Mayday! Is Your Investment About to Hit an Iceberg?

The main U.S. stock market indices currently hover at record highs. But a rising tide does not lift all boats. How many times have you heard someone on financial television news say: “This stock is a screaming buy!” But just because a pseudo-pundit on TV is saying it, doesn’t make it true.

Comedian Jon Stewart put it best: “If I had only followed CNBC’s advice, I’d have a million dollars today, provided I started out with 100 million dollars.”

Be forewarned: Many of those “hot stocks” getting hyped on TV are heading for an iceberg.

Like the Titanic, corporate icons can seem invulnerable but hubris, negligence and bad luck can send them straight to the bottom, regardless of sector.

10 Red Flags

Before investing in a company, look for classic signs of lurking trouble. Here are 10 red flags that a company is about to founder. Any single one, or combination, should worry you.

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 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.

With 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) 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.

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 company also could get slapped with significant fines and penalties.

While a low tax rate might initially appear beneficial, it often masks underlying risks that can have serious financial and reputational repercussions.

Companies using intricate structures, often involving multiple jurisdictions, may be trying to minimize tax liabilities. A significant presence in known tax havens also can be a red flag. While not illegal, such practices can signal attempts to exploit loopholes. Investors should be diligent in examining a company’s tax practices and wary of those that seem too good to be true.

7) Lack of financial transparency

If a company’s books are murky, management is hiding something. By focusing on companies with transparent strategies, investors can mitigate the risk of unexpected liabilities.

Accordingly, 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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