Investing maestro Charlie Munger has a great quote I love: “Tell me where I’m going to die, that is, so I don’t go there.”
It speaks to the importance of having negative knowledge. When choosing stocks to invest in, knowing what to avoid can be as important as, or even more important than, knowing what to buy.
One type of company that I think investors should preferably avoid would be those that have the following traits: (1) A historical inability to consistently generate cash flow, and (2) a high amount of debt.
An inability to generate cash flow could be a sign that a company has a low quality business. This is important because a stock’s price movement over the long-term is largely governed by how well its business performs.
Meanwhile, borrowings, when used wisely, can be a great way for a company to build value for shareholders. But, it could also be a source of trouble when things go awry – Swiber Holdings Limited (SGX: BGK), a support services provider to the oil and gas industry, is a high-profile and recent case of a Singapore-listed company that collapsed under the strains of a debt-bloated balance sheet and a poor business environment.
And speaking of Swiber, when the company failed back in last July, I wrote an article on 29 July that highlighted a few other oil and gas companies that were at high risk of following in Swiber’s footsteps. The companies I mentioned in my article were: Cosco Corporation (Singapore) Limited (SGX: F83), KS Energy Services Limited (SGX: 578), Ezra Holdings Limited (SGX: 5DN), AusGroup Ltd (SGX: 5GJ), Pacific Radiance Ltd (SGX: T8V), and Nam Cheong Ltd (SGX: N4E).
I had singled out the six companies because they had net-debt to equity ratios of over 100% (a sign of having a really high debt load) and negative operating cash flows. Here’s how the share prices of the sextet have changed since the publication of my aforementioned article.
Source: S&P Global Market Intelligence
As you can see, most of them have seen their share prices fall hard. In the case of Ezra, it will likely even go to zero because it declared bankruptcy on 19 March 2017. Meanwhile, Nam Cheong announced two weeks ago that its auditors have highlighted a “material uncertainty” over its ability to continue as a going concern.
A Foolish conclusion
Companies that have borrowed heavily and that have negative operating cash flows need not necessarily be poor investments going forward. But if you see such a company, it’s preferable to avoid it. At the very least, you have to be aware that such a company can be a highly risky investment.
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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 owns shares in AusGroup.