Showing posts with label Avoiding financial fakery. Show all posts
Showing posts with label Avoiding financial fakery. Show all posts

Sunday 22 September 2019

Companies to avoid

Avoid these companies described below.  That is not to say there are no good investments to be found, but the chances of this happening are much lower, increasing the risk of us running into a dud.

Some examples are as follows

1,  Companies with an excessive growth focus.

Growth is good and beneficial if it is the result of a job well done, which generates resources over time which are reinvested increasing the strength of the company, but this tends to be more the exception than the rule.  The obsession with high growth targets is extremely dangerous.   Once again there is an agency problem:  who are the company's management working for - themselves or the shareholders?  Growth is only a good thing if it is healthy.


2.  Companies which are constantly acquiring other companies.

If the acquisition is not focused on increasing the competitive advantage of the main business, it can end up becoming a rueful folly, or what Peter Lynch calls 'diworsification', diversifying to deteriorate.
Growth ca also ring with it two other problems:  first, more complex accounting can more easily conceal problems; and second, each acquisition eds up becoming bigger than the last, increasing the price and therefore the level of risk.

It is worth reiterating ow detrimental it can be when some mangers feel the pressure or the desire - after selling a substantial part of the company - to buy another of a similar size, instead of returning the money to the shareholders.


3.  Initial public offerings

According to a study, companies who float on the stock market via an IPO post 3% lower returns than similar companies after 5 years. 

There is a simple reason for this:  there are clear asymmetries in the information available to the seller and what we know as purchasers.  The seller has been involved with the company for years and abruptly decides to sell at a time and price of their choosing.  The transaction is so one[sided that there can only be one winner.

4.  Businesses which are still in their infancy.

Old age is an asset: the longer the company has been going, the longer it will last in the future.  A recent study shows that there is a positive correlation between the age of a company and its stock market returns.  It takes a  certain amount of time for a business to get on to a stable footing, depending on the level of demand and competition.  Until this happens, we are exposed to the high volatility inherent in any new business, with an uncertain final outcome.

5.  Businesses with opaque accounting.

Whenever there's significant potential for flexible accounting, being ale to trust in the honesty of the managers and/or owners is essential.

Long-term contractors in the construction sector, or in infrastructure or engineering projects, are examples where there is scope for flexible accounting, with latitude to delay accounting for payments or being forward income.

We can include banks and insurance companies in this category, where the margin for accounting flexibility is very significant and it is relatively simple to cover up a problem for a while, compounded by having highly leveraged balance sheets.

Prior to investing in these types of businesses, it is absolutely imperative to be certain we can trust the mangers or shareholders.  No one forces us to invest in them, so the burden of proof is on the company.

6.  Companies with key employees.

These are companies where the employees effectively control the business, but without being shareholders (the latter could even be positive).  For example,, many service companies reportedly have very high returns on capital, ut only because capital isn't necessary:  investment banks, law firms, some fund managers, consultancy companies, head-hunters, etc.

The creation of value in these businesses benefits these key employees, while the opportunities for external shareholders to earn attractive returns are limited, despite supposedly high returns on capital employed.

7.  Highly indebted companies.

"First give me back the capital, then return something on it."

Buffett also remarks that the first rule of investing is not losing money and the second and the third ..

Excess debt is one of the main reasons why investments lose value.  We do not need to flee from debt at every opportunity, when it is well used it can be very helpful, but it should not have much weight in a diversified portfolio. 

By contrast, markets don;t particularly like companies to hold cash rightly fearing that such financial well-being might lead to bad investment decisions. 

{To sleep well and to make the most of incorrect market valuation, ensure that over half of the companies in the portfolio have ample cash.  Do not be worried about excess cash, provided that capital is reliably allocated.}

8.  Sectors which are stagnant or experiencing falling sales.  

While it is not worth paying over the top for growth, on the flipside, falling sales can be very negative.  Quite often these companies can cross our radar because of the low prices at which they are trading but over the long term, time is not on our side with them..  Sometimes sales will recover but mostly the opportunity cost is to high, given that the situation can persist for sometime.

9.  Expensive stocks.

It is obvious but worth spelling out.  In reality, expensive companies have historically obtained the worst results, because good expectations are already priced in and because it is less likely that the price will jump from - say- a P.E ratio of 16 to 21 than from 9 to 14.

That is not to say that good results cannot be obtained from buying the above types of stocks, but it is an additional hurdle which some may preferred to avoid.


