If an investment loses half of its value you need it to go back up by 100% just to get hit break-even. This bit of logic might seem simple but it is one of the most important ideas to keep in your head when you are investing.

Avoidance of loss is a critical element to making money out of shares. You can pick all the winners you like and still be tripped up by just a handful of losers.

Over the years, the likes of property services contractor Connaught, IT firm Quindell (now re-named Watchstone (WTG:AIM)) and more high profile names like Royal Bank of Scotland (RBS) have wiped out or almost wiped out many investors.

None of us can be right all the time. Using tools such as stop losses, which automatically place a sell order for an investment if they fall through a certain pricing threshold, is sensible.

However, being an eagle-eyed investor can also help you avoid racking up the losses – either by avoiding bad investments or spotting red flag warning signs to get out quick.

In this article, we identify five red flags and look at some more recent real world examples to help illustrate how these can be applied to your day-to-day investing.

In our view this is the biggest red flag of all. If you can’t understand a company’s accounts or how it makes money, then don’t go near it as an investment.

Numerous companies on the stock market love to adjust their figures to make them look better. They claim it is to give a clearer representation of the underlying business, but most of the time they are trying to gloss over real items of the business that should be taken into account when assessing performance.

You’ll probably come across the term ‘aggressive accounting’ as an investor. This refers to a company’s deliberate and purposeful tampering with its financials to show its revenue or profit as being higher than they actually are.

Messy accounts are problematic for investors for a number of reasons:

• They make valuation difficult to ascertain, if not impossible

Deciding whether a stock is undervalued or overvalued is a key part of the investment process but if you can’t decode the earnings data then any conclusions are meaningless.

• They reflect poor corporate governance

If a company is willing to flatter its earnings through aggressive accounting then what corners is it prepared to cut elsewhere and what problems could this lead to in the future?

• It can demonstrate an over-emphasis on earnings growth

It is particularly concerning if a company is focused purely on growth in earnings per share (EPS) as this metric can be easily manipulated.

The best approach is for a company to build a strong competitive position from which it can deliver sustainable growth over the long term.

• Companies are nearly always found out in the end

A company might get away with inflating its earnings figures for some time, particularly in a rising stock market. Eventually it will need to deliver the cash flow to back this up. Failure can be devastating for the share price.

How can I spot problems?

A key way of identifying issues is to look at the difference between the headline or adjusted profit number and statutory profit. We have been cautious on researcher YouGov (YOU:AIM) for some time relating to this subject.

Results for the six months to 31 January 2017 showed an adjusted operating profit of £5.7m but a statutory operating profit of just £2.5m once exceptional items (£103,000) and amortisation of intangible assets (£3.1m) were factored in.

Amortisation is the routine decrease in value of an intangible asset such as intellectual property or a brand.

The company previously told us the amortised intangible assets are ‘lumpy’ so the adjusted figure presents a more accurate picture. As the table shows amortisation of intangibles have been in a fairly consistent range between £1.6m and £3m over the last five years.

The amortisation of acquired assets could obscure underlying performance but internally generated intangibles through organic investment should be seen as a cost of doing business. Looking back at the accounts, typically around half are internally generated.

Using the adjusted earnings per share of 8.8p from the full year results ending 31 July 2016 and 261p latest share price, the stock trades on 29.6 times earnings.

That looks expensive but not overly so when you consider this is an historic number and the market is expecting significant earnings growth. Applying the unadjusted EPS of 3.3p however implies a price to earnings ratio of 79 – which is sky-high.

The market does not seem overly concerned about the disparity at present. The shares are up 300% over the past five years, suggesting that investors like the impressive growth story as management roll-out the high margin Data Products and Services (DP&S) division.

However, any growing pains might see the market take a closer look at how the company is valued.

At least in YouGov’s case the adjustments are transparent and the company is not doing anything underhand.

The same cannot be said of managed services IT and communications supplier Redcentric (RCN:AIM) which saw its share price drop 70% in November 2016 after it discovered misstated accounts and its chief financial officer Tim Coleman was booted out.

Huge overstatement of profit

Full year results to 31 March 2016 included adjusted earnings before interest, tax, depreciation and amortisation (EBITDA) of £25.8m. It turns out these were overstated to the tune of £12.8m, with revenue overstated by £6.2m and costs understated by £6.6m.

This largely resulted from the company omitting costs for invoices which had yet to be received and booking revenue from invoices which had yet to be sent.

Net debt was understated by £12.5m at £25.3m as an overdraft with Barclays was excluded and, extraordinarily, an £8.5m cash balance was found not to exist.

Serious accounting problems like this almost certainly reflect wider issues in the business as Canaccord Genuity analysts Daud Khan and Paul Morland explain.

