"What do you guys think about Company XYZ?"
We get that question a lot at Motley Fool Pro, and for good reason. With over 2,000 ASX-listed companies putting out glossy results presentations, it can be tough to cut through the spin.
So this time, instead of talking about what makes a great company, we're going to run through 6 signs the company you are looking at is a dud…
1. It's Constantly Diluting Shareholders
Dilution might just be the dirtiest word in investing. And it can strike right when you least expect it.
Everything seems to be going swimmingly, your high-growth company's revenue is soaring and the share price has been rocketing up along with it. You are feeling pretty happy with yourself.
Then… boom! Out of nowhere the company is issuing more shares to raise equity, and diluting away the ownership stake of all its loyal shareholders. Suddenly a big chunk of that growth has to be shared with the new investors. The pizza got bigger, but it's been cut into more slices.
Even more painful is when that dilution comes after a fall in profits. The company hits a rough patch and management chooses to dilute current holders at the exact wrong time – while the share price is at record lows.
Unfortunately it is all too easy for low quality companies to raise extra cash by issuing more equity, often at a discount to the current share price. Existing shareholders are hurt, but management's corner offices remain undisturbed.
That is a big part of the reason we put a premium on trustworthy management. It's also why we love capital-light businesses with strong operating leverage – they can boost sales without having to stump up loads of extra cash.
The dilutionary equity raise is all too common in Australia, and especially with speculative miners. This insidious destroyer of long-term value is the first warning sign that the company is not deserving of your hard-earned capital.
2. Salvation Is Always a Year Away
A cheeky pub in New Zealand used to have a big sign beside the bar that read "Free Beer… Tomorrow".
Some companies seem to be perpetually stuck in gonna status. Next year we're finally gonna get approval for that experimental drug. Next year we're gonna start pumping all that oil we think we've found. Next year we're gonna launch our market beating product.
You get the idea.
Sadly, just like the punters at that bar, we eventually need to face up to the fact that for some companies, tomorrow never comes.
3. They Are Always Talking About the Size of the Opportunity – Not Their Progress
It's great to invest in companies with a big vision for the future and that are scaling in to ever larger markets. A huge international market opportunity can make the difference between a company becoming a stable local player, or a world-beating home-run.
But when the size of the market opportunity takes up the first 20 slides of the company's presentation, and there is no mention of current revenue, it's a sure sign that management have their heads in the clouds.
Big market opportunities are great, but only if the company is actually making progress to deliver on that potential. To do that, they need to actually get out in the real market and prove that they have a competitive advantage that will allow them to turn that potential into pay dirt.
If management are all talk and no walk, then there is no reason you need to keep listening.
4. It's Never Management's Fault
As investors we strive to take personal responsibility for our actions. There are always a lot of variables out of our control, but only by having an attitude that 'the buck stops here' can we learn from our mistakes and plan for the future.
The least we ask of our management teams is that they do the same.
If your company's management team is continuously blaming the weather, commodity prices, or challenging market conditions it's a sign that they are incompetent, it's genuinely a terrible business – or both!
We can check this out by reading through past presentations and seeing how the management team have faced up to previous failures. If it looks like management have a habit of shirking their responsibility, it's time to walk away.
5. Management Keep Selling Shares
Every now and then management will need to sell some of their shares for personal reasons. Perhaps they are purchasing a house, or a new jet ski, or buying a private island (I would if I could!). There will always be the occasional necessary sale.
But there is no surer sign that management don't really believe in the company than a pattern of steadily selling down their shareholding.
If we have to choose between actions and words we'll choose actions every time. If your company's management team are preaching a bright future while also offloading their shares as quickly as they can, then it might be a sign you should follow their lead.
6. A History of Losses
Jerry Maguire said it best: "Show me the money!"
All the glossy reports and bullish predictions don't matter if the company isn't able to turn their potential into positive cash flows. A long history of losses is a sure sign that the company has not been able to deliver on its promises.
Perhaps it's just a terrible industry, perhaps the company is poorly run. Either way it doesn't need to be your problem.
The only exception is when the company is going through an intense investment phase and pumping everything it can back in to feed its growth machine. But if that is really the case we can check the company's progress through revenue growth and market share, both of which should be soaring in response to their aggressive investments.
If a company has been continuously losing money and is showing no signs of gaining traction then it's time to cut the cord.
