The financials may look good, but you’d be mad to invest: in his new book Clem Chambers, chief executive of ADVFN, points out where you should never put your cash
Companies can look great but in reality there is something nasty going on. The company can fit all the criteria nicely, have a marvellous balance sheet, but still you want to invoke a special rule and say no thanks. Here are mine. You should look to develop your own over time. Investing is a game of skill and like all skill-based activities, skill will develop with practice. The more skill you develop, the bigger your returns will be.
No-No 1: Family Firms
Blood is thicker than water and family firms carry a risk that business is not for the benefit solely of shareholders but for the benefit of the family.
The chairman’s son may be a bright guy, but it would be incredible if he was absolutely the right and best executive in the world to run the company. Who could possibly imagine that the fact he is the son of the boss wasn’t a big factor in his hiring?
There is nothing wrong with this per se, good luck to them, because we can see the relationship upfront and decide accordingly whether to invest. This is how the market should work, not though edict but through transparency. That doesn’t mean, however, that family inheritance in the governance of a PLC is a good thing.
When companies don’t act in the sole interest of their shareholders, investors should beware. Over time I have noticed many family businesses fail on the markets, to be bought back for a song by the family shareholders. This makes them as a whole group dangerous to your wealth. I apologise to scrupulous family firms, I’m sure there are paragons, but an overall heightened risk means I throw every single one of them out of my stock picking universe. I’m surely wrong about some of them and I’m sure it’s my loss, but as a group their specialness disqualifies family firms out of hand. Someone else is welcome to the gold nugget that gets away.
Apart from the risk of close family ties to outsiders the opposite can also be a big danger. Families fall out and then all sorts of internecine actions take place which can destroy a business.
The conflict of interest inherent in family firms means that I will exclude a value stock which is family run.
When it comes to family, family comes first, which is how it should be; however, I don’t want to be on the outside of that arrangement when investing.
No-No 2: Government Footballs
Governments are unpredictable things. Their policies are unstable and they are run by people who care little for economics or business. Governments care about politics and will warp, destroy and generally mess up anything in business they touch. Governments don’t care about profits, they care about taxation. Politicians don’t care about profits either; they care about votes and getting good press.
If you have a business and politicians think they can get votes closing you down, they will close you down.
You might be providing a vital service, or be trying to, you might be employing thousands, but if there are votes in it to stomp on your business they will do it without a thought.
Cover a mountain with giant windmills at uneconomic prices, no problems.
Have a coal mine which might produce energy for everyone cheaply but is sited near a pretty village with important votes or with some rare amphibians nearby, forget even trying to get going.
Political footballs are always utterly vulnerable to disaster originating from the government and political system. Once a share is ensnared in politics it is immediately poised on the edge of doom.
Of course there are plenty of examples but a notable one to research is Railtrack; I could write a separate book on that case and I’m sure someone has. Companies get horribly mashed up by being too close to government time and again.
If a company is a political football, just say no.
For example, it takes a lot of nerve to hold a nationalised bank like Lloyds, being aware that it only takes a single bad decision from government to kill the value of that company. This is ironic as I hold this company as of January 2012 and only time will tell if this rule-breaking position will bite me. If you are going to break rules a huge amount of consideration is required, if only to have your excuses lined up when things go south.
No-No 3: Financial Restatements
If you own shares in a company that restates its financial figures revealing a hole in its accounts, sell it. Only if it is trivial should you not bail immediately.
Certainly do not buy the share that reveals accounting errors of any material kind unless it happened a long time ago and the management has changed significantly. Even then be very careful.
Many companies that restate their figures promptly go bust.
It shouldn’t be the case that there is any skulduggery on the stock market but it is fair to say not many weeks go by without some scandal or other cropping up.
This is exacerbated by modern accounting that produces company accounts far removed from a financial reality we would recognise as a member of the public. The arcane nature of accounts means that all sorts of nonsense can go on in the shadows and then be buried away out of sight.
An investor is reliant on the company’s auditors and the honesty of a company’s directors to make investments. If these barriers are breached then the investor has nothing to go on. As such if a company reveals a significant inaccuracy in its past accounts, unless of course miracles of miracles the company has done better than it thought, sell the shares immediately or refuse to buy any if that is the reason it is ‘cheap.’ There are plenty of cheap companies and there is no need to risk good money on dodgy accounting.
No-No 4: Legal Outcomes
Don’t buy companies that are relying on the outcome of a big court case to change their fortunes.
The law is not known as a good business model for anyone but lawyers and funnily enough there aren’t any/many lawyers listed on the stock market.
This doesn’t stop certain companies that look cheap on paper to actually be relying on some kind of pay-out in court to keep them going. Sometimes this can pay off, but it’s simply not worth investing in the faint hope. Companies mired in litigation do not often prosper; the more unlikely the court action or remote from a decent jurisdiction the case is, the worse the prospects.
This kind of thing often affects mining companies. As soon as they hit pay dirt someone tries to muscle in using the ‘interesting’ local law system to try and grab the winnings. This is a situation that a value investor doesn’t need or want to invest in.
Let the lawyers make their money and steer well clear.
This extract is from A Beginner’s Guide to Value Investing, by Clem Chambers, £2.05 from Amazon.