‘We note that in 2014, broadly the same management team claimed to have created a business capable of 23% EBITDA margins. Following the re-statements, we now have a business generating around half that promised level of profitability.

‘We find it hard to understand how accounting systems and controls can be blamed for a failure to achieve strategic objectives.’

UTILITYWISE: Red flags here, there and everywhere

Energy services group Utilitywise (UTW:AIM) should be part of every accounting or business studies course at university when it comes to practical examples of companies with a worrying number of red flags.

The two biggest problems for Utilitywise are messy accounting and a revolving door with staff both at the senior and junior level.

Utilitywise has long been criticised for having questionable accounting practices. It quickly recognises revenue from helping a client move to a new energy deal but it can take years for the cash to appear in its bank account. That’s because utility companies can be slow at paying commission for the types of customer Utilitywise brings them.

Some suppliers did provide cash advances; but Utilitywise has now decided to stop accepting this money in order to have greater independence from suppliers. It’s like it doesn’t want any cash!

This will result in a significant increase in net debt over the next few years, making its balance sheet look horrible. Shore Capital says the company is merely building foundations for the future. Sadly we’ve heard it all before when Utilitywise previously said it would sort out the revenue/cash delay issue and still hasn’t properly done so.

Panmure Gordon analyst Michael Donnelly estimates the recent half year results were the third year in a row where Utilitywise had to restate its accounts – another red flag in our book. ‘It’s tough to keep track,’ he says.

The same applies to management change. Last year the boss of Utilitywise’s most profitable division quit after less than 18 months in charge. Over the last few years we’ve also seen the deputy CEO and finance director leave; plus the CEO has switched roles to chairman and the COO moved over to do something else in the business.

High churn levels among call centre staff is also a concern, given how much time it therefore has to spend constantly training new employees. The latest results show an improvement in ‘energy consultant’ attrition to 25% from 39% a year earlier – but still too high, in our opinion.

Most analysts are positive on the stock; however the market seems to have a different view. The shares are down by nearly a third in value since March this year. They are down 65% in the past three years.

On 3 April 2017 shares in chip designer Imagination Technologies (IMG) lost 60% of their value as Apple opted to stop using the group’s graphics intellectual property within the next 15 months to two years.

This news demonstrated the risk of relying on just a single client for such a large chunk of revenue. Apple accounted for around half of Imagination’s sales, based on most analysts’ forecasts.

First, it leaves a business at risk of a massive revenue shortfall if the major customer walks away or orders fewer goods or services. Second, it puts the business in an extremely weak negotiating position should it need to pass on input cost increases, for example.

AJ Bell investment director Russ Mould notes another key risk associated with Imagination which also afflicts all technology businesses – namely that its technology is made redundant by innovation elsewhere.

‘Obsolescence risk remains a key challenge for any tech firm, no matter how cutting-edge their products seem to be today,’ he says.

‘The smartphone and tablet computer are just the latest developments in a never-ending cycle of technological evolution.

‘Each turn of the wheel has brought feast for a select few winners, who “got it” and had first-mover advantage – and also famine for those whose offerings were overtaken and left looking old hat...’

Plastic packaging firm RPC (RPC) has seen billions of pounds wiped off its market cap since it announced the £511m acquisition of North American rival Letica in February 2017.

The deal, funded by a £552m rights issue, was the company’s sixth acquisition in less than five months and saw investors turn on the company and the spotlight fall on declining returns on capital.

Most academic analysis of mergers and acquisitions (M&A) activity concludes that it is more likely to destroy shareholder value than create it.

The acquirer typically underestimates the costs of integration, overestimates the potential benefits or fails to acknowledge how cultural differences can be an obstacle to a successful outcome.

Bolt-on acquisitions used to supplement organic growth are less of a concern but large ‘transformational’ deals can imply a company has ignored valuation to bag its target for some strategic reason.

Schroders and Artisan Partners, who together own 9% of supermarket Tesco (TSCO), are opposing its £3.7bn takeover of wholesaler Booker (BOK) for just this reason.

In a letter sent to Tesco chairman John Allan, fund manager Schroders argues ‘there is compelling academic and empirical evidence that, on average, acquisitions destroy value for acquiring shareholders’.

Schroders argues the high price paid for Booker, 23 times peak operating profit by its reckoning, makes the destruction of value ‘even more likely’.

The ‘strategic’ rationale for the deal is to tie up the end-to-end wholesale and retail business to create cost savings of around £200m a year.

RPC’S Red flags

Shares in RPC have begun to slide following its latest quick-fire trio of acquisitions, writes AJ Bell investment director Russ Mould.

