Investing is, in the words of investment manager and author Richard Oldfield: “Simple but not easy.” But, while the basic principles are quite straightforward, time and time again we all fall into the same old traps – I’ve fallen into them many times myself. Of course, reading the annual report is always important, but there are a lot of other things to look at as well. This article will flag up you a few of the warning signs to look for, and will help you follow Warren Buffett’s first rule of investing: never lose money.

You can’t always pick winning stocks, but I’ve found that reducing the number of very bad investments has as big an effect on portfolio performance as picking winners. Some of these items can be researched quite easily on a desktop, some may need a phone call to the company or even more effort. But the more of these you can do, the more successful your investing will be in the long run.

Does it make sense?

The common sense check is one of the first things to do when looking at a company. Is there a good reason why the price-earnings ratio (PE) is only two, the price to book ratio is just 0.5, or that they have a massive market share but nobody has heard of them? Wasn’t it odd that Globo said they had lots of cash, yet were raising a high-yield bond? Or that Naibu had lots of cash but the chief executive took his dividend in scrip? Look at everything with a critical eye, and if any characteristic is unusual, try to find out why. Sometimes there is a valid reason, but if there isn’t, consider it a warning flag. The presence of one or two warning flags alone doesn’t make something uninvestable, but if there are many, or the flags are significant, be forewarned. We all like to think that where there’s muck, there’s brass, but usually there’s just more muck.

If you don’t mind throwing out some babies with the bath water, just eliminate all resources stocks and all foreign stocks from your Alternative Investment Market (Aim) portfolio – you’ll protect yourself from a lot of losses with this simple step. It’s always tempting when you see the ‘value’, though, and I’ve made that mistake more than once. For example, I purchased shares in a resources company trading well below its cash balance. It didn’t take long, however, for that cash to follow management’s ambitions down a series of speculative undertakings, taking my investment with it.

So near yet so far away….

Where is the company based? If it’s not based in the UK, then why have they chosen to list here? The travails of Chinese companies listed in London are well known, and some of these have turned out to be outright frauds, delisting at a small fraction of their listing price and with investors nursing heavy losses. But it is possible for a foreign company to have legitimate reasons for listing in the UK. Perhaps the dominant UK business has been sold, leaving a smaller foreign business, or it is the spin-off of foreign operations of a UK company. Or it could be that the market in the UK was more receptive to companies in that industry (eg, gaming). Somero (SOM), a US company, was listed in the UK in 2006 by a private equity seller keen to find a good market. It went through a difficult time in the last recession, but is a fundamentally good company with a now strong balance sheet. But more often than not, the reasons will leave you scratching your head –common reasons include ‘it helps improve the image of the company in our home market’, or ‘it helps us with customers’.

What about the directors? Do the executives live where the headquarters are, and if not, why not? Can they do their jobs from far away? Also look at the non-executive directors (NEDs). They’re there to protect your interests – do they even speak the same language as the executives? I’ve come across companies (usually Chinese) where the European NEDs have to have a translator provided for them; how can you be sure they’re able to get an accurate picture of what’s really happening? How often do they physically attend board meetings, and how often have they actually walked around the factory floor?

One diligent colleague went to the trouble of travelling all the way to China to visit some companies in which he’d invested. By doing so, he was able to conclude (among other things) that one company only employed about one-third as many people as it claimed – a fact that escaped the NED.

A word about the numbers

Have a good look at the financials of the company; the annual report should always be available on the company website. What’s acceptable will vary greatly on the industry and stage of the company, but the golden rule remains: ‘turnover is vanity, profit is sanity, cash is reality’.

How are sales progressing? Are they growing at a reasonable pace, and coming from more than one source? Is the margin on these sales reasonable and is it rising or falling?

Look at the earnings progression year over year – are things moving forward reasonably smoothly? It’s a lot harder to pick the timing of a turnaround from loss to profit than it is to anticipate another year of profits. Growth is great, but very fast growth can either be a warning sign or lead to a very high PE ratio. Look for a forward PE ratio in a range of eight to 20 times earnings. Much lower and there’s usually something wrong with the business, much higher and an earnings miss may hit you with a double whammy of contracting earnings and a falling PE multiple. Expected earnings of 5p and a forward PE of 20 gives a price of 100p – if earnings come in at 4p and the PE then drops to 12, you’ll have lost half your money.

The optimal dividend yield will depend on the type of company and its maturity, but a good range is 1.5 to 4 per cent. Much lower and the company may be too young (or in trouble), much higher and it may not be sustainable.

Look at the assets of the company as well. Is the price-to-book ratio high? An acceptable range will depend greatly on the type of business – a property company should be around one times, but a software or marketing company could easily be three or five times. It’s also important to look at the composition of the assets – land and buildings at historical cost give a safety cushion, and are of course generally much more valuable than intangibles, and a third-party valuation is generally better than the opinion of the directors.

