This is the continuation of a series exploring red flags. Associate professor Mak Yuen Teen and his team have released a booklet on “Avoiding Potholes in Listed Companies.” These red flags should alert investors to possible wrongdoings and shenanigans and push them to dig deeper — or avoid such companies altogether.
The team came up with the B-C D-E model, which focuses on four areas: business model, corporate governance, disclosure and reporting, and events and transactions. Here are the next three red flags investors need to be mindful of.
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4. Is the company listing when the business is at the peak of the cycle?
Beware of companies that choose to list only when conditions are favourable and the outlook is optimistic for the industry in which they operate. Of course, one may argue that most companies will seek such conditions in order to list, as it would boost their odds of raising a higher sum of money for business expansion. However, investors need to assess if industry conditions are temporarily boosting the earnings and prospects of the company, as this may signal that profit growth is unsustainable.
This may entail a little more digging into where the business is in its cycle, but it’s not tough to figure out as there are usually news articles written on the company and its industry. The IPO prospectus will also contain information on industry conditions, and some prospectuses may also commission an independent third party to conduct research and publish findings on the industry in which it operates.
5. Is the expansion plan overly ambitious relative to the company’s current operations and capabilities?
It goes without saying that companies are always seeking growth, but there is a fine line between sustainable, steady growth and gunning for growth that’s over-ambitious and likely to over-stretch the company’s resources. Investors need to assess if the company’s growth strategies belong to the former, or the latter.
We should keep the company’s current scale, size, operations, capabilities, and competencies in mind when assessing if its stated expansion plan is overly ambitious. Companies with grandiose plans and lofty profit or revenue targets usually take outsized risks in order to try to attain their goals. This increases the probability of them crashing and burning should something go wrong.
6. Is the company loss-making?
It should be obvious to investors that profitable companies make good investments. Therefore, it would be a big red flag if a company starts to report losses. If the loss is a one-off incident arising from a write-off or exceptional item, then perhaps investors can look past it. However, if a company reports persistent losses with no sign of a turnaround, then it’s probably best avoided, and investors should look for better opportunities.
There are “unicorns” that exist in the market right now, which are defined as multibillion-dollar companies that continue to bleed cash and incur losses. These unicorns attract a lot of investors and “smart money,” but I would caution against investing in a business that has yet to make a single dime of profit and that offers no foreseeable timeline for turning a profit.
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