Investing money in listed companies is risky. Even high street names such as Woolworths can go bust while major brands can fall from grace with spectacular speed.
Remember Ratners, the high street jewellery retailer? At a speech to the Institute of Directors in 1991, the company’s CEO Gerald Ratner explained that he was able to sell his products at such a low price because they were “total crap.”
Not the best PR exercise in the world if you are looking for people to invest money in your business. Not surprisingly (though obviously it was a surprise to Gerald), the value of the Ratner group fell by around £500m. By 1993 the Ratner brand name no longer existed.
Not every company fails due to ill-chosen words from its CEO. HMV and Blockbuster Video were household names that went bust because technology stole their business.
Donald Trump’s Trump Entertainment went bust twice – in 2004 and 2009. In 2001, Independent Insurance – one of the top ten UK insurers, went spectacularly bust. It’s chief executive was later jailed for fraud.
From Enron to Lehman Brothers, how do companies go bust so quickly and what were the warning signs investors missed?
Hiding the truth
One of the main reasons people miss the warning signs is that they are not always obvious due to lack of transparency. Take Maxwell Communication Corporation, as an example. On the face of it a highly successful FTSE100, media operation with businesses in the UK and in the US.
In 1988 Maxwell acquired Macmillan Publishers a large US name and the same year launched a trans-global newspaper, The European. But by 1991, the company was in administration with the full extent of its debts only coming to light following the chairman’s death.
The information leaving the company had always been tightly controlled – in fact, the proprietor, Robert Maxwell, kept most of his own directors in the dark. It emerged that he had used hundreds of millions of pounds from his companies' pension funds to save his empire from bankruptcy.
Accounting firms under scrutiny
In this instance, the accounting firms came in for scrutiny on the diligence of their financial reporting. Even today, the Financial Reporting Council has big-name accounting firms under investigation and individual accountants are struck off and banned from practising.
With so much power vested in the hands of a single man, should more question have been asked of Maxwell? With hindsight, the answer is yes.
Only 20 years earlier the Department of Trade found Maxwell unfit to head a public company and unable to differentiate between his own funds and those of his shareholders. A warning sign was there for anyone who looked.
Investing money unwisely
What other warning signs are there for investors that companies might go bust?
Production levels might be dropping or the company’s new orders book might be looking sparse. They may be struggling to pay suppliers. The company may have been told they can have no more credit or the painfully unfavourable terms offered by lenders could spell trouble ahead.
Widescale redundancies or major store closures, however they are dressed up, are seldom a sign of rude health. Is it a leaner, more efficient operation focussing on core strengths or just a business on its last legs?
The senior leadership team may be lacking in ideas and musical chairs in the boardroom should make any investor nervous. Unexpected changes at the helm can be a major warning that the ship is sinking. An out-of-the-blue resignation by the CEO citing ‘personal reasons’ is a red-flag event.
A company cutting back on employee benefits is usually a negative sign that all is not well. It’s not exactly good for workplace morale either. That might not be the best time to be investing money in this company.
Cash is king
One of the big issues is cash flow. Good companies run into cash flow problems – not just bad companies. In seeking critical mass, many promising, fast-growing businesses have gone to the wall because they didn’t have enough cash to keep expanding.
It is not difficult to monitor cash flow at public companies since they report revenues, profits and cash flow at the half and full year. Look at the company’s quarterly/half-year/full year cash flow statements – you want to see more pounds going into the business than leaving it.
Debt itself isn't necessarily a problem. Debt can be used for growth, hiring, development into new markets and ev en acquisitions. However, if debt becomes excessive relative to cash flow, problems start to build.
When companies start talking about debt restructuring and you read about potential missed interest payments, the party may be over.
The rumour mill
Nobody would ever suggest investing money in or selling shares on the basis of rumours – let’s face it message board posts can often have ulterior motives.
However, if negative comments about a company persist and denials from the senior management don’t exactly fill you with confidence, then the exit door might be the prudent option.
It's not always clear when companies are facing bankruptcy. If it were, investors would never have their fingers burnt. Companies typically reassure shareholders that a turnaround is imminent right up until the bitter end.
Distinguishing a company with growing pains and short-term liquidity problems from one that will go under is not easy.
For instance, falling sales might be a concern but it could be due to seasonal demand or leadership issues that have since been resolved. The company could be well-placed to bounce back with new products and designs – only time will tell.
One warning sign should not necessarily influence a decision to bail out as an investor. But it should trigger a stress test of a company to see if the prospects of the business truly stack up.
Rather than focus on one set of sales figures, does the company have consistently falling sales? Is the decline in revenue combined with persistent losses and high debt levels?
The more headwinds a company faces, the less likely it is it will stay afloat. While bad news might mean the stock valuation of a prestigious brand seems incredibly cheap – don’t ignore the piling evidence. What looks, feels and smells rotten normally is rotten.