When researching stocks of new companies to buy – or assessing the ones you currently hold – there are countless positive metrics people usually look for to justify their investment.
Growing revenues, profitability ratios, free cash flow, competitive moat and much more are all often considered before dropping your cash into a company.
But what about the negatives, that can give off clear warning signs to avoid an investment? In many ways, these are just as – if not more – important to keep in mind prior to buying a stock.
Here’s our list of ten of the biggest ‘red flags’ when buying a stock we keep an eye out for that can instantly turn a company from a ‘buy’ to an ‘avoid’ in our eyes.
1. Not addressing deadlines that have passed
If a company has previously announced to investors that they will be performing/achieving a significant event by a certain date in an announcement to market, then fail to address this when the deadline passes.
This can be basically anything, depending on the type of business. Launching a certain product, results of a mining survey, finalising a partnership, providing updated sales or customer figures, etc. all would qualify.
Delays and unexpected events in business happen; that’s not the issue.
Listed companies that refuse (or conveniently ‘forget’) to provide updates to shareholders when important dates pass serves as a larger reflection on the company’s communication policy & transparency as a whole.
Like it or not, the stock market is a game of sentiment just as much as it is one of company fundamentals.
Not communicating reasons for missed deadlines often has ripple effects that lead to frustrated shareholders, with the share price typically either stagnating or drifting down soon after as a result.
2. Too large a % of retail ownership
The ownership composition of a company is something we talk about on here quite a lot.
Essentially: we like to see a decently diversified investment profile of owners.
This means a mix of management, institutions, private companies etc. – along with retail investors – all having incentives to see a company’s share price perform well.
If management/ownership’s own money is tied up in the company, then you can bet they’re going to be trying their best to grow their own personal net worth.
Likewise, if the ‘big boys’ such as instos & equity firms have cash at play, they’re all about generating maximum returns as well.
Something along the lines of this is ideal, particularly for non-large-cap companies:
On the opposite end of the spectrum, companies in which the vast majority of the share register are retail is a often a major red flag.
This is particularly true when it’s a smaller-cap company not making any money.
In these cases, retail investors are used as the ‘well’ to dip into to continue funding the company via capital raises… which leads to further dilution.
Here’s an example:
An ownership breakdown like this – which shows basically no outside interest from established investors – is often a company selling nothing but ‘lottery tickets’ to retail bagholders who buy management’s sales pitch.
And those pitches… can often be snake oil.
3. Big increase in Customer Acquisition Cost (CAC)
Oftentimes, when companies provide business updates, they will place a heavy emphasis on “top-of-the-line” growth in order to make for flashy/impressive headlines.
Metrics such as year-on-year increases in web traffic, customers through the door, total items sold, SaaS signups & more are often handpicked for the ‘big numbers’ that are displayed in the largest fonts and with the brightest colours.
This is particularly prevalent in e-Commerce businesses where a lot of the time, cranking up these numbers can easily be done as a direct result of increasing marketing spend – both digital & real-world.
The problem comes when the cost to acquire each new individual customer also rises disproportionately as a result: the Customer Acquisition Cost.
Most of the time this is fobbed-off as “we’re entering a growth phase!!”, and while this can be true to an extent, a lot of the time these higher costs simply become unsustainable over the long term.
This makes for a red flag for the company moving forward, as rising CAC numbers can be hard to trim back down again.
This is especially true if they’re still attempting to maintain headline revenue growth at all costs. This can end up making the next year’s YOY performance look poor (and cause a drop in the share price as a result).
4. Declining margins
Similar to CAC costs above, declining margins (especially if they’re not highlighted) can be a big signifier of company performance moving forward.
Growing raw revenue figures via expensive channels that eat into profits, or ramping up the volume of ore shipped, or selling more individual widgets – all of this doesn’t mean nearly as much if you’re paying significantly higher input costs to do so.
Much of the time, this is a factor that can be out of direct control of the company themselves.
Things such as:
- macro supply/demand fluctuations for individual commodities
- increased shipping costs or costs of material extraction
- rising wages to retain employees
- rising maintenance requirements
- competitors undercutting or being able to source product from alternate countries
… all of these and much more can eat into profit margins.
Margins of course shouldn’t be looked at in isolation, however they’re one key ingredient in the financial-health-salad that should be paid particular attention to… especially if a company is avoiding the issue & highlighting raw growth numbers at the expense of margins.
If you can’t attribute these declining margins to external factors not within the company’s hands, then yep – red flag.
5. Surprise management resignation
Few things can trigger nervous action in company shareholders than the dreaded “Resignation of Company CEO” market announcement – particularly if it comes seemingly out of the blue.
Given the outsized influence executives can have on the direction/performance of a company, it’s only natural for investors to want to know whether this was part of a properly-planned transition.
