While investing in the stock markets, we look for companies which are not only financially ‘healthy’ but also exhibit a ‘growth potential’ going forward.
But, how do we find such companies?
One way to go about it is to identify companies that you must stay away from.
By identifying companies to avoid, you ensure that you never invest in a company where there is a significant risk of loss to your capital.
In this post we look at companies you must avoid investing in.
1. Companies with corporate governance issues in the past:
Buying equity is taking part ownership of a company. When you invest in the shares of a company, you repose faith in the management of the company to run it in the best interests of its shareholders at all times.
However, where there have been corporate governance issues associated with the company, you cannot say that the management has always acted in the best interests of the shareholders.
I would insist that you stay away from companies where you cannot trust the integrity of the management/promoters.
2. Companies unable to generate positive cash flows from operations:
A very efficient metric to judge the efficacy of any company is to check whether it is able to generate more cash from its operations than it spends.
A company may exhibit negative cash flows in one or more quarters for various reasons. One of them could be the seasonal nature of the business, liberal credit periods on sales or any temporary contraction in demand.
However, businesses unable to generate positive cash flows from operations for periods exceeding one year should be red-flagged.
3. Debt exceeding the net worth of the company:
Companies with huge debts on their balance sheets can be virtual time bombs waiting to explode. Debt comes with a periodic interest repayment burden. Also, the principal has to be repaid according to the terms of the loan.
Principal and interest servicing on debt requires real cash outgo and when this liability is large it could really strain the finances of the company – especially during difficult times.
We know that the economy is cyclical in nature. We encounter periods of boom and depression. During the periods of depression, demand in the economy contracts as a whole. Companies during such periods of depression, experience curtailment in the demand for their products or services and hence their profitability and cash flows suffer.
During such times, companies with huge debts on their balance sheets will find it extremely difficult to service their debt related liabilities.
Any prolonged default in repayment (on account of a cash shortage) could subject the company to litigation proceedings; the control of the company may pass on the creditors or worse still the creditors may call upon the company to be liquidated.
4. Companies with no pricing power operating in a competitive industry:
Product differentiation is the key to having a pricing power in the market.
A company operating in an industry with very little product differentiation is very susceptible to competition. It has to rely heavily on internal efficiencies and new customer acquisitions to drive profits. Moreover, it cannot abruptly raise prices to match any rise in operating costs as it has to keep an eye on its competitor’s pricing strategy.
A company with no pricing power will have to match or better its competitor’s pricing strategy in order to survive in the market. Note that any innovation on the part of the competitor which enables it to offer the same product at a reduced price may virtually take it out of business.
5. Companies that cannot generate enough cash to fund Capex requirements:
There are certain capital intensive companies which require constant expenditure in capital assets to keep their operations running. If such companies are not able to generate enough cash from their operations to fund their recurring capex (capital expenditure) requirements, they will constantly have to borrow from external sources to keep their operations running.
An ideal company is one that can keep its existing projects running from internal cash accruals without having to rely on any additional external funding.
6. Significant Promoter holding pledged:
A warning signal for you, in case of a promoter controlled company is where a majority of the promoter’s holding is pledged.
In case the promoters are unable to repay the debt against which they have pledged the shares of the company, the control of the company may pass on to such financial creditors who may then run it in their best interests (and not in the interest of the shareholders).
7. Companies facing technology or product obsolescence.
Companies facing technology or product obsolescence have no future unless they can ‘turnaround’ through innovation. However, innovation is not so easily achieved. Unless the company has constantly demonstrated in the past its ability to innovate and has at present, the resources needed to launch new products or services, you are well advised to stay away from such companies.
Hope you liked our presentation on the types of companies to avoid while investing. Keep visiting FinMint for more.