When companies suffer a catastrophic drop in their share price, it is investors and employees who lose out.
But my years as a fund manager have taught me that many of these disasters could have been predicted by little more than a browse through the annual reports.
Getting the odd stock pick wrong is forgivable. But it is inexcusable to make a series of blunders on an industrial scale.
Stock market flops: Investors could have avoided backing the firms which have seen huge share price falls this year by following simple rules
Neil Woodford, for instance, disregarded numerous tried and tested rules in the management of the Woodford Equity Income fund, which led to a once-famous fund manager having to spend more time with his family.
Picking stock market winners consistently is very difficult, which is why even the best professional investors rarely stay at the top of their game for ever.
But it is possible to avoid stock market disasters. This is probably more important than picking winners.
You can do this through a simple analysis of annual reports. Apply the ‘Iceberg Principle’: an annual report is only the tip.
It cannot tell you all you need to know, but if there is something in it that makes you feel uneasy, there may well be other, even more worrying things, lying below the metaphorical water line. Remember, also, that cash is king.
These simple rules can help you make money regardless of what themes and trends are playing out in financial markets.
Rule 1: The only fact is cash. Avoid companies that don’t generate it. It’s quite simple, despite all the welter of figures and spin that companies throw at investors, every number in a set of accounts, except cash, is a matter of opinion.
Rule 2: Avoid companies that have large amounts tied up in long-term contracts.
Who knows if they will ever get paid? The collapse of Carillion in 2018, one of the Government’s favourite construction companies, was a corporate disaster where a cursory look at the balance sheet would have indicated it was heading for a fall.
Carillion did not generate cash, and its profits relied on the questionable basis that it would be paid large amounts owed on complex long-term construction contracts.
Rule 3: Avoid taking shares in floats. They are liable to be over-priced. Take the UK’s only remaining luxury car maker, Aston Martin Lagonda, which came to the market in 2018. The shares have free-wheeled downhill since then.
Treat floats brought by private equity owners with extreme caution as they are adept at getting out at the top of the market and often load companies with debt.
Rule 4: Avoid money lenders that fail to provide for bad debts. Any old fool can lend money. Getting it back is the difficult bit.
A lesson indeed to payday and peer-to-peer lenders. Amigo, Provident Financial and Funding Circle – all disastrous investments.
Rule 5: Steer clear of acquisitive companies. Mostly, big deals do not add shareholder value.
Just ask all those investors who supported the acquisition of Autonomy by Hewlett Packard, or Slater and Gordon’s purchase of Quindell.
Rule 6: Look out for broken trends. Looking at a series of numbers from one year to another would have been a useful exercise for investors in AO World and Pets At Home.
Normally, balance sheet items, like debtors and creditors, move roughly in tandem with a company’s activity levels. If that is not the case, it should ring an alarm bell.
At online electricals retailer AO World, a spike in spending on advertising with search engines – which was clearly shown in the company’s helpful float documents – indicated that there was a new cost paradigm in play and previous profits were going to be difficult to replicate. It has yet to report a profit since it floated.
As for Pets At Home, its financial statements at the time of its float showed that it had already benefited from the swing in sales from low-margin tinned dog food to high-margin dry food.
Rule 7: Avoid buying companies with large amounts of inventory.
It is always difficult to detect fraud from a company’s annual report. Just ask Luke Johnson at Patisserie Valerie.
But the level of inventory indicated that the Black Forest gateau may have been 80 days old, which should have rung an alarm bell.
Anyone who looked would have thought that was unbelievable – and they would have been right.
Tim Steer is the author of The Signs Were There, published by Profile Books.
Popular Shares – British American Tobacco
British American Tobacco may be one of the world’s biggest cigarette makers, but investors’ attention these days is focused squarely on its vaping and new products business.
After rival Imperial Brands’ profit warning in September, which blamed a US crackdown on vaping, shareholders will be seeking reassurance BAT hasn’t been hit by the same problems when it releases a trading update on Wednesday.
Chief executive Jack Bowles, who took over in April, has already launched a restructuring plan that will axe 2,300 of 55,000 jobs worldwide by the end of next year and put more of an emphasis on e-cigarettes and heated tobacco products.
This leaves the company more vulnerable to regulators in the US, who have proposed banning flavoured e-cigarettes to make them less appealing to teenagers.
The Lucky Strike and Pall Mall maker got a boost this week when US authorities temporarily shelved plans to reduce the content of nicotine in traditional cigarettes – but this is still a future risk.
Analysts will be seeking an update about BAT’s debt levels, which are higher than many in the City would like after its £38billion purchase of US group Reynolds in 2017.
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