I wonder where that fish has gone, You did love it so, You looked after it like a son And it went wherever I did go.
Here’s some pointers for spotting dodgy companies that might disappoint you:
- short listing history
- India/China/Russia companies
- low PERs that seem out-of-whack with ostensible prospects – great growth companies don’t usually trade at absurdly low valuations. If you spot one that does, it is worth double-checking to see if there’s any elephant in the room
- revenue growth which seems too high. Growth is good, but it’s worth asking how that growth was achieved. Was it organic, or through a series of acquisitions? Ask if the revenue growth seems to be too good to be true
- number of shares in issue – is the number of shares increasing or decreasing? There may be innocuous reasons for an increase in the number of shares – like a split – but sometimes a company issues shares aggressively.
- declining ROE – sometimes you see points 4-7 happen in unison. You have high revenue growth, the share count increases dramatically, and there is a steady downtrend in the ROE. Be suspicious of this type of pattern
- increasing or absurd debtor days. Debtor days will vary with industry, but be suspicious when the number of debtor days look suspiciously high. Look at GNG (Geong International), for example. If has receivables of £17.6m when it reported on 30-Sep-2011. It’s half-year revenue was £11.3m, so the debtors days is 9 months (12 x 17.6 / (11.3 x 2)). That’s a long time, even for a consultancy, and raises doubts if the revenues are real. At the very least, it points to poor cash conversion. The legitimacy of GNG’s figures are constantly being argued backwards and forwards on the bulletin boards
- just plain accounting issues talked about on the boards. Read the bulletin boards. If there’s a lot of to’ing and fro’ing over accounting issues, then you will probably want to pay special attention
- net cashflow consistently below net profit. This may indicate that the profits are not as real as they seem.
- too much debt, or too much cash. The problem of too much debt is an obvious one. The issue of too much cash seems a strange complaint. Don’t get concerned just because the company has a lot of cash, and may be using it inefficiently. But sometimes, things don’t quite add up. Take a look at ACHL (Asian Citrus Holdings), for example. Its revenue went from £22.6m in 2005 to £136.4m in 2011. In its finals issued on 16-Sep-2011, it reported a net profit of £107m, but net cash flow of only £60m. So here we see rapid revenue growth, poor cash conversion, and yet, oddly enough, the company is reporting cash of £215m against a market cap of £526m, with neglible liabilities. How can this be? I believe that the answer to this riddle lies in the number of shares in issue. The count went from 500m in 2006/09 to 1230m at present. So presumably, the company is issuing lots of equity in order to have lots of cash pumping into the system. I should also note that it is currently trading on a PER of 7.8. At the very least, the directors are being unmindful about capital allocation.
It’s quite common to see many of these factors operate in concert. That’s the real warning flag.
Do readers have any other tips that they use as red flags?
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