2 Danger Signs To Watch Out For When Hunting For Bargain Stocks

A little over six months ago on 10 June 2016, I published an article titled 1 Seemingly Dirt-Cheap Stock That Actually Hides Some Huge Risks.

The stock in question was offshore support vessels builder and owner Nam Cheong Ltd (SGX: N4E). In my article, I wrote that Nam Cheong was dirt-cheap because it was a net-net stock. I explained:

“A stock with a market cap that’s lower than its net current asset value [total current assets minus total liabilities] is known in investing parlance as a net-net stock. A net-net stock is also a great bargain, theoretically.

That’s because investors can get a discount on the company’s current assets (assets such as cash and inventory) net of all liabilities. To sweeten the deal, the company’s fixed assets (assets such as properties, factories etc.) are thrown in for free.”

But, I also pointed out in my article that Nam Cheong was a risky stock for investors because of two reasons: (1) An inability to generate cash flow from its business, and (2) uncertainty over the real economic value of its assets. Here’s how I described the two sources of risk in my earlier article:

“The company has had trouble generating cash flow from its business; in the five years from 2011 to 2015, Nam Cheong had generated positive operating cash flow in only three years. Moreover, the company’s total operating cash flow in that five year block had been a negative RM503 million.

Investors might also want to pay attention to Nam Cheong’s total current assets. Of the S$988.3 million in total current assets that Nam Cheong currently has (as of 31 March 2016), some 63% of that is in the form of inventory.

Thing is, Nam Cheong’s inventory consists largely of the costs incurred for the offshore support vessels that it is building. Given the weak market conditions now in the oil & gas industry, there’s a chance that Nam Cheong may not be able to fully recover from its customers the costs of the vessels it’s constructing.”

Turns out, from 10 June 2016 to today, Nam Cheong’s share price has declined by 34%. This happened despite oil prices being essentially flat over the same period. Moreover, Singapore’s stock market benchmark, the Straits Times Index (SGX: ^STI), had climbed by 6.6%.

Nam Cheong’s experience highlights how the two sources of risk I pointed out about the company are actually danger signs that investors should keep an eye on if they are trying to hunt for bargains based on the asset values of stocks.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn't own shares in any companies mentioned.