a look at some warning signs that should help investors spot trouble before it arrives

In his Gothic fiction tale The Tell-Tale Heart, Edgar Allan Poe tells the story of a genderless narrator who commits a murder and tries to cover it up by hiding the dead man’s body under the floorboards of a house.

However, when the police arrive, the murderer finally confesses, after believing he or she hears the incessant beating of the dead man’s heart, which gets louder, and louder – at least in the murderer’s mind.

Interestingly, some investors wish they could hear the beating of a tell-tale heart – but instead of the heart of the murdered man, it is the ‘heart’ of wrong-doings or potential problems in a company.

A few weeks ago, we looked at financial ratios and how they could help us determine the health of a company.

This week, we take a look at some of the tell-tale warning signs that should alert investors that their investment (or potential investment) may not be as good as they first imagined.

We have seen some spectacular company crashes in recent years, both locally and in the United States. Not all of them could have been predicted, but with these tips, hopefully you’ll be able to spot trouble before it arrives.

How Big Is A Company’s Customer Base?

If you’re investing (or have invested) in a company, this is something that you need to look out for. Certain companies may have one or two major customers that could represent a very large part of their business. This is particularly of concern when a customer makes up 40 per cent or more of a company’s total sales over a long period. In such cases, the loss of that one customer would potentially send revenue and profits reeling. So be extremely careful with companies that depend too much on a single customer, and watch out for signs of that customer-company relationship starting to sour.

Large Losses, Little Cash

It’s normal for companies to hit bumps along the road, but when a company starts losing money quarter after quarter it’s time to start to worry. Companies usually have a cash reserve somewhere, but when losses start to mount these reserves can dry up very quickly. So it’s best to check their financials to see where the company stands. True, the company could borrow more money or issue more stocks to generate some cash, but this brings us to our next warning sign: debt.

Debt Levels

The more debt a company has, the higher its interest owed. Just like a person who’s spent too much on his/her credit card, companies can be crushed by the weight of their debt. And, because a company that is floundering has a higher risk of default, some banks and financial institutions may charge a higher interest rate for money lent, which in turn shrinks profits even more. So if a company’s debt levels are on the up-and-up, it’s best to look and see why.

Investigations

Ever wondered why the share price of a company usually plunges whenever news that the Commercial Affairs Department (CAD) or the Corrupt Practices Investigation Bureau (CPIB) is talking to its senior management? There’s a good reason – an investigation has oftentimes – though not always – preceded a corporate collapse. While many investigations are simply that – investigations, some of them turn out to be major cases of fraud or impropriety.

Resignations

Another warning sign to watch out for is resignations, as the sudden departure of one or more key executives can be a tell-tale sign of rough times ahead. Again, oftentimes, these can be completely innocent. But if the person who quits has a reputation as a good leader, or as a vocal/strong independent director, it is particularly worrying.

Another possible warning sign – the sudden replacement or resignation of an auditor. After being burned by corporate scandals in recent years, auditors these days often want to distance themselves from a company that is guilty of impropriety. Another reason why auditors leave is that they see fundamental difficulties with a company’s business. In either case, it’s a bad sign for an investor.

Product Differentiation – Or The Lack Of It

It’s important to note that some companies build their brand on a single, very successful product. From this starting point, they diversify and continue to deliver some newer or improved-upon products. However, some companies, after reaching initial success, are unable to move on to developing new products. Thus, an investor should always be wary over a company that has built its success on a single, key thing, because if the market for the product collapses, where will the company stand?

Big Share Movements – From The Inside

If institutional investors or those within the company start to dump their shares, the retail investor had better pay attention. This is usually a worrisome harbinger that hard times are ahead and that those in the know expect the worse.

These are just some of the things that investors should be watching out for. It may not always be possible to predict when is the best time to walk away from a company, but, if we listen closely, we may just hear the faint beating of its tell-tale heart. And if you do, don’t ignore it.