The Motley Fool

3 Red Flags That Should Alarm Investors

Investing clearly brings opportunities but there are, also understandably, pitfalls we have to watch out for. With this in mind, the National University of Singapore’s Mak Yuen Teen and his team recently released a 48-page report on “Avoiding Potholes In Listed Companies”.

In it, he details his team’s research on listed companies in which he looks for signs of corporate governance lapses or glaring red flags. After analysing 37 potential warning signs, his team narrowed it down to a total of 16 which he found to be the most important.

The main takeaway from the report is that companies do not just implode without warning. As investors, we need to be alert and watch out for early warning signs. These signs may point to cracks which may later lead to more serious red flags. As investors, if we are able to ask the right questions and spot the early warning signs then we can avoid pain further down the road.

Professor Mak’s team introduces the B-C-D-E model which focuses on four areas: business model, corporate governance, disclosure and reporting, and events and transactions. Let’s ask ourselves pertinent questions related to the first three red flags.

1. Is the company listing at the peak of the cycle?

Companies usually choose to carry out an IPO at the peak of their business performance, as this fetches the highest valuations and ensures that the owner is able to raise the most funds (and also cash out at a premium, in some cases).

Investors need to be wary of buying into the hype and of management over-promising on future prospects. Take a close look at the industry which the company is in to determine if it’s at risk of hitting the peak of its business cycle. If so, this should pop up as a red flag on investors’ radar and they should avoid investing in the company.

2. Are expansions plans unrealistically ambitious?

While companies should obviously be lauded for trying their best to grow and expand the company’s operations, be careful of grand plans and over-ambitious statements. Management may tout a new technology or paradigm which they plan to introduce to “disrupt” the marketplace but things rarely tend to be that simple.

Other companies may have big plans for expansion into remote, far-flung countries with weak regulatory regimes and unique business challenges, thus creating its own set of obstacles. Investors need to be alert to the risks of glossy promises which are out of touch with business reality.

3. Is the company loss-making?

There is a growing trend of loss-making companies seeking listings, and these companies are usually from e-commerce or financial technology (fintech) industries. Investors need to be mindful that unless the company has clearly articulated a plan to go from losses to profits, there is a high chance that losses will continue.

Investing in these companies may entail a long and painful wait for profits to show up. Not only that but and there’s also a good chance that the company will not pay dividends or may even announce a rights issue to raise more money to strengthen its balance sheet.

Click here now for your FREE subscription to Take Stock Singapore, The Motley Fool’s free investing newsletter. Written by David Kuo, Take Stock Singapore tells you exactly what’s happening in today’s markets, and shows how you can GROW your wealth in the years ahead.  

The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.