The above are not the only examples of companies to avoid,, but they are a good starting point.



Thursday 20 November 2008

Red Flags and Pitfalls for Avoiding Financial Fakery

Aggressive accounting: There are literally dozens of techniques that are perfectly legal and aboveboard, but which have the efect of fooling an observer into thinking that a firm has posted true operational improvements when all it has really done is moved some numbers around. You need to know how to identify what’s known as aggressive accounting so you can avoid the companies that practice it.

Outright fraud: Even worse than aggressive accounting is outright fraud. The hucksters of the world are naturally attracted to the stock market because it is the perfect arena for profiting from the greed and carelessness of others. Knowing the signs of potential fraud can save you a lot of financial pain.

It is not hard either. Although you might need a CPA to understand exactly how an aggressive or fraudulent firm is exaggerating its results, you don’t need to be an expert to recognize the warning signs of accounting chicanery.


SIX (6) Red Flags

Watching for these 6 warning signs will help you avoid maybe two-thirds (2/3) of potential accounting-related blowups.

1. Declining Cash Flow
Watch cash flow. Over time, increases in a company's cash flow from operations should roughly track increases in net income.

2. Serial Chargers
Be wary of firms that take frequent one-time charges and write-downs. Frequent charges are open invitation to accounting hanky-panky because firms can bury bad decisions in a single restructuring charge.

3. Serial Acquirers
Firms that make numerous acquisitions can be problematic - their financials have been restated and rejiggered so many times that it's tough to know which end is up. Acquisitions increase the risk that the firm will report a nasty surprise some time in the future.

4. The Chief Financial Officer or Auditor Leave the Company
Who watches the watchmen? When it comes to financial reporting, those watchmen are the chief financial officer (CFO) and the corporate auditors. If you see a CFO leaves a company that's already under suspicion for accounting issues, you should think very hard about whether there might be more going on than meets the eyes. If a company changes auditors frequently or fires its auditors after some potentially damaging accounting issue has come to light, watch out.

5. The Bills Aren’t Being Paid
You should track how fast the A/R are increasing relative to sales - the two should roughly track each other. A/R measures goods that are sold, but not yet paid for. It is simply not possible for A/R to increase faster than sales for a long time - the company is paying out more money (as finished goods) than it is taking in (through cash payments). On the credit front, watch the "allowance for doubtful accounts."

6. Changes in Credit Terms and Accounts Receivable.
Check the company's filing for any mentions of changes in credit terms for customers, as well as for any explanation by management as to why A/R has jumped.



SEVEN (7) Other Pitfalls to Watch Out for.

Watch out also for the following ways that firms can embellish their financial results.

1. Gains from Investments
An honest company breaks out these sales, and reports them below the “operating income” line on its income statement. The most blatant means of using investment income to boost results is to include it as part of revenue.

2. Pension Pitfalls
Pensions can be a big burden for companies with many retirees because if the assets in the pension plan don't increase quickly enough the firm has to divert profits to prop up the pension.

3. Pension Padding
To find out how much profits decreased because of pension costs or increased because of pension gains, go to the line in the pension footnote labeled either “net pension/postretirement expense,” “net pension credit/loss,” “net periodic pension cost,” or some variation.

4. Vanishing Cash Flow
If you are analyzing a company with great cash flow that also has a high flying stock, check to see how much of that cash flow growth is coming from options-related tax benefits.

5. Overstuffed Warehouses
When inventories rise faster than sales, there’s likely to be touble on the horizon.

6. Change is Bad
Firms can make themselves look better by changing any one of a number of assumptions in their financial statements.

7. To expense or Not to Expense
Companies can fiddle with their costs by capitalizing them.



Investor’s Checklist: Avoiding Financial Fakery

  1. The simplest way to detect aggressive accounting is to compare the trend of net income with the trend in cash flow from operations. If net income is growing quickly while cash flow is flat or declining, there is a good chance of trouble lurking.
  2. Companies that make numerous acquisitions or take many one-time charges are more likely to have aggressive accounting. Be wary if a firm’s chief financial officer leaves or if the firm changes auditors.
  3. Watch the trend of accounts receivable relative to sales. If accounts receivable is growing much faster than sales, the company may be having trouble collecting cash from its customers.
  4. Pension income and gains from investments can boost reported net income, but don’t confuse them with solid results from the company’s core operations.