How to spot a dog

Written by Susanne Baillie

Worried that your hard-earned dollars may be wrapped up in the next Enron or Nortel? When it comes to equities, just who can you trust and how can you spot tomorrow’s dogs? It’s simple: Do your homework. Basic due diligence can help you tell whether an investment is worth a second look. And the same practical business sense and experience that helped you build your business can give you a leg up when evaluating stocks. Of course, there are no guarantees, but there are plenty of checkpoints and red flags that may signal danger ahead. Here’s what to look for:

A weak business model:

Start with the basics and “apply common sense,” says Murray Leith, VP and director of investment research at Vancouver investment firm Odlum Brown Ltd. Some questions to ask: Does the company you’re considering have a strong competitive position? Will it be able to survive? History won’t necessarily repeat itself, but look for a record of stable or growing earnings and a decent return on shareholders’ equity. “All businesses have to reinvest in themselves to change with the evolving competitive landscape,” says Leith. “If a company is not generating a decent return on its capital, then it won’t have the means to keep up with the Joneses.” He suggests favoring companies that pay dividends, which indicate their earnings are real and their cash flow is healthy.

Execs who don’t deliver:

Suss out managers who aren’t true to their word. “Grab the last five years of a company’s annual reports and start reading from the earliest one forward to see what was in the chairman’s and CEO’s messages each year, what were their goals, did they attain them and did they have reasonable excuses if they didn’t,” says Leith. That will give you a good idea of how much you can trust their forecasts and proclamations. You can find company reports, proxy statements and other public securities filings online at www.sedar.com.

Richer or poorer?

Even if you earn $200,000 a year, you probably don’t consider yourself rich, suggests a recent survey by American Express. The AMEX study, which examined Canadian attitudes toward money, found that more than half of those with incomes of $200,000 believe they are just getting by on their salary. Interestingly, the majority of high earners are twice as likely as most people to spend $2,000 per person on vacations (48%), pay $250 for a hotel room (58%) and drop $100 on dinner (94%). Rich or not, says AMEX director of marketing Debra Ambrose, this group has high expectations: “They are willing to pay for the best.”

Suspicious financial statements:

You don’t need to be a financial analyst to pick out dogs, but a working knowledge of financial statements will help. Red flags can hide here. For example, if a firm’s accounts receivable are rising as fast as sales, then the company may be selling product and booking the profit on the statements, but not necessarily getting paid for those sales. “That’s something Nortel was doing,” notes Leith. “They were giving product away and saying, ‘Pay us later.’ In the end [customers] never did pay for that product, so Nortel had huge receivables they never got paid for.”

Examine inventories as well. “If a company is building their inventory, perhaps they’re producing too much and that’s been helping them lower their unit costs, but down the road that’s going to have implications,” he says. If the firm can’t unload the inventory, it will have to take a writedown.

Always read the footnotes to financial statements. That’s where you’ll find information on accounting policies, changes in accounting methods, litigation matters and executive stock options. Companies often hide unpleasant information here, hoping the average investor won’t read it. Generally, the more complex the financial statements, the more opportunity there is to massage the company’s financial picture.

Management-dominated boards of directors:

Outsiders are more likely to act as effective checks and balances to executive behavior and policies, so make sure the majority of directors are independent, says Don Reed, president and ceo of Toronto-based Franklin Templeton Investments Corp. Only independent directors should sit on key committees, such as audit and compensation. Look for companies that also separate the duties of chairman and CEO, says Reed (who is also on the board of the Canadian Coalition for Good Governance, www.ccgg.ca). It’s more likely that resolutions will be implemented if the CEO is accountable to a board he doesn’t run.

CEOs without ownership:

Management and directors should own stock in the company, says Leith. “That provides you with more comfort that your interests and their interests are aligned.” As proof of commitment, suggests Reed, check for an investment of at least two to four times their annual compensation from the firm.

Aggressive growth by acquisition:

“A lot of failures over time have been aggressive acquirers of businesses,” says Leith. (Think Laidlaw and the Loewen Group.) Not all heavy acquirers are ticking bombs, “but when companies are growing through acquisition, they’re afforded a fair amount of latitude to manipulate the numbers.” Examples include confusing restructuring charges or reserves the company can bring back into earnings down the road. “Even a full-time analyst can find it difficult to ascertain whether or not there’s any funny business going on.” If you don’t have the know-how or the time to investigate fully, run away, recommends Leith: “Only invest in things that you can understand and make sense of.”

Exercise your rights: Vote your shares, no matter how small your holdings. “If all those [smaller] shareholders vote, they do have influence,” says Reed. “Silence is consent.”

© 2003 Susanne Baillie

Originally appeared on PROFITguide.com