Here Are 7 Danger Signs In A Stock Investors Should Look Out For

Over two years ago on 4 March 2015, I wrote an article about construction services provider and steel structures fabricator Yongam Holdings Limited (SGX: AXB). The article touched on the performance of Yongnam against a nine-point checklist developed by investor Pat Dorsey.

I bring this up because Yongnam failed to meet most of Dorsey’s criteria, and its stock has fallen by 67% since the publication of my aforementioned article from a split-adjusted price of S$0.62 to S$0.205 currently. (The company underwent a one-for-four consolidation shortly after my article was published.)

Dorsey’s criteria

You can see the nine criteria from Dorsey’s checklist below:

1. The firm provides regular financial updates, has a long track record as a publicly-listed entity, and has a market capitalisation that isn’t too small.

2. It has consistently earned an operating profit.

3. It has generated consistent operating cashflow.

4. The firm earns a good return on equity.

5. It has been able to grow its earnings consistently.

6. It possess a clean balance sheet.

7. The firm can generate lots of free cash flow.

8. There are infrequent appearances of one-time charges.

9. There has not been major dilution of shareholders’ stakes in the firm.

In my aforementioned article, I shared three charts that showed just why Yongnam failed to clear the hurdles in criteria 2, 3, 4, 5, 6, 7, and 9.

Yongnam’s performance

The first chart plotted the company’s operating income, net income, operating cash flow, and free cash flow from 2004 to 2014. You can see it here:

Source: S&P Global Market Intelligence

I wrote back then that “as you can observe, there hasn’t been any real consistency nor real-growth in those four financial figures for Yongnam over the past decade. As such, criteria 2, 3, 5, and 7 would deserve a tick in the “no” box.”

The next chart illustrated Yongam’s returns on equity, cash position, and total debt levels for 2004 to 2014. Here’s the chart:

Source: S&P Global Market Intelligence

The following are my observations from the chart that I penned down for my March 2015 article:

“Although Yongnam has managed to generate really high returns on equity at times – the firm’s return on equity had been above 20% from 2005 to 2011 – this financial metric has shrunk to near-zero levels for the construction outfit in recent years.

In addition, the chart also makes clear that Yongnam’s balance sheet has been weak over the past decade with its debt coming in way higher than cash. From 2013 to 2014, the firm had also seen its balance sheet weaken yet further with its cash position declining and its debt-levels climbing to new highs.

It thus follows that criteria 4 and 6 would also deserve “no” responses.”

The last chart showed Yongnam’s share count from 2004 to 2014 and it is found below:

Source: S&P Global Market Intelligence

What I wrote about this chart in my earlier article was:

“The firm had a big jump in its share count from 747 million at end-2006 to 1,217 million at end-2007.

The increase had partly been due to share placements Yongnam had made in 2007 which totaled 243 million shares; the placements were made to raise capital to help shore up the firm’s balance sheet as its gearing was at an appallingly high level of 10.6 at end-2006.

With Yongnam having diluted shareholders significantly in the recent past, criterion 9 in Dorsey’s checklist would be a clear “no” as well.”

A Foolish conclusion

Over two years ago, Yongnam failed seven of Dorsey’s nine criteria. I pointed that out as a huge risk back then, and the risk ended up coming home to roost given that the company’s stock has fallen by over two-thirds since then, as I mentioned earlier.  

Not every company that has displayed the same seven signs as Yongnam would subsequently end up as a poor investment. But, if they do show up en masse in a stock, there better be good reasons why that’s so.

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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.