There are many ways you can begin your research into a company before deciding whether to invest in shares or not.
Ploughing through the company’s annual financial statements, some of which can run to one hundred pages or more, is one way; reviewing the last three years of company announcements released through the Regulatory News Service (RNS) is another.
However, what if time is against you and you have an hour to kill while waiting for that Amazon home delivery, or to be blunt, you have no idea what to look for in the financial statements anyway.
I thought it might be helpful to highlight some of the less obvious issues or warning signs that you should consider before investing in shares.
1. Exceptional items
Taking managed risks is part and parcel of a board of directors’ responsibilities. As an investor, you want to be on the right side of those management decisions as often as possible. Sometimes, things do go wrong of course: companies can overpay for acquisitions in a competitive bidding situation or complex IT projects can lead to significant cost overruns.
Where this happens, the company is obliged to acknowledge the financial consequences of these management decisions. They are required to calculate the impact of the over payment or the cost overrun and write this off as an exceptional charge in the P&L account. While these cost impairments or asset write-downs are not ideal, they do happen.
However, if year after year, a succession of write-downs, impairments or other one-off charges appear in the financial statements, then investors should pause and reflect on the nature of the risks being taken by the company’s management or its inability to successfully manage the risks needed to grow the business.
Either way, the appearance of exceptional items in the financial statements on a regular basis does not reflect well on decision making by the executive team and perhaps the company should be avoided by investors. There’s a Dutch proverb which when translated says: even a donkey doesn’t hit his head on the same stone twice.
2. Pension deficit
British Airways is a well-known example of a company with pension deficit issues. At one point, the deficit was £2.8 billion. Under a recovery plan agreed with the pension scheme trustees, BA are required to make fixed contributions of £450 million per annum, from April 2020 to March 2023 to address the deficit problem.
As an investor, you should be alert to any mentions of pension deficits in the financial statements or the wider media. It is important to establish what plans, if any, the company has or proposes to put in place, to reduce or eliminate their deficit.
Before investing in shares of a company with a pension deficit, investors need to explore and understand the impact of those plans on operating cashflow and company decision making.
For example, could addressing the deficit lead to a reduction in capital expenditure needed to grow the business. Or could the dividend be suspended (and if so, for how long), will a discounted rights issue be required at some point to raise the cash needed to clear it.
3. Employee turnover
The revolving door syndrome. To lose one CEO is unfortunate, to lose two in quick succession is concerning. And not just CEOs. Losing any key personnel or senior employees can be seen as a negative by the stock market, especially if they are poached by a competitor.
Questions about turnover in senior executive employees need to be asked. Was the organisational structure too complex or the role too demanding? Were the operational challenges ahead too difficult? Are there funding concerns that the CFO believes were not easily resolved?
Equally, haemorrhaging staff can be an indicator of low employee morale or a demotivated workforce. Investors should ask themselves why: fear of impending staff cutbacks maybe, or has the annual bonus been scrapped because performance targets have not been met? What’s going on behind closed doors?
4. Dividend suspension
It is important to understand the rationale behind the suspension or fall in a company’s dividend payment before investing in shares; as any changes in its dividend distribution policy will directly impact the share price.
For example, investors should be concerned when the reason offered relates to plugging a pension deficit; or a profit warning (caused by exceptional charges), means distributable reserves will be insufficient to meet dividend expectations in the current financial year.
However, if a company indicates that it intends to preserve cash by not paying a dividend in order to fund the introduction of a new product or service activity, or to acquire an expensive piece of plant or equipment, any of which could lead to an improvement in earnings, then obviously this would be a more acceptable reason.
5. Closure of staff canteen
Obviously, investors would not expect to be informed of a canteen closure by way of an RNS but if you happened to hear about it through the grapevine, then it may be worth some reflection.
Many years ago, I worked for a Japanese asset management company in the City which had a fantastic staff restaurant. As a single bloke, not particularly adept at cooking, I ate there every day, so I was very upset (to put it mildly) to be informed that it was closing down. Anyway, shortly after that again, I was advised that the company itself was shutting down. After one hundred years in business, Yamaichi was no more.
On the other hand, closing the staff canteen could simply be the act of a ruthless, cost-cutting CEO and the resulting marginal increase in profits might be returned to shareholders by way of an increased dividend (probably at the expense of a significantly demotivated workforce).
I admit that the closure of the staff canteen is a slightly tongue-in-cheek warning sign but it illustrates a very important point: whatever the reason for the closure, it sums up the difficulty in assessing what is really going on in a company and the challenge for anyone thinking of investing in shares. The same event can have two very different interpretations.
However, the most important take-away from this is that you weigh up alternative explanations before making a commitment to invest in a company.
Further articles in the series: Investing in shares
While I have covered some of the warning signs to watch out for here. There are certain issues that deserve a much more detailed analysis such as profit warnings and over leverage (debt to equity ratio), and you can learn more by clicking on the links.
