How can you spot a company that might not performing quite as well as it seems? Numerous stock market stars have slipped up in recent years. Anyone remember Versailles, Independent Energy, Independent Insurance and, most recently, Bioglan Pharma (LSE: BGP)? Here are four pointers to help you single out those duds before they smash a hole in your returns.
Profits Versus Cash
Watch out for companies that have trouble converting their stated profits into cash. One of the best ways to look at this is to compare operating profits against operating cash flow over periods of 1, 3 and 5 years. It's relatively simple to manipulate profits, but it's lot harder to make cash appear out of thin air. If cash flow is more than, say, a third below profits, then it may be worth steering clear.
Suspiciously High Margins
Beware of companies that seem to have very high profit margins when compared to their competitors. How do they manage it? It may be that they are much better than the competition. But there is also a good chance that the profits might not be all they seem.
This is a trap that often catches those looking for outstanding companies to invest in. Tempted by high margins, it is often easy to overlook the simple phrase that "if something looks too good to be true, it often is".
When A Sale Is Not A Sale
This trick is a relatively new one. One company invests £10m in another company and then, as part of the purchase agreement, immediately gets back a contract worth £5m. The £10m is recorded as an investment in the balance sheet, whereas the £5m goes straight to the profit and loss account.
There's nothing wrong with doing this but it all depends on how you value the £5m that goes into the profit and loss account. Most profits are valued on the basis that they will be recurring, using the price to earnings (P/E) ratio. However, these sort of profits are much more likely to be one-off in nature. This means you may want to discount them if you are valuing a company using methods such as the P/E.
Limited Track Record
Most of the recent duds have been fairly small companies, around the £100m to £500m market value. It is much less common to see larger companies encounter such troubles, although it does happen. Companies with longer track records also seem to be safer bet. But it is quite possible to pull the wool over investors' eyes for a few, or even several, years. However, with each passing year it gets harder and harder to keep up the pretence.
More: Building A Share Portfolio
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