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Investing in the stock market is hard enough. The last thing you need is to find yourself owning a company that has questionable accounting, disclosure or other policies. [Below is] a review of 5 things you should watch out for when investigating companies for a stock investment. Words: 740
So says Peter Hodson (www.sprott.com), in an article* originally written for the Financial Post which Lorimer Wilson, editor of www.munKNEE.com (Your Key to Making Money!), has further edited ([ ]), abridged (…) and reformatted below for the sake of clarity and brevity to ensure a fast and easy read. The author’s views and conclusions are unaltered and no personal comments have been included to maintain the integrity of the original article. Please note that this paragraph must be included in any article re-posting to avoid copyright infringement.
Hodson goes on to say:
Most investors find accounting boring…[which is unfortunate] because the financial statements of a company can predict problems or opportunities long in advance. However, sometimes problems take a while to surface [and] investors get bored waiting assuming that if nothing has been wrong at a company for a few years then everything must be okay, despite earlier warning signs, weak accounting or other questionable aspects at the company. A rising stock price is often a great excuse for investors to assume everything is fine. You should, however, examine the financials closely. At least read them.
Here, then, are a few issues to watch closely:
1. Receivables or inventories rising faster than sales.
Simple enough to calculate -look at the growth rate of sales compared with the growth rate of accounts receivable -or monies owed but not yet paid -and the growth rate of inventory. If receivables are growing at a faster rate, it may indicate customers are not paying in a timely manner. This could mean customers are unhappy, which may result in returns. Or, it could mean that customers simply are having trouble paying. Neither is good. To fully understand the issue, you need to know things like the company’s return policy, customer concentration and charge-off history. These are often buried in the notes of the financial statements, but are usually there if you look hard enough.
2. Watch related-party transactions:
Any third-party transaction should be treated with caution. There is simply too much potential for conflict, despite what the financial notes may say about third-party valuations and so on. Once in a while a company may need to transact with a related party, but if a company has a regular history of doing material deals with related parties then you should be very cautious before investing.
3. Growth by acquisition:
While not, in and of itself, a bad sign, you need to be cautious. Many companies employ a “roll-up” strategy, where they use high value public company stock to make acquisitions of private companies at lower values. This is often an easy way to grow and make accretive acquisitions. However, this strategy only works when investors reward the strategy, and maintain the high valuation of the acquiring company. This is typical in the early stages of the rollup strategy or during a rising market. Once the acquirer’s valuation changes, however, the entire roll-up acquisition strategy often falls apart, quickly.
4. Big write-offs on a recurring basis:
Often, when a company uses aggressive accounting methods, it is forced every few years to reset the books. It may write off inventory (weak product line), receivables (weak customer base), goodwill (bad acquisitions) or research expenses (weak R&D). In any case, if a company has a history of write-offs you should use extreme caution. Often the company will try to position these as ‘one-time’ write-offs, but you might be surprised at how regularly they occur at some companies.
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5. Companies that use options excessively as incentives for employees:
Executives motivated by stock options may make aggressive accounting choices or make decisions for short-term gains without due consideration of long-term consequences. Look at how much stock executives own in their company. Options are free, remember, but if executives put a company in jeopardy you want them to lose [some of their own] money, too.
* http://www.sprott.com/Docs/ViewFromTheStreet/2011/Jun-25-2011.pdf
Other Articles by Peter Hodson:
1. Here’s a Game Plan for the NEXT Time the Market Plunges
Sooner, rather than later, [excessive] volatility will break out again so it is important for investors to have a gameplan in place for such a future event. [Below is just such a plan that I would like to share with you.] Words: 1407