This wheeler-dealing, coupled with restated accounts, an increasingly indebted balance sheet and less-than-ideal triggers for management bonuses and options are all potential red flags.

Rapid acquisitions can work well but these so-called industry roll-ups can come unstuck if deals come too quickly and target selection goes astray, so execution risk is high.

In addition, the accounts for 2013, 2014 and 2015 were restated the following year, while the profit and loss is littered with items which are deemed ‘exceptional’ – only for them to keep recurring.

Meanwhile, management bonuses are heavily tied to ‘adjusted’ operating profit, a figure which has come in between 38% and 83% above stated operating profit in the last three years.

Stripping out all those so-called ‘one-offs’ boosts executive pay, which is also linked to return on capital employed. This ratio could be flattered by regular impairment charges and write-downs which will lower the capital employed base.

Two-thirds of management stock options are linked to ‘adjusted EPS (earnings per share)’ – a figure which can be flattered by regular acquisitions and the exclusion of one-off items.

It is possible to grow EPS while still destroying shareholder value. The recent share price action suggests caution is warranted even if the stock no longer trades on a big premium earnings multiple to the wider UK market.

 

If a company is carrying a lot of net debt then a significant proportion of profit and cash flow is likely to be going towards interest payments. As a shareholder, you are part owner of a business, so that’s YOUR profit and cash flow being used to service borrowings.

High debt will reduce the likelihood of dividends and mean that a company has limited scope to invest for future growth.

In more extreme cases a company might default on its debts or breach covenants (based on a ratio of earnings to net debt agreed with a lender).

Even if a company does not go bust, it could be forced to offer its creditors equity in the business in return for forgiving its debts, leading to big dilution for existing shareholders.

Declining revenue and high debts = bad

A downturn in a company’s end market could be devastating if they are loaded with debt and have a fixed cost base.

Let’s take a hypothetical manufacturing business as an example. It generates £90m in revenue and costs are £80m, so it makes £10m operating profit.

Market conditions deteriorate and it only makes £60m revenue in the following year. The costs are still £80m, which means it has suddenly gone from a nice profit to making a £20m loss.

It therefore needs to use debt to repay debt! This is obviously unsustainable.

Oil sector caught out

The dramatic collapse in oil prices since June 2014 caught out several oil companies, some of which have been forced into heavily dilutive refinancings.

Existing shareholders’ ownership of Kurdistan oil producer Gulf Keystone Petroleum (GKP) was diluted to 5% after a debt-for-equity swap in September 2016.

You can now see why it is important to consider all a company’s liabilities when assessing its balance sheet.

Newspaper group Trinity Mirror (TNI) saw net debt fall by £62.4m to £30.5m in 2016. But a £160.8m increase in its pension deficit to £466m helps explain why the stock trades on a heavily-discounted rating of just 3.3 times forecast earnings. That’s greater than the current £325m market value of its shares.

There are several hazards associated with investing in a company run by an overly dominant or particularly influential chief executive.

First, they could leave at any moment; this is also known as ‘key person risk’. Having written positively on Allied Minds (ALM) in September 2016 we immediately changed our view after the surprise and unexplained departure of CEO and co-founder Chris Silva (13 Mar). We minimised our losses by taking decisive action.

Allied Minds helps people with new technologies to commercialise their ideas and we were concerned Silva’s departure would affect relationships with these innovators.

The shares are now down 56% in the wake of his exit and trade below the issue price from the June 2014 IPO, as the company subsequently suspended funding for seven of its subsidiaries.

Power play

Another risk is an all-powerful chief executive who runs roughshod over the rest of his board and shareholders.

Although it is some time ago, Fred Goodwin’s tenure at Royal Bank of Scotland is perhaps the best example. The (disastrous) €71bn acquisition of ABN Amro in 2007 was the culmination of
his hubris.

A situation where a chief executive wears more than one hat is also problematic. Wine retailer Majestic Wine (WINE:AIM) has just announced that chief executive Rowan Gormley would take over as managing director of subsidiary Majestic Retail following the departure of John Colley, as well as doing his existing duties as CEO.

‘A key concern is that Rowan may be taking on too much responsibility,’ says investment bank Liberum. ‘However as part of the transformation project at Majestic Retail, John set-up a “retail operational board” that meets once a week.

‘This team contains numerous roles that were not in existence previously and hence Rowan takes the lead of a business that is not only back in growth but has far greater depth and breadth.’

We take a sceptical view towards Gormley’s broadened role; so too regarding individuals who think they can do both the CEO and chairman role. For example, Stephen Marks does both these roles at retailer French Connection (FCCN) – whose shares are down 12% over the past 12 months.

The CEO should be the leader of the business; the chairman provides leadership to the board of directors. We cannot see any good reason why someone should do both jobs.

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