Since there have been a couple of disaster stocks in the past year, and a few outright scams in the market, we thought it might be a good time to outline a few ‘red flags’ when you are doing your stock research. We have said before it pays to be highly cynical of everything in the market, but you might want to pay extra attention to these five particular issues.

• Accounts Receivable Issues: Sales are great, but if money can’t be collected they are not worth too much. Take Poseidon Concepts (PSN on TSX, halted). In its June 30, 2012 financial report, it has $118 million in receivables. Sales were good, but in the Sept. 30, 2012 report receivables has grown to $125 million. At that amount, receivables were close to nine months’ worth of sales. Lo and behold, later in the year Poseidon announced it had problems collecting on its sales and took massive write-downs. It now faces numerous lawsuits and has been halted for more than a month. Receivables growth needs to be watched very carefully.
• Auditor Changes/Auditor Quality: Some companies change auditors frequently. On occasion, this is due to bona fide reasons, or the company has outgrown its auditing firm. More often, though, it is because of an accounting dispute between the company and its auditors, and the company simply changes firms to get a more agreeable opinion. Too many changes in auditors should be a very big warning sign. In addition, watch the size and quality of the auditor in relation to the size of the company. One of the frequently cited complaints on Sino-Forest prior to its bankruptcy was that its auditors were too small and not well known at all.
• Variable Debt: Investors don’t care much about interest rates these days, with rates so low that companies can borrow money almost for free. But—one day—interest rates are going to go up. In the financial notes of the companies you invest in, they will list the interest rate and terms of the company’s outstanding debt. If a company’s debt has variable interest terms, then it is far more vulnerable to problems when interest rates rise. Debt that is easily carried today can be a crippler in the future.
• Press Releases: Even when there is a disclosed problem, you can still prevent further losses by reading press releases carefully. Back to Sino-Forest: When its assets were questioned, it said in an early press release it would take some time to determine its ownership of tree plantations. What’s that? You either own them or you don’t—call your lawyer, check the files, half a day of work to confirm, tops. Sino was still worth $300 million when this release came out and careful readers of the release could have still sold. Or, with Poseidon, in its press release on Nov. 15, 2012 announced “some long-term agreements were suspended or cancelled”, and it took the first $9.5 million in write-downs on the aforementioned receivables. The company was still worth $400 million then. Then, a bigger flag: On Jan. 11, 2013 PSN said it was ‘deferring’ its already-declared $0.09 per share dividend. Basically, it told investors it had no money then. PSN the next day was still worth $140 million.
• Analyst Disconnect: Often, a company will report bad earnings, or have debt issues, and you might get a bad feeling about your investment in the company. Yet analysts stay positive, indicating all is well with the company. Your gut tells you differently though. This can be a subtler red flag. Maybe—just maybe—the analysts stay positive for a longer period of time because they are fishing for a corporate financing deal: a share issue, debt restructuring or so on. They don’t want to appear overly negative if there are future fees to be had. If one of your companies has serious problems, or worse, big debt issues, then it probably pays to listen to your gut rather than conflicted Bay Street analysts.

Peter Hodson, CFA