Protecting Against Disaster

Sean Casterline, CFA

I want to deviate just a bit from our normal technical education and take a look at a bigger concern for today's investor. Most investors truly ignore the warnings signs thrown off by a company in distress. How many of you remember WorldCom and Enron? In the not too distant past these companies owned market caps worth hundreds of billions of dollars. Today, they don't exist. Their collapses came as a surprise to most of the world, including their investors. Even large shareholders, many of them with an inside track, were caught off guard. Millions of individual investors were burned by these companies in the bubble, but even the most insightful institutions got caught with there britches down. Further, we continue to see stories on a regular basis of new accounting issues with new companies. Because of the pressure to hit earnings numbers, corporate leaders will most likely continue to skate in the gray area going forward. It's not to say it's easy to spot a corporate train wreck before it happens. It involves work, but by “kicking the tires” on a regular basis, even the average investor can identify potential problems. Here are some general guidelines for spotting companies that may be headed for trouble.

First, keep a raised eyebrow to cash flow . Cash flow is considered the life blood of a company and is the most reliable way to insure you're not holding a bunch of accounting tricks in your stock certificates. When a company's cash payments surpass its cash take, the company's cash flow is negative. If this occurs over a sustained period, it's a sign that cash in the bank may become dangerously low. Without fresh injections of capital from shareholders or lenders, a company in this situation can quickly find itself out of business. There are some companies that, during a bear market, may only temporarily have negative cash flow. But, that's not unusual. What you want to focus on is the trend in cash flow. In essence, you want to focus on what's termed a company's burn rate . If a company burns cash too quick, it runs the risk of going broke. As an example, Enron's cash flow fell from negative $90 million in Q1 2000 to a very troubling negative $457 million a year later.

Second, you want to pay attention to a company's debt levels . Interest repayments place pressure on the aforementioned cash flow, and this pressure is likely to be multiplied for troubled companies. Struggling companies offer banks more risk of default so they must pay a higher interest rate. Debt therefore tends to shrink their returns. A measure to consider for debt health is the total Debt-to-Equity (D/E) ratio. In fact, it's the most commonly used measure for banruptcy risk. It compares a company's combined long- and short-term debt to equity. High-debt companies have higher D/E ratios than companies with low debt. According to debt specialists, companies with D/E ratios below 0.5 carry low debt. And that means that conservative investors will give companies with D/E ratios of 0.5 and above a closer look.

Unfortunately, companies like Enron can mask their total debt through what's called “off balance sheet debt” but that's a topic for another article. Let's consider Enron's debt-to-equity levels before it declared bankruptcy in December 2001. At year-end December 2000, its D/E ratio stood at 0.9. At June 2001, it grew to 1.1. Finally, its September 2001 quarterly report showed a D/E ratio of 1.4. Enron would have qualified as a risky debt prospect each time.

Third, investors should pay attention to the technical side of the equation. The savvy investor should watch out for unusual share price declines on the chart. Almost all corporate collapses are preceded by a continual share price decline. Enron's share price started falling two years before it went bust. In fact, I remember one of our fundamental guys making a comment about how attractive Enron was becoming from the earnings front. We all looked at each other and said “there's something really wrong with this picture”. Truth told, if you simply looked at Enron's earnings, you would have been buying it all the way down. But, like WorldCom, the HUGE drop-off in the stock was telling you something was seriously amiss on the earnings side. Remember, technical action is typically a strong indicator for the future direction of earnings.

Next, you always want to monitor your company's earnings consistency . The way to do this is keep on top of profit warnings . While market reaction to a profit warning may appear swift and brutal, there is growing academic evidence to suggest the market consistently under-reacts to bad news. As a result, a profit warning is often followed by a gradual share price decline not necessarily a one time haircut. That said, keep a thumb on the trend in your companies profit warnings if they exist.

Last, companies are required to report, by way of company announcement, purchases and sales of shares by substantial shareholders and company directors . Executives and directors have the most current information on their prospects, so heavy selling by one or both groups can be a huge red flag of trouble ahead. While recommending that investors buy his company's stock, Enron Chairman Kenneth Lay sold $123 million in shares in 2000. That was nearly three times his gains in 1999. Take a look at the table below and you'll see that Lay wasn't the only one selling company stock going into 2001. Management was going through a mass exodus of Enron stock. Admittedly, insiders don't always sell simply because they think their shares are about to sink in value, but insider selling should give nvestors pause.

None of these indicators by themselves is going to give you a complete picture. Just as an athlete with a blown ACL can make a full recovery and go on to have a great career, some broken companies can make recoveries. But, the probability of a company turning around when all the above mentioned indicators are negative is very low. Typically, when a company is struggling, the warning signs are there. Your best line of defense as an investor is to be informed. Do your homework and be alert to unusual activities. Make it your business to know the company's you invest your hard earned dollars with and you'll minimize your chances of getting caught in train wreck.