Video Update: Red Flags That Signal a Sinking Company
This is John Persinos, editorial director of Investing Daily, with a video update for Tuesday, May 5.
Companies are cutting dividends at a rate not seen since the global financial crisis of 2008. Energy supermajor Royal Dutch Shell (NYSE: RDS.A, RDS.B) last Thursday cut its dividend for the first time since 1945, slashing its payout by two-thirds. A wave of bankruptcies is looming in the energy sector.
At the same time, many companies, such as Apple (NSDQ: AAPL), have withdrawn their near-term earnings guidance. First and second quarter earnings for the S&P 500 are expected to be dismal.
These dire conditions have generated questions from Mind Over Markets readers who are worried about the fundamental health of their individual holdings.
To address those concerns, I’ve put together a list of the 10 signs of a company that’s in trouble. Any single one, or combination thereof, should worry you.
For the purposes of concision, in the following video I focus on two metrics that are especially salient during the coronavirus crisis: dividend cuts and unmanageable debt. I examine the remaining eight criteria in the article below.
Conditions remain dangerous…
Stocks enjoyed a resurgence in April but the coronavirus pandemic continues to undermine the global economy. In recent weeks, dozens of companies have suspended or cut their dividends to shore up their balance sheets.
To be sure, not everything is bleak. We’re seeing glimmers of hope. Governments are relaxing COVID-19 restrictions. Businesses around the world are reopening. Financial markets are regaining momentum. As of this writing Tuesday morning, stocks were poised to open higher and beaten-down oil prices were rising.
But health experts warn that the pandemic is far from over. Unemployment remains at staggering levels and scores of businesses won’t survive.
We’re likely to see many more dividend cuts in the days ahead, in a variety of sectors. Let’s look at the 10 red flags that warn of a sinking corporate ship.
1) Dividend reductions
Companies that reduce or eliminate their dividend payments aren’t necessarily on the road to bankruptcy. But a dividend cut can be an ominous portent.
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.
When investing in dividend-paying stocks, investors need to be mindful of the trade-off between risk and reward. If a company suddenly can’t generate enough cash flow to support its dividend, it may cut the dividend or get rid of it altogether.
When judging the merits of a dividend stock, always look for 1) healthy payout ratios; 2) plenty of cash on hand; and 3) earnings growth. These quality dividend payers demonstrate greater resilience during an environment of rising rates and market volatility.
2) Unmanageable debt
U.S. corporate debt has swelled to nearly $10 trillion and the pandemic is putting pressure on indebted companies.
Companies that loaded up on cheap debt since the end of the Great Recession face difficult tests ahead, exacerbated by the virus-induced economic crash. Over the next five years, a $4 trillion mound of maturing bonds come due (see chart).
Chaos in the energy markets is expected to trigger a wave of bankruptcies among oil companies. With oil prices in a funk, many indebted energy companies are having trouble making interest payments.
How can you tell if your holding will buckle under the load? Study the 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.
3) 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.
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.
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 U.S. tax overhaul bill passed in 2017 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.
Let’s look at it in personal terms. I’m an avid baseball fan; my team is the Boston Red Sox. If I owned, say, a baseball autographed by Ted Williams, I wouldn’t sell it unless I was going broke. Same principle applies to companies.
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