Two Fridays ago, offshore support vessels builder and owner Nam Cheong Ltd (SGX: N4E) requested for its stock to be suspended from trading.
The company’s shares were exchanging hands at a price of S$0.02 each just before the trading suspension kicked in, down a stunning 74% and 96% over the last 12 months and last three years, respectively. Those are undoubtedly painful losses for the company’s investors.
In here, I would like to run through some of the lessons we can learn from Nam Cheong’s episode so that we can lessen the chances of ending up with big losers.
Lesson 1: Be wary of debt
A big problem for Nam Cheong was the debt it had. The company’s trading suspension came shortly after it revealed last Thursday that it will temporarily stop all repayments for its borrowings.
As of 31 March 2017, Nam Cheong had RM1.84 billion in debt, compared with just RM259.7 million in cash and equivalents. The company’s net-debt to equity ratio has been really high the past few years as well – to the point, it ended 2015 and 2016 with a net-debt to equity ratio of 93% and 111%, respectively.
Nam Cheong is not the only oil and gas company to have run into big problems due to debt. Two earlier high-profile cases were Swiber Holdings Limited (SGX: BGK) and Ezra Holdings Limited (SGX: 5DN). Swiber filed for judicial management in July 2016 while Ezra filed for bankruptcy in March this year.
Lesson 2: Be wary of a lack of operating cashflow
Cash is the lifeblood of a business. And we can see how strong a company’s business is partly by observing its operating cashflow. The financial number tells us how much cash a company has brought in for a given period of time – it can also be negative, in which case the company has seen cash flow out of its coffers.
Having negative operating cashflow need not necessarily be a bad thing. But when it happens for a prolonged period of time, it is a yellow flag. From 2013 to 2016, Nam Cheong only managed to produce positive operating cashflow in one year.
Source: S&P Global Market Intelligence
In fact, back in July 2016, shortly after Swiber collapsed, I had pinpointed Nam Cheong as an oil & gas stock that had a high chance of running into serious trouble because of its weak balance sheet and inability to produce positive operating cashflow.
Lesson 3: Be wary of a lack of pricing power
Nam Cheong’s main business model is to build offshore support vessels for sale. The demand for these vessels in turn depend on oil prices. If prices are high, there are incentives to drill for oil, leading to more offshore support vessels needed. Conversely, when oil prices are low, drilling activity will be anaemic, leading to lower demand for offshore support vessels.
When oil prices collapsed from over US$100 per barrel in 2014 to around US$50 today, Nam Cheong’s business suffered. Its revenue declined drastically from RM 1.93 billion in 2014 to just RM 950 million in 2015. In 2016, the company’s revenue fell even further to just RM 170 million.
From this, you can see how Nam Cheong lacks pricing power – it cannot control the prices of its products and services because the demand for its business is governed by changes in oil prices. And, the movement of oil prices is not within any company’s control.
The Foolish bottom line
Companies with the trifecta of having a weak balance sheet, inability to produce operating cashflow, and lack of pricing power could easily become big long-term losers in the stock market. These are characteristics of companies we want to avoid when we are looking to invest our money.
Instead, we hunt for companies with robust balance sheets that are flush with cash, the ability to produce strong streams of operating cash flows, and the presence of pricing power. Not every company with such characteristics will be a long-term winner. There are other things to look out for as well.
At our premium stock recommendation service, Stock Advisor Singapore, we do this every day. We feel that by looking out for the right characteristics in a company, it helps to stack the odds of investing success in our favour.
Editor’s note: A version of this article appeared in the 24 July edition of Take Stock.
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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 company mentioned.