Aggressive international expansion, poor cash flow, celebrity CEOs and crowded trades are among several ‘red flags’ that investors should beware of when considering which companies to back, according to Orbis Investments’ Rob Perrone. 
Investment counsellor Perrone said through its research on companies whose share prices have fallen and never recovered, the asset manager has been able to identify several red flags that investors may find useful.
Aggressive international expansion
The first red flag for investors identified by Orbis is aggressive international expansion. This is best illustrated in recent years by Royal Bank of Scotland under former CEO Fred Goodwin, who oversaw the acquisition – as part of a consortium – of Dutch banking giant ABN AMRO.
“In the years before the global financial crisis, the Scottish banking group went on an international buying spree, hoovering up banks and stretching its balance sheet to the limit,” said Perrone.
“The adventurism ended in tears – in 2008 the group had to be bailed out by UK taxpayers.”
Performance of stock over 15yrs
Source: FE Analytics
As the above chart shows, the bank has failed to recover to pre-crisis levels and it remains majority-owned by the UK government.
He said: “While international expansion is not always a bad thing, it is an expensive business, requiring a lot of capital to make inroads into often unfamiliar markets and should be looked at closely, rather than taken at face value as a promising avenue to growth.”
No cash flow
The absence of cash flow is a potential red flag for investors as the Orbis investment counsellor said “one of the biggest signs that all is not well with how a company manages its finances”.
“Companies that are continually short of cash and funding their operations with credit are an obvious concern,” said Perrone. “In everyday life, these companies can be likened to those who are permanently broke despite boasting a nice car and an impressive house.”
Expensive money-raising
Investors should also consider why and how a company is raising money: issuing new shares or taking on more debt can often lead to troubles further down the line.
While new issuance is a fairly common way for listed companies to raise money, it is not always in the best interest of investors.
“Unless the shares are richly priced, this is an expensive way to raise money and it can dilute the value of the shares held by existing investors who could be left owning a smaller portion of the company – forever,” said Perrone. “So, if a company starts raising equity, look closely at its motives.”
Additionally, rising levels of corporate indebtedness can be a red flag for investors.
“For many companies, some debt is appropriate, but excessive debt can leave a big hole that one day needs to be filled,” said the Orbis investment counsellor. “If the company struggles, servicing that debt can quickly overwhelm a business.”
Celebrity CEOs
Outspoken and high-profile chief executives have become as increasingly common as companies have embraced celebrity culture. Yet, in some circumstances that can spell danger for investors.
“The success of programmes such as The Apprentice, Dragons Den and The Shark Tank, not to mention the drama and intrigue surrounding Tesla’s Elon Musk, is testament to the increased interest in business personalities in pop culture,” said Perrone.
Performance of stock over 1yr
Source: Nasdaq
“And, like it or not, admiration for the individual makes people, including serious investors, less sceptical and willing to overlook warning signs.”
He added: “While Musk, for example, may well be something of a genius, he shirks discussing cash flow in favour of more entertaining commentary, while his company has a significant amount of debt and has raised capital repeatedly.
“All factors that may not be noticed by investors star-struck by the personality at the helm.”
Incentivised management
Something else investors should look out for is whether management’s interests are aligned with shareholders or if they are remunerated in a different way.
“If the company leadership are founders or shareholders, or the incentive structure is sound, their interests are likely to be aligned with investors,” explained Perrone.
“But if bonuses are based on weak targets that could be easily hit or even manipulated, management may be more incentivised to cash in their own rewards at the expense of shareholders.”
Overly complex corporate structures
Investors should also beware of companies that are overly complex using shell companies, cross holdings or subsidiary networks in different jurisdiction. Such practices are usually employed to hide what companies are doing from investors.
“This can make the reading of financial reports difficult, and distort the true financial position of a business,” said the Orbis investment counsellor. “Complex structures therefore warrant proper research and the effort required to gain full understanding of the structure and rationale for it.”
Crowded trades
The ‘fear of missing out’ (or ‘FOMO’) phenomenon that leads to crowding and bubbles in markets should be avoided, given the tendency of bubbles to burst leaving investors much worse off.
One such example is the ‘dotcom’ bubble of the early 2000s as investors sought out fast-growing online retailers and communications companies as internet usage expanded dramatically.
Indeed, between 10 March 2000 – when the Nasdaq Composite index peaked – to the trough of 9 October 2002, the index lost 77.93 per cent, as the below chart shows.
Performance of index 10 March 2000 to 9 October 2002
Source: FE Analytics
“Any company or sector that appears to be a crowded trade, should come with a serious wealth warning,” said Perrone.
However, there are also time when markets panic and headlines tempt investors to alter long-term strategic allocations based on “short-term, often emotional, triggers”.
“Research into company fundamentals and assessing the risk/reward trade-offs is critical to the long-term success of an investment and even more so when market noise creates the temptation to make short-term decisions,” said Perrone.
Inflated share prices
Finally, investors should try to identify when share prices are trading at more inflated prices highlighting one particular practice employed by some companies.
“Active buying and selling of shares between subsidiary companies within a group can inflate share prices,” said Perrone. “Share prices go up because of the increased buying, but without any fundamental changes to the underlying businesses.”