The investment team at Avenue Investment Management learned an early lesson on red flags in the summer of 2003. The fledgling firm was poring over financial reports trying to build a solid portfolio when it came across the latest filing from Nortel Networks Corp. "We spent four hours on it and we just gave up and threw it in the garbage. It was 400 pages thick," partner and portfolio manager Paul Gardner says.
Turns out it was the beginning of the end for Nortel, which went from a total market value of nearly $400-million in 2000 to bankruptcy within a few years. In December of 2003, the communications equipment maker revealed an estimated $900-million in unstated liabilities over the previous 3 1/2 years.
In the end the team went with Leon's Furniture and its 15-page report. Leon's stock has more than doubled since then.
Complicated and cumbersome reports are just one red flag Mr. Gardner looks for when companies release financial reports. Here are some others:
– Start with the management team: Check regulatory filings and run Internet searches on the chief executive officer and chief financial officer to see whether they have been involved in failed or shady businesses. "Ask yourself: Would you give money to these guys?" he says.
– Read the footnotes: To adhere to general accounting principles, financial statements tend to be generic. Anything outside the format that is pertinent is often reported in the form of a footnote. Mr. Gardner says in some cases they are sometimes used to hide blemishes such as changes in auditors or accounting policies, or even pending litigation. "Everyone has footnotes but if there are a lot of footnotes, that's a yellow flag."
– Cash should be in hand: On the revenue statement some companies will record revenue before receiving the cash. "You ring the bell and make a big sale to a company that might not even pay you. You recognize the revenue and a quarter later you need to claim it back," he says. "Revenue should be recorded only when there is an exchange of goods and cash." He says the same rule applies to services, and provisions should be included for computer software companies with return policies.
– Over optimism: When companies list pension liabilities they sometimes get creative in their growth projections to make their financial obligations look smaller. He says the practice has become more prevalent in this age of rock-bottom bond yields. "If they put a discount rate of 7 per cent and interest rates are at 4 per cent, it would be a complete mess," he says.
Red flags can also be found beyond the financial statement. Brian Bolan, stock strategist at Chicago-based Zacks Investment Research, has seen all the signs. Here are a few:
– The CEO may be the boss but the CFO oversees the books. When a CFO change comes, most companies take great care to ensure shareholders of a smooth transition by announcing it far in advance. Sometimes it comes suddenly. "Any time you see that, you sell first, ask questions later," Mr. Bolan says. He adds that such a transition should be announced at least six months in advance and in most cases when the company uses the word "resigned," it's just a polite word for "fired."
– Avoid companies that are under investigation by government or securities regulators. "Any time there's an investigation, you want to get rid of the stock," he says. One current example he uses is auto maker Tesla Motors, which is being probed for three battery fires in its luxury electric cars.
He says even if Tesla manages to avoid liability, just the risk of a costly legal defence could hurt a stock. News relating to the investigation lopped off one-quarter of Tesla's stock value in just two days in early November. "It could be nothing, but it could be something. More often than not they're not going to have an investigation if it's about nothing," he says.
– When you start getting stock tips from people who aren't investment professionals there's trouble ahead. "You're definitely buying at the top when you're taking stock tips from your butcher or a cab driver," he says. Studies show retail investors are generally late to a stock rally, and late to get out.
He says the advice applies to individual stocks and the broader market. "When you get that tip from someone who shouldn't be giving it to you, it's more a tip about the entire market. It means you are at that froth level and you should take down a percentage of all your investments across the board."
– Media pundits tend to "talk their book." That means they already have a position in the stock they claim to love and they want other investors to buy it, too. "All these guys telling you about a stock are telling you about a stock they already own and they just want it to go higher," says Mr. Bolan.