Making investments – what to look out for!

When investing in shares of publicly traded companies, investors (specifically private ones) can do at least the following: make a bet, ask for a hot tip of a friend, ask a financial adviser, pull a well-remembered company name out of their memory, consult an investment magazine, or do some homework and study the fundamentals of the companies. Investors beware: Even fundamentals can be highly misleading. It just depends on what you are looking at and how closely.

James Gilpin has demonstrated this using the example of the collapse of two British companies in 2010: Connaught plc and Rok Group plc, which both provided social housing repairs and maintenance. In hindsight, the collapse of both corporations looks like carelessness and it’s more than interesting to do some forensic investigation, equipped with a reading glass, a pencil and a calculator.

The detective’s journey was fuelled by the following questions: What led those companies to be so highly leveraged? And the famous question: Could investors have seen it coming? What lessons can we learn from these situations in order to become smarter and wiser in the future?

Equipped with a few utensils and a good portion of curiosity the investigator went out to discover the causes which may have contributed to the (unexpected) downfall of those companies and thus the overnight-destruction of many shareholdings. He found smoking guns and blood on the floor.

Cash Generation was poor. A string of acquisitions led the companies to only see the many trees of newly to be integrated firms but not the forest anymore. They accumulated debt and had no idea that they wouldn’t be able to pay it back. They paid dividends to shareholders at the 11th hour before going bust. They didn’t understand the importance of operating cash flow and watching over the company’s net cash position.

From the story of the two companies, one can derive a whole warehouse of warning signs to investors. As James is pointing out in his study [1], examples are:

Dodgy corporate governance, incentive awards that focus on earnings per share and overly on accounting profit, hefty and sweet bonuses for executive directors for delivering acquisition-fuelled earnings per share growth, internal controls and IT systems which don’t keep pace with the growth of a company.

Other warning signs relate to accounting policies. A great example is how revenue is recognised. The two companies on our investor’s surgery table, Connaught and Rok, generated the majority of their revenues through long-term contracts, which requires judgment over when revenues, expenses and profitability should be recognized over the life of each contract. Due to weaknesses in IT systems and financial controls, both companies failed to reliably measure the outcomes of dozens of contracts. It led them to recognise revenue which was not really there yet, leading to profit warnings and their ultimate collapse. Not knowing what revenue one can book is a costly lapse, here a collapse.

A further alarm bell should go off, when companies capitalise costs which they better should expense. The leeway here stems from the fact that in many cases directors have to make a judgement on what may be capitalised compared to be expensed. Capitalise too much, then one’s profits look good in the short-term, however amortising those capitalised costs later on may well destroy the income statement – at a point in time, when management has already jumped ship to escape the debacle. Investors beware of signs of aggressive capitalisation of costs.

Working capital management is another area one should get one’s investigative hands on, as James suggests. One of the companies under study here managed to expand that part of the business which was cash consumptive (i.e. requires lots of positive working capital), whereas the other part of the business that was cash generative (i.e. had negative working capital) was decided to be shrunk.

Company disclosures are a fertile hunting ground for the alert investor. The case study here revealed misstated operating cash flow and reclassification of millions of GBP of cash flows between operating activities and the ‘impact of exceptionals’. Unfortunately that gave a misleading impression to investors of the company’s ability to service its debt. Out of the blue it couldn’t do it anymore.

Having come across the many corporate sins, James then draws out the ten important lessons from this case [1]:

  1. M&A: A high volume of bolt-on acquisitions increases financial and operating risks, if funding and integration are not managed effectively. Look out for incremental cash flow and not just incremental earnings.
  2. Corporate Governance: Non-executive directors should outnumber the executive directors, especially if there is an executive chairman (not meant to call for physical fights in the boardroom…)
  3. Incentives: Annual incentives based purely on financial performance and ‘adjusted’ earnings per share can lead to excessive deal-making and leverage. Expect to hopefully find a wider set of useful incentives.
  4. Internal Controls and IT: Strong internal controls and efficient IT systems are essential to ensure accurate management information and must keep pace with corporate growth. Watch out for ‘IT upgrades’ and ‘the introduction of new systems’: It may well indicate the existing systems are not fit for purpose and until they are fixed the firm operates neither with pilot nor with autopilot. As investor best to deploy the parachute.
  5. Accounting Policies: Aggressive accounting policies such as the capitalization of costs reflect management’s attitude towards financial reporting and earnings management. A prudent investor may want to prefer prudent accounting policies.
  6. Trade and Other Receivables: Amounts recoverable on contracts in excess of trade receivables suggests inefficiencies and delays in client invoicing.
  7. Working Capital: Always worth to examine the gross as well as the net working capital position and compare the outstanding trade payables against available headroom and cash to assess liquidity risk. If suppliers lose confidence and demand payment, the company may face a liquidity crisis and breach financial covenants.
  8. Ratios in Results Presentations: Be sceptical of ratios in results presentations, such as cash conversion, and double-check them against the audited accounts.
  9. Dividends: A dividend payout does not necessarily indicate availability of free cash flow but may simply provide false assurance.
  10. Management Optimism: CEO’s are eternal optimists but sometimes blinded by financial reality. Don’t trust statements such as ‘once in a lifetime opportunities’ and ‘the outlook remains positive’ until you have understood the company’s liquidity and solvency risks and are confident that it can continue as a going concern.

Some of above points are easy to discover e.g. with a look into an annual report. Others take a bit more time to check. The less the bulk of investors look very carefully, the more an opportunity arrives to profit as a prudent investor: If one detects lots of smoking guns, it’s time to pull the plug, sell the shares or go short on the securities. If the company looks boring and survives all of above checks plus the obvious ones of making a profit and of its cups spilling over with free cash flow etc, then one has potentially discovered good value.

For the full analysis, see the report here.

Various sections quoted from the report with kind permission from its author.

References

[1] James Gilpin, “Losing Connaught and Rok looks like Carelessness!”, JG Financial Training, London, 14 Feb 2011.

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