Before investing in a company’s stock ask yourself how likely is it to increase its profits over time. Don’t roll your eyes! More profits drive share prices higher and allow greater dividend payments, obviously, but finding these companies is not as easy as it sounds. There are plenty of examples of hot investments that went bust, and successful businesses that have never caused a stir in the stock market.
Netting out
The internet has brought ruin to many a business model. Anyone with access to the world wide web can now be their own travel agent and book the flights and hotel for their family holiday without the help of say, Thomas Cook, and price comparison sites have compounded the problem.
Information asymmetries have disappeared, with buyers and suppliers having access to current market prices, for example. Middlemen are cut out of deals because suppliers can search and contact buyers from smartphones.
Streaming services destroyed movie rentals from stores or via the post, and ride-hailing services are taking customers away from taxi and mini-cabs. Digital businesses can scale incrementally with membership growth, without lumpy investments and customers prefer the convenience and choice on offer.
How easy is it to do what the company you are looking at does? Can you think of a way to do it better or is there already a competitor out there who does? If your business caters to a niche market, offering unique and personalised packages it will stand up better against online, mass-market competition than one that does not.
Stranded assets
Coal, oil, and gas reserves are assets now, but could one day find themselves worthless. Energy companies that do not diversify into low-carbon sources could struggle in the future. Oil producers that can extract cleaner oil for lower monetary and carbon costs will struggle less with carbon taxes than those that pump dirty, expensive oil who might find their reserves are economically worthless.
Production lines that produce internal combustion engines might be worthless if electric motors start to dominate. If ride-hailing and car-sharing services reduce overall car ownership, then a chunk of car producing capacity becomes redundant.
Look at your companies’ assets, and ask yourself will they continue to be valued in the future.
Funny financing
Mounting debt with interest payments rising ever closer to operating earnings is generally a bad sign. But also look for use of unusual financing that suggests a company cannot secure traditional lines of credit.
Having banks pay suppliers and reimbursing them later is something Carillion did before it went bust. If you can find evidence of suppliers being paid late (accounts payable are ballooning) that may be evidence of struggling to make ends meet.
Poor leadership
Look back through reports to see if management has actually delivered what was promised. Did they expand margins, open enough new stores, or realise those cost synergies from acquisitions? If forecasts and strategies are consistently wrong or fail, then how much faith can you have that this time things will be different?Â
Seek advice
Don’t be afraid to ask for help. Other people may be more familiar with a company or industry than you are, and can help steer you in the right direction. But always make sure that recommendations are justified, and the assumptions are reasonable.