The first question novice investors always ask is – do you have any hot stock tips to share? Most of the time, I will just smile and politely decline to comment as I am not licensed to give stock recommendations. I enjoy doing analysis on companies and derive satisfaction from discovering gems. Rather than offer hot stock tips, i will rather share with my friends what are the kind of stocks to avoid. Negative demonstration is often the best form of education.
Warren Buffett is the greatest investor of our generation. He and his teacher Benjamin Graham epitomise Value Investing. They review financial statements of companies to determine whether they are under or over-valued. They have a systematic and disciplined approach to buy good businesses at undervalued prices that has made them rich.
The flip side of good companies are the bad ones that go down under. We can always take a leaf out of the book by looking at such negative examples. Sometimes, learning from the mistake of others can save us a lot of money and pain.
I was reading the Straits Times on 6 May 2020. The front page of Business section caught my attention. 3 big companies were featured as facing financial issues. I was very curious what went wrong with these 3 companies and how their financials looked like.
Useful Tools
Before I dive into the analysis, I will like to share with you some free online tools that I use for analysis. They definitely make my life much easier.
Morningstar: https://www.morningstar.com/
It is a global financial services firm headquartered in U.S. The cool thing is you can find detailed financial information of almost any stock listed on exchanges around the world on Morningstar – for FREE! Of course there is the premium version whereby you get more detailed and historical numbers. But for the good part of my investing life, the free version works well.
Just go to our best friend – GOOGLE…type in [company name] Morningstar. And there you go!
Gurufocus: https://www.gurufocus.com/
This is another financial services firm which offers free and paid data. I love their DCF calculator which shows you the Fair Value and Margin of Safety (Warren Buffett’s favourite numbers). Go play with it and have fun.
Now let’s look into the 3 featured companies in detail.
L Brands – owner of Victoria Secrets
L Brands is a women’s intimate, personal-care, and beauty retailer operating under the Victoria’s Secret, Pink, and Bath & Body Works brands.
Screenshots below taken from Morningstar for reference. Some of the “red flags” I observed which we should take note:
- The margins are very low, and in fact Net Margin is negative. Hence the business as a whole is not making money.
- Return on Assets is negative.
- Earnings Per Share (EPS) is decreasing and negative in the latest year.
Hertz – Car rental company
Hertz Global Holdings Inc operates an automotive vehicle rental service through the Hertz, Dollar, Thrifty, and Firefly brands.
Screenshots below taken from Morningstar ofor reference. Some of the “red flags” I observed which we should take note:
- The margins are very low, and in fact Net Margin is negative. Hence the business as a whole is not making money.
- Return on Assets and Return on Equity are negative.
- The debt compared to equity (Debt/Equity ratio) is very high. This is alarming as the company may not be able to meet its financial obligations, especially in a downturn.
- Earnings Per Share (EPS) is decreasing and negative in the last 2 years.
- Cashflow is negative and worsened in the last 2 years.
HTL – Sofa maker
- https://www.straitstimes.com/business/businesses-on-the-brink
- The company was delisted in 2016 and acquired by Chinese furniture company Yihua Lifestyle Technology.
- HTL’s core manufacturing activities in China were severely affected as a result of factory closures and movement restrictions imposed to control the spread of the coronavirus.
- Since we cannot find financials of HTL as it’s not a publicly listed company, let’s take it a step upstream and review the financials of its parent company listed on the Shanghai Stock Exchange.
Screenshots below taken from Morningstar for reference. Some of the “red flags” I observed which we should take note:
- The margins are very low, and in fact Net Margin is negative. Hence the business as a whole is not making money.
- Return on Assets and Return on Equity are negative.
- Earnings Per Share (EPS) is decreasing and negative in the last 2 years.
- Cashflow is negative and worsened in the last 2 years.
Conclusion
We can see there are common “red flags” in companies which end up in financial difficulties:
- Low margin businesses. After factoring in expenses, the net margins are negative
- Declining and negative cashflow. This could be due to low margins, significant investments in expansion and repayment of bank debts.
- Earnings per share is declining / negative. This destroys the shareholders’ value.
- Significant amount of bank debt which worsen the cashflow. Especially during a downturn, the company risk having the banks call on the debt which leads to further pressure on cashflow and possible bankruptcy.
Most of the times, there are early warning signs of trouble if we look at the trend of the key numbers / ratios. Strong companies exhibit traits which are direct opposite of the “red flags” we see above. Those are the companies which we should target to buy based on Warren Buffett’s value investing approach – Buy wonderful company at a fair price, rather than buy a fair company at wonderful price.
Disclaimer – The stocks mentioned in the article are purely for education purpose. I am not making any Buy / Sell recommendation.
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