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10 Warning Signs Your Investment Is a Sinking Ship

By John Persinos on January 15, 2018

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.

Before investing in a company, you need to open the kimono. Get a good look at what you’re buying. Here are 10 signs of a company that’s in trouble:

1) Dividend cut

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

If a company you own has slashed its payout, watch for falling or volatile profitability. Beware of an excessively high dividend yield compared to peers. Negative free cash flow is another bad sign.

2) Turmoil in the auditing process

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. However, the dismissal of an auditor for no clear reason should make you suspicious. It typically indicates internal dissension over how to handle numbers. Those numbers could be fishy.

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. Does an auditor letter raise doubts as to the company’s viability? Get worried.

3) Unmanageable interest payments

Study a company’s balance sheet. Determine whether it has sufficient cash to satisfy creditors. If a company is imploding, its cash cushion will wane. Soon it won’t be able to 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 means that a firm has a solid chance of paying off its debt; below one means the firm probably can’t.

Some indebted companies beat the odds and clean up their balance sheets. But poor debt metrics usually spell doom.

4) A stampede of top executives for the exits

High executive turnover means that the firm is suffering internal turmoil. When top managers quit their cushy jobs on their own volition, it usually means one thing: the firm is in trouble.

Look to politics. President Trump’s White House is a revolving door. Never a good sign.

5) Excessively high valuation

Seems like a no-brainer, right? Well, this rule is often ignored.

Investors can get excited about a hyped stock that seems too compelling to avoid. Even if it’s absurdly overvalued.

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.

The tax bill passed last month slashes the corporate tax rate. But it won’t mean the end of tax cheating.

7) Lack of financial transparency

If a company’s books are murky, management is hiding something. It’s one reason many investors shy away from investing in China-based stocks. Anti-corruption watchdogs have decried the country’s opaque accounting practices. But companies in the developed world can be guilty of the same thing.

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 signal that investors are souring on the stock and it bears closer scrutiny.

9) Increased insider selling

If corporate insiders are dumping a stock, they know something that the rest of us don’t. It’s 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 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 assets at fire sale prices just to keep the lights on, 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 is managing editor of Personal Finance and chief investment strategist of Breakthrough Tech Profits.

 

 


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