If it hasn’t been indicated at all in prior communications (say, the previous AGM or quarterly/half-yearly update), it’s understandable this can be seen as a red flag.
How such statements are released to the market regarding these ‘resignations’ is often important as well.
It’s particularly a bad sign when companies intentionally make it vague/difficult to read between the lines and determine whether the resignation was voluntary or not.
Factors such as the executive’s age, duration of work for the company, announced plans for succession & more can all determine how ‘dodgy’ an abrupt resignation truly is (and the market’s subsequent reaction).
6. Sudden major acquisition
There’s obviously nothing necessarily wrong with a company making acquisitions in general.
Oftentimes, it can be an easy and logical way to accelerate growth. This can be done while also reducing sector competition, or adding additional products which compliment a business’ product range, or auxiliary services that suit their existing customer base.
Red flags tend to arise when companies announce acquisitions out of the blue however, with little warning or prior discussion with their investor base.
This typically happens soon after a new board or executive team come on board, or the company receives some kind of cash injection. This can be an unexpectedly profitable half-year, selling off an asset(s), or another unexpected windfall.
It can also occur when an existing board under fire want to create some ‘positive headlines’ and generate figures they can use to juice the accounting stats for the next report.
An attempt to ‘make a splash’ can also often lead to the company that is making the acquisition paying a premium over market value for the acquired company.
It can then take a long time for the acquisition to pay for itself – if it ever does – and cause the share price to tank.
7. Slowdown (or reversal) in revenue growth
While most will initially look at an overall drop in revenue as one of the most obvious warning signs, keeping an eye out for a slowdown in growth can be equally important.
Even if a company’s revenues are still in the positive, it’s important to consider the level of growth over several of the past years in a row on a %-basis.
Most of the time, given the market is forward-looking, even a ‘positive’ result of continued revenue growth may not be received well.
This is especially true when it’s lower than the previous year, as this can give the impression that a company is getting closer to maxing-out their potential market share (for large-caps), or becoming unable to attain more (for smaller businesses).
It’s not necessarily a bad sign if the correlation between earnings/profits and raw revenue is still strong. Companies may choose to focus on higher-value clients who offer better margins, for example.
If the drop isn’t too severe and nothing has changed fundamentally with the company, then this can often be dismissed.
However if the trend continues over a couple of quarters – back to back – it may be time to cut bait with your shareholding.
8. Selective use of ‘vs. previous period’ comparisons
Companies that go out of their way to cherry-pick “vs. previous period” comparisons – by hand-picking the most favourable way to look at the comparison – are a massive red flag.
Generally, if management choose to only report on/lead with either “vs. the previous quarter” or “vs. the previous year”, and not both in the same report, they’ve done so for a reason.
This is particularly true if that reporting metric changes from one report to the next.
Not showing both metrics can be tiptoeing around the fact that seasonality provides a huge boost to some kinds of businesses (e.g: retail).
Especially if they’re obviously outliers or caused by a one-off event, which the company chooses to pull out and display front-and-centre as the headline figure.
We saw this happen numerous times during the first year of the Covid-19 pandemic.
During this period, companies cited big spikes in profits, which we later saw came largely as a result of government support packages.
It can also happen when certain commodity prices go through a temporary spike that benefits the company through no real skill/decision making of the management team.
As a result, you ideally want to see reports that contain both “pcp” and “YoY”.
9. Company stops reporting on key metrics (KPIs)
A lack of consistency from one company report to the next is something you’ll likely want to keep an eye out for.
Has one of the major key metrics/KPIs that they touted in the last report (that was, obviously, very positive) suddenly gone missing in their latest update?
Have they shifted from talking about profits to revenue?
Have they omitted to show reduced margins, or monthly active users, a decline in repeat customers, reduced EPS growth… or any other major business indicator which they were previously proud to show off?
Be particularly wary of this if the switch happens after a key board position has changed since the previous report. This may indicate a shift in overall business plan/philosophy moving forward.
10. Insider selling with no concrete reason provided
It’s inevitable that at some point, ownership are going to want/need to sell off shares for any number of reasons.
Company owners are people too, and taking some profits from their efforts is the end goal of pretty much any business owner.
However, sudden insider selling of some of their shareholdings can immediately spook the market. This is particularly true if it’s a substantial sized portion of the stock they own.
A surprising amount of the time, these insiders don’t bother/don’t feel like they should have to disclose the reason for their sale.
This then leaves retail holders scratching their chins nervously, wanting an explanation.
A simple single-sentence explainer on the announcement doc can go a long way to keeping investor confidence in a company for a relatively minimal amount of effort on management’s end.
Not bothering, again, shows a sign that they don’t spare much thought for the others who hold shares in their company.
These are ten of our biggest red flags for companies – are there any that we missed, or that you look for?
Let us know in the comments below.