Is the company generating cash? Unless it is growing very quickly, or making big investments, it should be, and should roughly equate to declared profits. If it’s not, look a little deeper. Beware a company such as Globo, purporting to be profitable and having lots of cash, yet needing to raise a high-yield bond.

And while we’re on the topic, look at debt levels. In tough times, an extended balance sheet and a breach of a banking covenant – or a need to refinance – can be very painful. In contrast, a company with cash is not only more resistant to a downturn, but can capitalise on the opportunity when a weaker competitor stumbles.

Defined benefit (DB) pension plans are another area to watch out for. They tend to be present in older companies, often in manufacturing or other industries where staffing now is a fraction of what it was. The size of the pension fund can dominate the company, like at National Milk Records (NMRP). It has a sound underlying business with a fantastic market position in milk testing, but shares a joint liability over a DB pension fund many times the size of themselves. These plans can require very expensive contributions, but on occasion they are overly discounted in the price.

Liquidity in the shares is also an important factor. If the free float (shares not in insider hands) is small, it can be very hard to get out of a position without substantially moving the price. It’s usually a lot easier to get in than out.

Let’s talk

How does the company communicate with investors? Is it presenting constantly, at every investor event, leaving the chief executive or chief financial officer barely enough time to actually run the company? Or does it provide information to investors only sporadically? Can you understand the Regulatory News Service (RNS) announcements and company presentations, or are they incomprehensible? I recall meeting Quindell, now known as Watchstone Group (WTG) at an investor seminar, looking at a table of all the businesses the company was in and the interaction between them, and simply scratching my head.

On the other hand, engineering company
Goodwin
(GDWN) is reluctant to present at investor events – but this is more than made up by a comprehensive investor relations section on its website.

And have a look at the annual report, which is always available on a company’s website. Is it clear and readable, giving a good explanation of the activities over the year? Or is it filled with jargon and gobbledegook? Photos of the board members are helpful, but a full page glossy of each smiling face is often driven more by ego than identification.

Have a look at FT columnist Lucy Kellaway’s Guffipedia at https://ig.ft.com/sites/guffipedia/. If something cannot be stated clearly, there might be good a reason. I sat through a half-hour company presentation once and still couldn’t figure out how it made money. But in the two years since, the share count is up by a factor of seven following rescue fundraisings, the share price is down, and the company has continually made losses. Hapless investors have been largely washed out.

What about when the company does have an investor presentation or annual meeting? Do they accept probing questions and give a straight answer? Hopefully, they don’t do as I’ve seen one executive do: deliberately present for the entire time slot, say ‘sorry no time for questions’, and dash off to an important engagement. If they do accept questions, do they have a persistent questioner ejected from the meeting as EROS recently did, or do they respond like Jeff Skilling did (the former chief executive of Enron who now resides in the Federal Prison Camp in Montgomery Alabama), publicly calling the questioner an ***hole? I confess to having listened to that Enron call, and ignored the warning to abandon ship!

Also look at bulletin boards for chatter on the company. Some boards for more volatile stocks have a lots of posts, often with aggressively expressed viewpoints. If you’re looking for long-term returns, avoid those, and look for shares where the chatter is less frequent and more measured.

What do the company and its managers say about themselves? If the chief executive describes his own career path as brilliant and original, saying he ‘began winning at everything he set his hands upon’, or the company announces that it is to ‘reset expectations about the trajectory of its opportunity’, you know they might not have their feet firmly on the ground. In fact, the only thing headed earthwards might be the share price.

Heads I win, tails you lose

Look at executive compensation to see that it’s in line with the size of the company and industry norms. Is there a reason why the chief executive needs to be paid 5 per cent of the annual sales of a company which has in aggregate lost money in the 10 years since listing and never paid a dividend?

What’s the chairman being paid? Is he getting six figures, for one of many part-time roles? And, even worse, did he receive share options worth twice that? The UK Corporate Governance Code certainly believes this fails the independence test. Maybe if he’s not independent he shouldn’t participate in the remuneration committee determining the payoff of the chief executive in the paragraph above.

There’s a new fashion, particularly with Aim companies, to compensate chief executives with private-equity-style pay awards. But private equity-style awards should be given where the chief executive is taking private equity-style risk – drawing only grocery money and personally invested in a private company up to his/her eyeballs, not holding a small number of shares in a listed company and receiving a comfortable salary. Did you know that some of your portfolio companies actually have an intermediate company between the plc and the operating company, whose sole purpose is to divert up to 15 per cent of the returns away from investors and to management? Thanks to ‘entrepreneurs relief’, management may pay only 10 per cent tax on the gains, which would have been subject to capital gains tax (CGT) in your hands!

Is someone with a salary, benefits, pension contribution, bonus, variable compensation plan, and a long-term incentive plan (LTIP) really looking out for your interests, or their own? What do you think management is focusing on if the annual report of this company uses the word ‘remuneration’ more than 100 times?

