AVOIDING THE DUDS
HOW TO AVOID INVESTING IN POOR QUALITY COMPANIES THAT MAY GO BUST  

How to Avoid the Duds and that Sinking Feeling 

In July 2012, Silverdell an AIM company, had its shares suspended out of the blue “pending clarification of the company’s financial position” and it was delisted six months later with not much communication to shareholders in the meantime. The company also announced that the shares were worthless and it then went into administration. This article attempts to explain how one can avoid such situations by examining the profile of that company.

Shareholders in Silverdell will have felt that they were on a sinking ship as soon as the suspension was announced. But they were unable to jump ship of course as the shares could not be traded.  Though it’s not unusual in such cases for the captain and other directors to go overboard regardless.

 

This article (first published in the ShareSoc newsletter in February 2014) covers how to avoid  investing in companies that quickly become “duds” like Silverdell. This is of course possible not just with AIM companies but with any listed company (although it’s more common in the small cap sector) – Polly Peck was one example of a FTSE-100 company.

 

So this is about prevention rather than cure, because it’s actually a lot easier to avoid the problem in the first place rather than try to recover from a difficult financial position later.

Diversification is a protection 

Having a company go bust is one of the most damaging events to happen to your investment portfolio, even though all your other investments choices are wise. Almost  every investor in small cap stocks will have some stocks go bust, or fall out of bed without notice due to unforeseen events, in a lifetime of investing. 

 

So the first principle to control the risks you face is to have a reasonable number of stocks in your portfolio so that a failure of one is not too damaging. This is the classical “diversification” strategy. Now different commentators give you different views on this. A minimum of 10 stocks is suggested by some, but that tends to assume they are “uncorrelated”, i.e. not all companies operating in the same market sector or subject to the same economic influences.

 

Indeed with risky AIM stocks you probably want to look more at 15 to 20 stocks. Obviously it depends on how risky the AIM stocks you pick are. If they are all well established companies, with strong balance sheets, high repeat revenue and sound management you can move to having fewer stocks.

 

Look at the overall risk characteristics of your portfolio 

Likewise there’s no problem with having more risky stocks in your portfolio if they are counterbalanced by some more heavyweight boring ones. One useful approach is to run a “barbell” style portfolio where you have a few boring stocks on one end (such as high dividend paying FTSE-100 companies), counterbalanced by more risky growth stocks on the  other. 

 

Look at the Business Model 

When looking at the risk associated with a stock, forget all the academic financial ratios (Beta, Sharpe ratios, etc) because it’s the company’s business model that is the real determining factor, i.e. the markets it is operating in, how it is operating  and how it controls the risks it is facing. 

For example, the disaster that struck BP in the Gulf of Mexico was not foreseeable by financial analysis of the shares volatility or the company’s balance sheet. But if it had been highlighted that the company was drilling oil wells to a depth of over 10,000 metres in deep water (at a record depth) in a hurricane prone zone, and that the operational supervision of such activities and safety management in BP was questionable, then investors might have thought twice about holding the shares. 

 

So it is important to understand what the company is actually doing, the nature of its customer contracts and the ability and experience of its management. Also how prone is the company to unexpected events that might damage its cash flow?  

 

Construction companies and those running large engineering projects are particularly disaster prone in that big projects are often under-budgeted and overrun time wise, thus leading to much higher costs. They are also prone to technical hiccups due to unforeseen problems with new technology (this often affects IT service companies –    reliance on new technology is a  major risk). 

 

Let’s take the case of Silverdell. This company certainly had some business related risks – to quote from their web site: “With a 30-year track record of delivering complex projects on behalf of our customers in technically demanding, high-hazard and sensitive regulated environments” is mentioned for one major subsidiary. 

 

It was also clear from the presentations the company gave and news announcements that there was a focus on major contract wins, with extended delivery times. In other words, the sales could be lumpy with large amounts of work in progress at any one time. Now large amounts of work in progress are two danger signals  – firstly because accounting for it can be problematic, and secondly because work in progress consumes cash.

 

Look at the Balance Sheet 

When looking at the quality or risk attributes of a company, examining the balance sheet is a key factor. How much debt does it carry and hence how leveraged is it? Does it have low gearing and high interest cover? Does it have onerous banking covenants or is it likely to become a poodle of its bankers if it gets into financial difficulties? The bankers of course apparently took control of events at Silverdell, leaving the shareholders side-lined.

 

A quick examination of Silverdell’s published accounts for the full year to September 2012 tell you that finance charges were £787k when the operating profits were £1,319k – inadequate cover in essence. In the six months to March 2013 the picture was even worse – charges of £555k (i.e. rising) when there was an operating loss. In addition the company reported rising debt at the half year – up from £6.7m in 2012 to £15.8m in 2013.

 

Look at the Key Finance Ratios 

You don’t need to necessarily study the balance sheet in detail to figure out there are possible issues to study more closely. You just need to examine a few ratios, and rather than  calculating these yourself you can obtain many of them from information services such as Stockopedia or ShareScope. I will quote from the former’s report which gives the figures for when the company’s shares were suspended. So it reports gross gearing of 66% and negative interest cover.

