How to spot a stock heading for trouble

Investment banks are gearing up for the next big downturn. How can you make sure that your portfolio doesn't contain the next Marconi? Tim Bennett looks at the warning signs

Times are still good for the global economy, but, according to Bloomberg, investment banks are hiring distressed debt' specialists, who advise bankrupt firms, at the fastest rate in five years. How can ordinary retail investors tell if a stock looks vulnerable? The good news is that, as Deloitte puts it, "typically when a company is struggling the warning signs are there". So, if the following red lights are flashing, consider selling.

1 Beware the one-trick pony

If a firm relies on one thing for too much of its business, it may be vulnerable to changes in the market, or an economic downturn. Look at the "operating and financial review" or the "directors report" for clues. Most obvious is over-reliance on a product that could be rendered obsolete or replaced with a cheaper alternative. HMV and other specialist retailers are cases in point the latest advances in digital technology and the internet mean that fewer and fewer people are buying music on the high street. With no sign of the trend stopping, where will that leave the likes of HMV five years from now?

Another common problem is over dependence on one large customer or supplier. At one stage, computer giant Apple depended heavily on Motorola supplying its G4 chips, meaning the health of one was very much bound up with the other. Locker manufacturer American Locker Group's share price took a big knock when it lost the US Postal Service account, which generated more than 50% of its sales.

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For an overpriced one-trick pony, look no further than Clinton Cards (LSE:CC), currently trading on a p/e of 47. With sales almost entirely reliant on greeting cards, the chain looks very vulnerable to growing competition from supermarkets, as well as any squeeze on consumer spending. Not a stock we'd recommend.

2 Acquisitions can spell trouble

There are basically two ways to expand a business; the traditional way is through organic' growth. In plain English, this means you graft away to build a business on the back of hard work, profits and cash flows. Internet giant Google grew this way right up until it listed on the stockmarket in 2004.

But this takes time. An easier way to grow rapidly at least in theory is simply to buy someone else's firm. This is frequently the route most favoured by investment banks, as mergers and acquisitions bring in fat fees but it's not necessarily the best option for investors. Sometimes acquisitions can work, but studies by various organisations, including Arthur D Little, have shown that, on average, combining two firms can actually decrease value for the predator by up to 4%. The reasons vary, but are mainly due to the difficulty of combining two (or more) corporate cultures; plus management teams being distracted by bid activity when they should be running the business. Energy giant Enron was a hugely acquisitive firm. And, as Blackwells observe, it was buying poorly understood businesses that "ultimately killed Marconi" as it tried to compete in the telecoms market.

3 Cash must be king

It's easy for investors to be lulled into a false sense of security by a rosy-looking profit and loss account and forget about the life blood of any business: cash flows. Fast-growing firms in sectors such as software services, biotechnology and telecoms are particularly vulnerable to a cash crisis. Here's how it happens. Let's take one month's trading for a fictitious firm. Sales are a healthy £10m, opening stock (of products ready to sell) is £1m, purchases of stock during the first month are £5m and at the end of the month the firm has £1.5m of stock left unsold in the warehouse. The cost of making £10m of sales is therefore £1m + £5m - £1.5 = £4.5m (we assume that the opening stock has all gone and the closing stock will be sold the next month). Therefore, the operating profit is £10m of sales £4.5m cost of sales = £5.5m. Things look good.

But now let's look at cash flow. Because the business is small and trying to grow, we'll assume it made 75% of its first month's sales on credit (so customers take the goods and pay later), whereas 75% of its stock purchases from suppliers were for cash. The overall cash-flow position is £10m x 25% = £2.5m cash in from sales and £5m x 75% = £3.75m cash out. In total then, a cash outflow for the month of £1.25m. Ouch. If this continues, the business could go bust while apparently making very decent profits. Such firms, with a high cash burn' rate (which can be monitored using the cash flow statement, just behind the balance sheet) are unlikely to last, a point proved by many dotcoms.

Online-only content: more warning signs to watch out for:

Working capital worry if it isn't working

In the simple example above the company started the month with £1m of stock and ended it with £1.5m. Rising stock levels are fine if they are supported by rising sales. If not the company may be losing control. Overstocking is dangerous if you are a retailer because fashions can suddenly change and customers stop buying, leaving you with worthless inventory. Carrying stock is also expensive as every pound tied up there could be earning interest in the bank. Expanding businesses do, of course, need to stock up to meet demand - but Motley Fool's rule of thumb is to be wary of firms where stock (in the "current assets" section of the balance sheet) is rising more than 50% faster than sales.

The same goes for receivables or "debtors". Firms offering goods on credit will always have outstanding customer balances unless, like Tesco, you are lucky enough to sell most of your stock immediately for cash. However, if a firm's receivables (again found in the "current assets" section of the balance sheet) are rising more than 50% faster than sales, it may have taken its eye off the ball in terms of managing customer credit.

Low interest cover some sail too close to the wind

Just as a high mortgage in relation to income spells trouble for the UK consumer right now as interest rates rise, so the same can be said about companies that have been on a borrowing binge. If profits before interest and tax don't cover the interest expense at least twice (you can check this half way down the profit and loss account) avoid investing if you want to sleep at night.