And how is all of this paid for? Keep an eye on the share count over the years. If the number keeps increasing, without a lot of new assets and earnings to show for it, you can guess where the money has likely gone.

Dividends are a good discipline, even if the company can find good investment uses for the cash as well. But make sure that they’re paid in cash. Cash is one of the hardest things to fake in a balance sheet, and dividends paid in cash are always a good sign.

Related party transactions are also an area to watch. Does the chairman own the company headquarters? Does the CEO’s husband own a major supplier to the company? In the most benign interpretation these acts can be supportive, but there is a risk too that your company is being milked.

Hoist the drawbridge?

What is protecting your business? Have they got a moat that is hard to penetrate, or can anybody copy what they are doing. IP and patents are great, but an effective moat can also be created by product studies and approvals that would take years to replicate, such as
Bioventix
(BVXP). On the other hand, a dominant position in the marketplace can sometimes be destroyed at a stroke by government legislation, as Slater and Gordon (purchaser of Quindell’s assets) found to its cost in November. Or if you look back a little further, the online gaming companies suffered when the US decided to act against them and arrested a number of their executives when travelling through American airports.

Customer concentration can also be an issue. My own worst experience in this respect was a pizza crust company that sold 72 per cent of its products to
Sainsbury
(SBRY). When the contract was not renewed, the company failed almost immediately.

Make some friends and get some help

Don’t count on help from regulatory bodies, the number of prosecutions for behaviour ranging from naughty to outright criminal is shockingly small. There’s also a tendency for institutions to walk away from difficult situations rather than working out the problems. Even the exchanges have their own problems, as Alex Newman (of the IC) points out in his excellent article of 10 December (‘Cenkos shares swing raises nomad dual role quandary’).

But you’re not completely on your own. There are a good number of investor-based events, in London and in the remainder of the UK, where you can meet both company management and like-minded investors, compare ideas and network.

Read magazines and websites such as Investors Chronicle, where there is great analysis. Read the RNS, which you can find in various places including on the London Stock Exchange website or on www.investegate.co.uk. These contain all important announcements made by your company. Go to annual meetings and ask questions – don’t be shy, and remember the board is managing your company. Sharesoc (www.sharesoc.org) organises regular events and has an excellent annual meeting report library on its website, and its newsletter is full of topical investing issues.

Who is running the show?

Remember it’s your company and management are the custodians. Does the board take this responsibility seriously, or does nearly half the board not bother to attend the annual meeting several years in a row? (yet another expensive mistake of mine). Even worse when the annual report contains the same error in consecutive years!

How dominant is the chief executive? Is he a superstar? What happens if they fall under the proverbial bus, is there sufficient management depth? Attitude is also important – it’s a real warning when a chief executive says in a presentation ‘if you don’t like the way I run the company, you shouldn’t be a shareholder’. This chief executive has completely reversed the relationship between the owners of a company and its management. Strong leadership can be a good thing, but it can also be a sign of the chief executive not listening to sound advice, often with disastrous consequences. Sometimes a debt-ridden acquisition spree is more of a reflection on the ego of the chief executive than economic opportunity, and this usually ends in tears.

Is the board independent? Check how long they’ve been in place, and whether any of the directors are truly independent (according to the UK Corporate Governance Code). There should be at least one independent non executive looking out for shareholders’ interests.

How much time is your executive team devoting to running your company? Have a look at the Companies House website (https://beta.companieshouse.gov.uk/), where – now at no charge – you can look up all of the directorships held by each member of your board. You can also see how long they’ve been in place – the Corporate Governance Code recommends no longer than nine years to maintain independence. A long string of appointments can indicate a risk that the executive might be more interested in the fee than in helping the company.

Have a look at the share register as well. As Lord John Lee points out, it’s great if management owns a big portion of the company, particularly if they are the founders, as it aligns interest. Another plus is multi-generational ownership. But there can also be too much of a good thing, and once management ownership is at a control level, there can be issues of minority shareholder abuse which can extend as far as delisting. A small free float can be bad for liquidity as well.

By following a few simple rules and asking why, why, and why, you can eliminate a lot of mistakes and greatly improve your investment performance. Common sense is one of the most valuable tools in your armoury and there is a lot of valuable information available to you at no cost or relatively cheaply – these are pounds well spent. Don’t be put off by one or two red flags in an otherwise good company, but heed the warnings. By digging a little deeper on each one you can sometimes find a real pearl. Some of the best investments come from finding a beaten-down company that has successfully addressed critical issues. Enjoy the process, and think like an owner. They are your companies.

Happy investing!

Mark Lauber has been a private investor for many years, now focusing on small-cap and special situation investing. He blends this activity with managing a small family office and consultancy in private equity. Previously, he worked in the City structuring interest rate and credit derivatives in the UK and internationally. Among his directorships is a role at Sharesoc.

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