It is said that we learn as much from failure as we do from success.
This is just as true in investing as in life: we can learn from the struggles of companies that have gone bust, as well as those that have survived.
While there are tell-tale signs that a company’s share price is going to plunge, businesses will use accounting techniques to hide their weaknesses – so the trick is knowing how to read between the lines.
“The dives in share prices and company disasters that resulted in bankruptcy could have been predicted by little more than a browse through the annual reports, if you knew where to look.” Those are the words of retired fund manager Tim Steer, in his book The Signs Were There, published in November.
Steer examines 20 share price collapses, revealing how companies can disguise the truth about their financial health. Here are four of his examples, offering clues about what you should be wary of when picking stocks.
Floating and sinking
Buying shares in an initial public offering (IPO) can be risky business. Aside from the lack of historic information, Steers warns that it is often in the bankers’ interests to maximise the valuation of the company.
This was evident with Sports Direct. Just six months after its shares were listed in 2007, the company warned that it was not going to meet profit expectations for the next few years. In 2008, a year after its flotation, underlying profits plunged by 51 per cent.
It then took five years for the firm’s share price to reach the original 300p they were sold for at the IPO.
Though Steer points out that the “rushed away listings” meant that investors had little time to read the full IPO prospectus, he stresses that this document contained information that should have rung alarm bells – particularly in relation to a huge £20m stock write-down charge included in the inventory in the previous year.
By writing down an asset in one period, companies can produce a profit when they actually sell it, meaning they can choose when a profit is reported. Steer explains that, with a 70 per cent mark-up on sports goods, this potentially amounted to £34m of extra profit recorded in the year of Sports Direct's flotation, with no direct costs attached.
The lesson we can take from this? Inspect the balance sheet of a company before an IPO, and don’t ignore massive reductions in asset valuations, which might hit profits later down the line.
“One way to make costs disappear is to change them into something different by calling them assets,” says Steer. “That way the costs are removed from the income statement to the balance sheet.” This keeps profits moving ahead, and means that bosses can keep their well-paid jobs, while share prices fly.
He uses the example of failed public outsourcing company Connaught, which capitalised large amounts of staff costs, attributing this to building a new software system (which was recorded as an “intangible asset” on the balance sheet). Steer says that the big increases in the amount being capitalised (that is, making it count as an asset rather than an expense) should have raised suspicions.
In reality, the company was failing to cope with unexpected costs and obscured these problems in its balance sheet. Steer says that investors should pay attention to any “intangible” assets, particularly if they bypass the income statement.
“The overriding lesson of intangibles included in a company’s annual report is that they cannot be precisely assessed or defined,” he writes. “Because of this, they offer great scope for companies to massage their profits (up or down) and so are always worth looking at with care in a company’s annual report.”
While acquisitions are often see as a sign of strength, Steer warns that acquisitive companies rarely deliver value to shareholders. Sometimes this is because the deal makes little sense, or because there is a clash in cultures, but sometimes it can in itself be a sign that all is not well.
Take disaster recovery specialist Guardian IT, which made a string of acquisitions in 2000. “The company’s shares may have been riding high, but there was no growth in profits from its core activities. The growth reported was the result of very expensive acquisitions,” says Steer, pointing out that the lack of organic growth should have served as a warning.
“Companies that rely on acquisitions for growth need to be treated with caution,” he continues, stressing that profits can be manipulated in the short term through mechanisms like fair value adjustments. “It is often only a matter of time before the music stops and the weakness in the core activities is exposed.”
Finally, look out for a change in the quality of a company’s assets. Steer points to one example in our recent memory: Carillion. Before its collapse last year, the company was plagued with problems, and Steer says it was only surprising that it didn’t go bust sooner.
Most of the problems were rooted in the inadequacy of construction contracts, which he says rely too heavily on estimates that are easy to manipulate. Warnings include Carillion’s string of acquisitions (which failed to boost earnings), rising debt, and a rapidly growing pension deficit.
Carillion was taking longer to get paid by its customers, causing the amount of money owed on construction projects to rise drastically. This was a sure-fire sign that its overall current assets were reducing in quality, and therefore indicative of bad things to come.
So while we don’t have a crystal ball for the future, there’s a lot we can learn from the mistakes of the past.
And unfortunately, finding strong companies is often a matter of reading between the lies.