Behind every disappointing share is a business with some undesirable attributes.

The problem is that attractive characteristics can mask the problems. For example, I’m often drawn to firms with a reasonable valuation, or high earnings growth rates, or a chunky dividend yield.

However, three underlying potential problems can scupper the chances of a successful long-term investing outcome, so it pays to scratch the surface to ensure that these toxic conditions don’t exist before buying shares.

Weak balance sheets

No matter how well a company performs, a weak balance sheet could destroy investors’ total returns.

High bank debt, or debt such as bonds, often betrays a weak balance sheet. Less obvious debt, such as pension fund deficits, redeemable preference shares and future liabilities, is problematic too. If the debt level is high compared to cash flow or net worth, the company suffers from balance sheet weakness.

Debt also has potential to boost investor gains when things go well. Think of buying a company with lots of debt on its balance sheet as like buying the shares of a debt-free company with money we’ve borrowed ourselves. The shares have high upside if things go well, and a big downside if things go badly.

To gauge balance sheet strength, take the figure for Total Liabilities from that for Total Assets to work out Net Assets. Is it positive or negative? Negative indicates weakness. Under distressed conditions, Intangible Assets can be worth much less than a company paid for them. Deduct the figure for Intangible Assets from Net Assets to work out Net Tangible Assets. Is it still positive?  If so, that’s a good start.

The value of intangible assets tends to vary between industries, so some judgement and research is needed. However, the general point is sound: high debts with little hard asset backing is a bad thing.

Ineffective business models

Many firms achieve a stock market listing without an effective business model. We need to make a qualitative judgement about a firm’s business but there are financial indicators to help.

Red flags include lumpy profits that are up one year and down the next repeatedly, low returns on equity and on capital employed, low profit margins, trading losses, no revenue growth, revenue contraction, and profits that cash from operations fails to support. If I see any of these poor indicators during my research, the investment idea usually goes on the ‘rejected’ pile.

Poor management

As investors, we entrust strategic and operational control to the managers and directors of a business. They don’t always do a good job, so be alert to the warning signs.

Number one is excessive director pay and easily achieved incentive arrangements, such as share options. That makes me think that the directors are running the show for their own benefit rather than for shareholders first. If that’s their attitude over pay, I reason, what else might they do to benefit themselves that may harm the firm’s longer-term prospects?

I also look for a record of stable management. Fast director churn could be a sign of an unhappy working environment, which could be down to a poor culture or overbearing personalities at the top. That could hinder a firm’s progress.

If a company is forever restructuring, I ask myself why management got it so wrong in the first place. Then there’s the fallout from management decisions such as acquisitions. Did they work out? If not, I question management’s judgement.

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