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Avoid Bad Apples by Watching These Red Flags

July 30, 2013 | About:
Apart from the quantitative red flags found in the financial statements, the business practices and actions of the company can give clues to whether the company is shareholder-centric and if they will do things detrimental to the interest of shareholders.

Resignation of Key Managers, Directors or Auditors

Resignation of auditors or frequent change of auditors (more than two auditors within a five-year period) could suggest unsettled disputes on accounting practices or outright fraud. Ditto for CFOs.

Senior managers leaving the company prematurely without a valid reason should also worry investors. Similarly resignation of non-executive directors will point to existing or potential corporate governance issues.

Frequent Fund Raising

Companies should be returning excess capital to shareholders in the form of dividends or repurchases. Companies which frequently raise capital or borrow are at the mercy of capital markets. In the worst scenario, a Ponzi scheme could be at work, with companies seeking capital to fund “fake cash.”

Significant Insider Sales

Insiders like management and directors have significantly more insight into a company than outside passive minority investors. Heavy insider selling within a short frame of time is indicative of the confidence of the insiders in the company’s prospects. Furthermore, if insiders continue to sell down a stock whose price is continually dropping, this is a big red flag.

In the case of major corporate failures - Enron and Worldcom in the U.S. and Satyam in India - heavy sales of insiders were a signal of serious fraud. Insiders aware of the troubles ahead will tend to cash out.

Significant M&A

Significant major mergers and acquisitions (M&A) activities make it difficult to assess a company’s track and raise the risk of corporate divorces on the fortunes of the company. M&A also hides skeletons in the closet through the illusion of size and growth, and potentially helps bad management to siphon cash into their own pockets. Overpaying for target companies and di-worsification into business areas outside core competencies are perfect recipes for failure.

Change in Accounting Policy

Change in accounting policy, accounting classification and accounting estimates are signs of aggressive accounting and creative accounting. For example, the useful life of property, plant & equipment (PPE) could be extended on the basis of productivity improvements, but the actual impact is to increase the carrying value of assets on the balance sheet and to boost net income by reducing depreciation expense.

Complicated Business Structure

Significant income from investments in associates, non-consolidated joint ventures, makes it difficult the verification of sources and uses of its funds, as well as valuation of assets on its balance sheet.

In addition, as debt related to associates and joint ventures are not consolidated on the balance sheet, the gearing of the company could be severely understated.

In Summary

Signs of corporate governance risks can be picked out by paying special attention to reading through the annual reports and filings by the company.

About the author:

Mark Lin
Mark is a private value investor and runs the Cheapskate Investing website which borrows from the wisdom of value investing giants, using a systematic quantitative screening approach to filter the global stock markets for cheap deep-value cigar-butts and wide-moat compounders. He is also a regular contributor to various value investing communities.

Visit Mark Lin's Website


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