How to spot the red flags
South Africa has been rocked by a series of corporate scandals that have sent the share prices of former blue-chip companies like Steinhoff and EOH plummeting. Of course it isn’t a save-all and it is impossible to always get things right, but knowing how to spot the red flags can help investors to stay clear of high-risk companies.
Below are some of the top investment red flags that may together paint a picture of a highrisk investment.
The cult of the celebrity CEO
There’s nothing more appealing than the rags-to-riches story of someone who has come from nothing and risen to the top of the corporate hierarchy. Unfortunately, the hype created around a CEO’s public persona isn’t always matched by reality. A company built around the profile of its leader should be scrutinised.
Aggressive expansion
Companies that suddenly go on aggressive offshore expansion drives tend to use a lot of capital to make forays into markets they are often unfamiliar with.
Many South African companies that have recently expanded into unfamiliar territories ranging from the US to Australia and Nigeria had to return home with a bloody nose, or report struggling numbers following their acquisitions.
An absence of cash flow
Poor cash flow is one of the biggest signs that all is not well with a company and the way it manages its finances. Companies that are always short of cash and fund their day-to-day operations with credit are often poorly managed. We think of cash flow as the cash from operations less the capital expenditure required to maintain their assets. The inability to actually produce any cash is a red flag.
Significant share issuance
Equity capital is valuable because it is scarce. If a business is undervalued, issuing shares is a very expensive way of raising capital. Any share issuance dilutes existing investors into perpetuity.
Rising debt levels are a concern: you are taking from the future and spending today. Not only does that leave a hole that one day needs to be filled, but servicing that debt can quickly overwhelm a business. It is important to determine whether the borrowing is warranted. Very often it is not.
Overly complex corporate structure
The more convoluted a company’s corporate structure is, the easier it is to hide financial malfeasance.
Often companies will deliberately make use of complicated cross holdings, shell companies and an array of subsidiaries – frequently in different jurisdictions – to make it difficult to track precisely what they are doing. This is often reflected in overly complex financial reporting, which can also conceal debt levels or artificially inflate earnings.
Duncan Artus is portfolio manager at Allan Gray