The flip side of knowing how to make money by buying the shares of troubled companies that are subsequently turned around is to recognise apparently healthy companies that may get into trouble and to avoid buying their shares in the first place.
Since many growth shares - notably those in the information technology (IT) sector - of the past decade ended up as troubled shares, I thought it would be appropriate to provide some pointers on how to spot companies that may be heading for trouble.
Even if a company's management has good insight and foresight, the company can still end up in trouble because of the following factors (this list is by no means comprehensive):
- Mis-timing the economic or commodity cycle. For instance, a retailer may open a large number of stores just as interest rates rise and consumers curtail their spending. Or a platinum mine may incur large capital expenses to build more capacity to mine just as the platinum price takes a nosedive.
- The company's products become obsolete. An example is video machines after more affordable DVD players came on to the market.
- An adverse change in regulations. For example, when the rules governing microlending changed a few years ago, the risk profile of microlenders deteriorated as it became less certain that they would be able to collect repayments on loans.
- If a company is an exporter, it can be hurt by prolonged periods of rand strength, although strong commodity prices can provide a compensation. Local manufacturers (such as clothing manufacturers) face competition from cheaper imports when the rand strengthens. Conversely, importers of raw materials suffer when the rand weakens. Either way, getting the currency wrong can land a company in trouble. In other words, failing to pre-empt an adverse movement in the currency while exposing the company to undue currency risk can affect its profits. Although management cannot influence the currency, they can manage the risks that sharp movements in the currency bring to their company.
- Failure to successfully implement new technology can affect a company's ability to service its clients, and, as a result, hurt its brand. In the 1990s, some of the major banks suffered when they could not implement expensive new technology quickly and effectively enough.
- A poor acquisition with hidden costs and problems. In a previous column, I mentioned SAB's purchase of Miller as an example of an acquisition that was initially more troublesome than it appeared. Over time, problems associated with such an acquisition can be addressed, but the company's share price can suffer in the meantime.
The presence of any of the abovementioned problems are sufficient for a company to get into trouble. However, the company's cash flow situation plays a large role, and can be both a symptom and a cause of trouble. A weak balance sheet also reduces a company's ability to borrow in order to remedy its problems, and if its share price has already taken a knock, it becomes difficult to issue more shares to raise capital. So, although a weak financial position alone is a bad sign, it is usually coupled with operating problems.
In the case of some of the problems mentioned above, it could be argued that the operating environment turned against the company and that management could not have foreseen the problems. However, in many cases, management itself is to blame for the company's woes. Your suspicions should be aroused if you see any of the following in a company:
- Nepotism. It is hard to fire your favourite brother-in-law or fishing buddy if they are incompetent. Successful family/friend business partnerships do exist, but they are always accompanied by competence. Problems occur when the presence of nepotism is combined with the absence of aptitude.
- Extremely luxurious and large executive suites. I can recall a correlation between the commissioning of large new offices and the decline in the prices of some IT and financial shares over the past decade. The publication of fat glossy annual reports, complicated financials and loads of footnotes are further reasons to be cautious of a company, mostly because they make it easier to hide weaknesses, either intentionally or otherwise.
- Promises that are not met. If management often over-forecasts and then has a good story about why everything "will be alright the next time", be very, very afraid.
- If you cannot understand what a company's management is trying to achieve, it is highly likely they don't either. Be wary.
- Although a change in management is often necessary when a company is in trouble, as a rule a company's staff turnover at top level should not be high.
I have provided you with this list of warning signs so that you can try to avoid companies that seem to be heading for trouble.
While you build up a small pile of cash in your portfolio, pull out the old Scripline columns that focused on investing in troubled shares and wait for that perfect buying opportunity when the market hates a share.