 

Another useful ratio to look at is the Current Ratio, i.e. the ratio of current assets to liabilities. This is important because companies go bust when they can’t pay their creditors and run out of cash. That ratio gives the total of things that can be quickly turned into cash (typically stock, receivables and existing cash), versus cash likely required soon (typically short term borrowings to be repaid and trade payables).

 

The Current Ratio should normally be 1.3 or higher for trading companies. Any lower figure is suspicious. There are a few exceptions such as retailers who often sell goods to customers before they have to pay their suppliers for the same goods, and software companies are another  exception because of “deferred” maintenance revenue on their balance sheets as a current liability which should be excluded. However in the case of Silverdell the ratio was 1.15. Not only that, current assets included “inventories and work in progress”. How soon could they really be turned into cash?

 

A more sophisticated measure of the bankruptcy risk is the Altman-Z score which is somewhat more complicated to calculate yourself, but Stockopedia gave it as 1.65 which firmly put it in the “Danger” zone on their nicely presented graphical representation.

 

Revenue Recognition 

Another area where accounts can be misleading and give an over optimistic view of the financial position of a company is in revenue recognition. This can be a particular problem in software companies where delivery of intangible product can be manipulated by “channel stuffing” and other practices. ShareSoc has reported on past examples in such cases as  Alterian. Needless to point out that this issue has also been raised at Silverdell where it is alleged profits on new contracts have been recognised before work has commenced. Is a company’s revenue recognition conservative rather than aggressive and are they sticking to the rules? 

 

Return on Capital 

Financing a company with bank debt makes sense if you have a strong business model because it can be cheaper than equity. But clearly you have to be generating a better return on that debt, and on capital in general, then the interest cost you are paying. And what was the return on capital employed at Silverdell? Just 1.9%! A totally inadequate figure.

 

Operating Margins 

Low operating margins make a company very sensitive to falling into losses if revenue unexpectedly declines. At Silverdell it was 1.3%, another low ratio.

 

Cash Flow 

One commentator (not this author) attended a presentation by Silverdell and posted on Stockopedia and other bulletin boards about their accounts in early July 2013.

 

This summarises what he said: “A lot of the discussion centred on whether SID could grow without raising new capital. Sean Nutley argued the business could grow by as much as 15% without the need for more cash. Given the poor working capital characteristics of this business I was surprised he thought he could squeeze out so much growth without more money. I asked a question about capital expenditure (CAPEX) which had been incurred and was on the balance sheet but did not appear in the “cash flow from investing activities” section of the cash flow statement. It would appear the Company has been netting off most of its CAPEX against the movement in finance leases in the “cash flow from financing activities” section of the cash flow statement. Why does it matter? Well it has the effect of flattering Free Cash Flow (FCF) a very important metric which Sean Nutley referred to a number of times in his presentation to reassure those present of the Company’s cash generating prowess. This accounting approach has masked the Company’s negative FCF.

Be Sceptical of Forecasts

All the ratios discussed above are based on historical figures. It often happens that the financial history of a company looks poor, but the forecasts and prognostications for the future are much more positive. Profits will rise and cash will flow like water according to the CEO, and the company broker and other analysts believe his words and issue matching earnings forecasts. I am not suggesting that this happened at Silverdell, or otherwise, but it is a common trap that investors fall into after attending presentations by management. You need to put your “sceptical” hat on when looking at companies and consider profit forecasts with care.

 

Other Aspects of Concern 

Other bad news on a review of Silverdell’s last results were a report of a tough first half in UK decommissioning “due to the deferral of a significant contract”. It also mentioned the maintenance of a “direct labour force” as reducing it “reduces our responsiveness to sudden changes in demand”, i.e. the company is operationally highly geared where a drop in sales does not enable it to reduce costs to match.

 

Other poor quality indicators were an emphasis on reporting of “adjusted” figures, on EBITDA, on exceptional costs being reported, and past expansion via acquisition –always a risky strategy.

 

Monitoring Your Investments to Minimise Losses  

Of course the above discussion is based on the financial profile of Silverdell immediately before it apparently got into difficulties. It might have looked a better proposition at an earlier date. So it’s always worth monitoring closely any investments you hold and reviewing the current and prospective financial ratios, particularly after results announcements and trading statements.

 

Always keep an eye on the share price trend. If it consistently declines for no apparent reason, then other shareholders might have news of which you are not aware or have come to realise some concerns about the company.

 

Silverdell’s share price declined steadily from March 2013 until the shares were suspended in July.  Consider the use of “stop-losses” to ensure you don’t get trapped in a loss making situation.  Sell on the way down if a trend is clear – “the trend is your friend” as the stock market saying goes. You need to jump ship before the company sinks!

 

Conclusion 

I hope that in this article I have explained in simple terms what  investors should look at when considering a new investment in a company’s shares. No doubt some Silverdell investors will say that the above discussion is just hindsight. But there was more than one sceptical investor before the company’s shares were suspended. 

Of course attending a company presentation (such as at the events ShareSoc both organises and promotes) does give one the opportunity to study a company in depth and form your own judgement.  

 The other key message is to use some software to do the financial analysis for you expeditiously. ShareSoc provides special offers on such software to Full Members – see https://www.sharesoc.org/members-area/member-special-offers/ 

R.W.L. 1/Feb/2014