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10 Warning Signs Your Investment Is a Sinking Ship

How many times have you heard someone on CNBC say: “This stock is a screaming buy!” But just because a smug guy in an expensive suit is saying it, doesn’t make it true. Beneath the enthusiasm could be hidden risks.

I distinctly remember television analysts telling viewers in 2008 to buy Bear Stearns with both hands, even after the storied investment bank had struck an iceberg and was taking on water. When it finally slipped under the waves as part of the global financial crisis, there weren’t enough lifeboats.

All of which brings me to this anguished letter from a reader:

“Everyone was touting solar power as a great long-term growth trend, so I bought $10,000 worth of shares in what seemed like a sure thing: SunEdison. Then the company filed for bankruptcy and I lost everything. I’m thinking of getting back into stocks, but I’m nervous. How can I prevent a disaster like this from happening again?” — Elizabeth M.

Fact is, Beth, the warning signs were there but many analysts ignored them. Since 2014, renewable energy firm SunEdison had embarked on a reckless acquisition spree, spending $3.1 billion on takeovers that the parent company never fully digested. Growing debt and poor liquidity plagued the company until in April it filed for Chapter 11. Individual shareholders like you were essentially wiped out.

Fancy textbook terms such as “disruptive technology” and “creative destruction” are all fine and good, until you take a beating on a stock (or lose your job) because a fundamentally weak company has gone down the drain.

Open the kimono…

SunEdison notwithstanding, solar power remains a good investment. Igor Greenwald, chief investment strategist of MLP Profits and managing editor of The Energy Strategist, explains:

Solar power is more plentiful than ever and more competitive than ever with fossil fuels. This year the U.S. will add more utility-scale solar generating capacity than it will from any other power source… Homeowners and businesses continue to install roof panels at a dizzying pace.”

But as always, it’s not enough to pinpoint a promising industry. The key is to do your homework and find the right stocks.

Before investing in a company, you need to open the kimono, so to speak, to see what you’re really buying. Here are 10 signs of a company that’s in deep trouble:

1) Dividend cut

Companies that reduce, or eliminate, their dividend payments aren’t necessarily on the road to bankruptcy. But a dividend cut is often the dead canary in a coal mine.

If a company you own has slashed its payout, watch for falling or volatile profitability, an excessively high dividend yield compared to peers, and negative free cash flow.

2) Turmoil in the auditing process

All public companies are required to get their books audited by an outside accounting firm. It’s not unusual for a company to switch accounting firms, but the sudden dismissal of an auditor or accounting firm for no discernible reason should make you suspicious. It typically indicates internal dissension over how to handle problematic numbers.

Also, examine the auditor’s letter. As part of the proxy statement, auditors must write a letter confirming that the financial data was presented fairly and accurately, to the best of their knowledge. If in the letter an auditor raises doubts as to the company’s sustainability, you should get very worried.

3) Unmanageable interest payments

Study a company’s balance sheet, to determine whether it has sufficient cash to satisfy creditors. If a company is imploding, its cash cushion will incrementally wane until it can’t pay its bills.

A handy indicator is the “cash ratio,” which helps you calculate a company’s ability to pay short-term debt obligations. The ratio is determined by dividing current assets by current liabilities. A ratio higher than one indicates that a company will have a solid chance of being able to pay off its debt; below one is a red flag that a company can’t handle its debt.

Some indebted companies manage to beat the odds and clean up their balance sheets, but more often than not, poor debt metrics spell doom.

4) A stampede of top executives for the exits

High executive turnover usually means that the company is suffering internal turmoil that’s born of growing corporate vulnerability.

When top executives quit their cushy, well-paying jobs on their own volition, it usually means one thing: the firm is in trouble.

5) Excessively high valuation

Investors often get excited about an over-hyped stock that seems too compelling to avoid, even if the market is favoring it with irrational exuberance.

This truism bears repeating: If a stock is considerably more expensive that its industry or direct peers, or its estimated growth is greatly out of whack with its valuation, stay away.

6) Suspiciously low tax rate

If a company is playing fast-and-loose with the tax code, it usually faces a day of reckoning in the form of expensive and time-consuming audits that distract management. Not to mention the potential fines, penalties and bad publicity.

7) Lack of financial transparency

Embattled Valeant Pharmaceuticals (NYSE: VRX) is instructive in this regard. Earlier this year, after months of foot-dragging and an embarrassing Senate hearing, Valeant Pharmaceuticals finally filed its annual 10-K report to the Securities and Exchange Commission.

In its report, the company unveiled risk factors related to its accounting practices and new sales arrangements, as well as previously undisclosed state regulatory investigations. In the wake of releasing its 10-K, the company’s reputation and stock price got hammered.

8) A rising short interest ratio

Short interest is the total number of shares that have been sold short by investors but have not yet been covered or closed out. When expressed as a percentage, short interest is the number of shorted shares divided by the number of shares outstanding.

For example, a stock with 1.5 million shares sold short and 10 million shares outstanding sports a short interest of 15%. Most stock exchanges track the short interest in each stock and issue reports at the end of the month. If short interest is spiking, it’s a clear signal that investors are souring on the stock and it bears closer scrutiny.

9) Increased insider selling

If corporate insiders are suddenly dumping a stock, they know something that the rest of us don’t. It’s often a tip-off that the people running the company realize that the stock is about to underperform the market. But there’s a caveat: sometimes insiders sell for personal financial reasons that aren’t related to the health of the company.

If only one corporate insider is selling, or if the stock has run-up quite a bit, it may simply indicate an individual’s desire to pocket profits. But if several corporate insiders are all selling within a short period of time…watch out.

10) Selling the “family jewels”

If a company is dumping flagship products or property at fire sale prices just to keep the lights on, you know that the end is near.

Look at it in personal terms. If you’re a baseball fan and you owned, say, a baseball signed by New York Yankee legend Derek Jeter, you wouldn’t sell it unless you were going broke, right? Same principle applies to companies.

Have you ever invested in a company that failed? Your cautionary tale could help other readers. Drop me a line: mailbag@investingdaily.com — John Persinos

Control your destiny…

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