The Value Investor’s Handbook: More Warning Signs to Look Out For

Over the last few days, I have been pointing out a number of accounting red flags that investors should be on the lookout for when analyzing businesses - changes in free cash flow, various debt ratios, off-balance sheet liabilities and so on. Today, I wanted to look at some warning signs that anyone should be able to identify - irregular behavior by corporate executives.

High employee turnover

Any large business that has a high level of churn at the executive level should raise some eyebrows. There are a lot of highly motivated individuals out there who would jump at the chance to become a chief executive officer, a chief financial officer or a chief legal counsel. Why would someone leave such a job - and presumably also a handsome compensation package - behind?

Sometimes there are innocuous reasons for turnover - a CEO might be getting older and seeking retirement, and of course personal reasons can often interfere in professional lives. But if a lot of people are leaving well-paid positions at a company, that is a huge red flag because there are really only three explanations for a coordinated exodus from a business.

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First, it may be the case that executives are being poached from their positions - not a good sign for a business that is presumably trying to retain top talent. Second, they may be bad at their jobs, in which case that would suggest that the business is bad at identifying talent. Third, they might leave because they uncover some deep systemic issue at the company and want to get as far away from it as possible. None of these are good signs.

This is particularly true if a lot of founding executives leave immediately following an initial public offering. While there is nothing inherently wrong with a founder wanting to sell their stake in a business and retire early, it is a bit suspicious for an entire team to do so right after dumping their stock into the public’s hands.

Heavy share selling by insiders

A related phenomenon to the one described above is when executives begin selling their shares in large quantities. Determining the intrinsic value of a company is hard, but one would think the people who run the business are best placed to know what it is.

They are also privy to insider information before the rest of the market. While it is technically illegal to trade on the basis of material information, securities laws can sometimes be open to interpretation, so there have been plenty of situations in which insiders have gotten away with selling their shares.

As company insiders, they are required by law to disclose such operations, so investors have full access to this information. You can, and should, keep tabs on what the executives and directors of a business are doing. After all, actions speak louder than words.

Read more here:

• Bill Ackman on Becoming an Activist Investor
• Charlie Munger and Warren Buffett on EBITDA​
• The Value Investor’s Handbook: The Importance of Cash Flow

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