Knowing which shares to avoid is almost as important as being able to pick potentially profitable investments. Here are five "red flags" to watch out for.
1. Unnecessarily complicated accounts: Some industries are more complicated than others. But if a non-financial firm has many subsidiaries, and engages in complicated financial transactions, watch out. The classic example is Enron, which traded energy derivatives and set up subsidiaries, called "special purpose entities", to inflate profits and hide liabilities, before collapsing in the early 2000s. In short, if you can't follow how a company makes its money, don't invest.
2. Rapid growth in accounts receivable: One way for struggling companies to boost sales is to allow customers to buy on credit, even if they aren't particularly creditworthy. So watch out for sudden growth in the "accounts receivable" (what companies owe) line on the balance sheet. If this represents a large proportion of overall revenue, and is growing more quickly than total sales, be wary. At the very least, the company is vulnerable to customers defaulting.
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3. A big gap between cash flow and operating profits: There are many ways for managers to manipulate profits. One is deliberately to cut depreciation costs (the amount firms deduct for wear and tear on equipment) or amortisation costs (the cost of intangible assets) by spreading them over longer periods. Cash flow is harder to fiddle, so a big (and growing) gap between net income and cash flow is a matter for concern.
4. Sugar bowling: This is the art of under-reporting profits one year and exaggerating them the next, to suggest that revenue is smoother than it really is. One method is to set up reserve (or contingency) funds then transfer money between them and the main balance sheet. There are sound reasons for firms to do this, such as setting aside money pending the outcome of a legal case.But those that set up reserves for no reason and shuttle large sums between them should be viewed with suspicion.
5. Prickly management: Few companies take criticism well. But if a company's management appears especially sensitive, or starts to claim it is the victim of an organised "short-selling" conspiracy, then be alert studies show that short sellers get things right more often than not. Managers should ultimately be focusing on running a successful business not talking up the share price.
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