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Chris Mydlo
Chris Mydlo
Articles (166) 

Use Warnings Signs To Better Understand The Risks

September 24, 2014 | About:

The most important aspect of investing is understanding the risks involved. GuruFocus’ Warning Signs can help alert you to possible red flags. As recently highlighted by the Barron’s article, Where to Get the Best Accounting Analysis, the Warning Signs feature at GuruFocus prominently displays the warnings at the top of the stock summary page based on 32 measures of financial strength, profitability, growth and valuation. The warning signs are categorized as either “severe” or “medium.” Good signs are also displayed on the page.

The Warning Signs feature will help steer your attention towards an area that needs further investigation. Although the stock might look cheap compared to its earnings (P/E), sales (P/S) or book value (P/B), there might be some underlying issues bubbling towards the surface making the stock a value trap.

RadioShack (RSH) looks to be on the brink of bankruptcy with only $31 million in cash along with a negative operating cash flow of $-87 million and free cash flow of $-103 million for the second quarter. The company will need to do some wheeling and dealing to improve its balance sheet. GuruFocus editor and writer Holly LaFon brought attention to RadioShack using the warning signs two years ago with the article, “Cheap Stocks Keep Getting Cheaper: Fundamentals And Warning Signs.” The warnings signs were bringing attention to RadioShack’s long-term decline in gross and operating margins. The stock closed at $2.44 the day the article was published, October 19, 2012. The stock is now at $0.83.

The warning signs are meant to draw investors to certain aspects of the company for further investigation and possibly avoid value traps. For some examples in today’s market, I used the GuruFocus All-In-One Screener to find low P/E stocks with at least 4 severe warning signs. Although the stocks look cheap with low P/E ratios, the warnings signs can indicate reasons why the stock might not necessarily be a bargain . Clicking on the warning signs button will bring you to the analysis page for more information.

BHP Billiton PLC (BBL) is trading at a low P/E ratio of 7.80, but has 4 severe warning signs. The large cap company is a subsidiary of BHP Billiton Group and operates as a diversified natural resources company worldwide. Here are its severe warning signs:

  • Operating margin: Declined – BHP Billiton Plc’s operating margin has been in a 5-year decline. The average rate of decline per year is -1.5%.
  • Cash Flow: Divergence from reported earnings – Cash flow from operations has a severe divergence from the reported net income. This may suggest that the company is not receiving payment from its customers or it has other activities affecting its cash flow.
  • Asset Growth: Faster than revenue growth – If a company builds assets at 21.8% per year, faster than its revenue growth rate of 12% over the past 5 years, it means that the company may be getting less efficient.
  • Days Inventory: Building up – If a company builds up inventory, it may mean it is having difficulties selling goods.

Cincinnati Bell Inc (CBB) is trading at a low P/E ratio of 8.50, but has 4 severe warning signs. The company provides diversified telecommunications and technology service primary in Greater Cincinnati and Dayton, Ohio areas. Here are its severe warning signs:

  • Beneish M-Score: Possible manipulator – The Beneish M-Score is 4.87, higher than -2.22, which implies that it might have manipulated its financial results.
  • Per Share Revenue: Declined – Cincinnati Bell Inc revenue has been in decline for the last 5 years.
  • Operating margin: Declined – Cincinnati Bell Inc’s operating margin has been in a 5-year decline. The average rate of decline per year is -15.19%.
  • Cash Flow: Divergence from reported earnings – Cash flow from operations has a severe divergence from the reported net income. This may suggest that the company is not receiving payment from its customers or it has other activities that are affecting its cash flow.

Approach Resources (AREX) is trading at a low P/E ratio of 8.30, but has 4 severe warning signs. It is engaged in the acquisition, development, exploration, and production of oil and gas properties primarily in the Permian Basin in West Texas. Here are its severe warning signs:

  • Gross margin: Declined – Approach Resources Inc’s gross margin has been in a long-term decline. The average rate of decline per year is -1.3%.
  • Long-Term Debt: Keeps issuing new debt – Approach Resources Inc keeps issuing new debt. Over the past 3 years it issued $196.149 million of debt.
  • Cash Flow: Divergence from reported earnings – Cash flow from operations has a severe divergence from the reported net income. This may suggest that the company is not receiving payment from its customers or it has other activities that are affecting its cash flow.
  • Asset Growth: faster than revenue growth – If a company builds assets 38.5% per year, faster than its revenue growth rate of 23.2% over the past 5 years, it means that the company may be getting less efficient.

The purpose of Warning Signs is to warn you that the company may have red flags in certain areas, helping to avoid overlooking them. These warning signs do not necessarily mean you should not invest in the stock. But you should be aware of them before you invest. For more information see the feature article, “New Feature Announcement: The Warning Signs.”

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