Monday, August 8, 2016

How to avoid bankrupting companies

Avoid the bankrupting companies at all costs. Here are some hints:

·        I have several companies that have lost most of the stock values. It turns out most are Chinese companies; I do have some losers from Mexico, Israel and Ireland. Most were set up to cheat investors with ‘rosy’ financial statements. Avoid them especially small companies in emerging countries.

·        Many US companies failed due to frauds and wrong bets. When the CEO is using the company as his own AMT or having an extravagant life style, watch out. If they promise you a return doubling the current rate, listen to your wise mother: there is no free lunch. Despite of so many real examples, still fools are born every day because of their greed.

·         Do not follow the ‘commentators’ from TV; they have their own hidden agenda that usually are not in your interest.

·         Many companies fail due to unable to pay back their loans. Except for specific industries and situations, avoid companies with high debt (over 50% debt/equity to me). Financial institutions and companies that have high debts in order to finance their products for their customers such as some auto companies could be the exceptions.

·         I have a screen named Big Losers beating the market by more than 600% in Early Recovery (a phase defined by me). However, some bankrupted companies are not included in the database which is termed as survivor bias. I still use this screen but skip these companies using the following yardsticks.

·         The companies are usually safe with high Free Cash Flow / Equity and high Expected Profit / Stock Price.

·         The following are red flags: low Free Cash Flow / Equity, high Inventory and high Receivable (esp. relative to its Payable).

·         New government regulations could bankrupt an industry. What would happen when the U.S. takes out the rebates and subsidies of solar panels? When the U.S. banned solar panels from China, one of my Chinese stocks bankrupted.

·         Serious lawsuits. Most U.S. companies are required to file this information in the financial reports.

·         Obsolete products. Newspaper and similar products would be replaced by the internet. The opposite is new products such as virtual reality in 2016.  

·         If you expect the market will recover in 2 years, ensure the company’s cash and loans can support their burn rate for at least two more years.

·         Many investing sites (most required subscription) have safety scores.

·         If the Beneish M-Score is greater than -2.22, the company is likely an accounting manipulator.

·         Choose companies with Z-Score higher than 3. Both M-Score and Z-Score are available from GuruFocus, a paid subscription. Z-Score does not work for financial institutions.

·         Z-Score metrics are: “Working Capital / Total Assets” (A), “Retained Earnings / Total Assets” (B), “Earnings Before Interest & Taxes / Total Assets” (C), “Market Cap / Total Liabilities” (D) and “Sales / Total Assets” (E).
Z-Score = 1.2 A + 1.4 B + 3.3 C +.6 D + E

-     Small companies could be risky but very profitable. Typically they have low stock price (less than $5), small market cap (less than 50 M), low sales (less than $25 M) and low institution ownership (less than 5%).        

- Play market timing. It does not always work, but it is far better to follow a proven technique than not. It is far safer to take money off when the market is risky.

·         Invest and not trade for most of us.

Investing is risky to start with. However, investing especially in stocks has been proven the best vehicle to beat inflation. 

This is one chapter of my book "Complete the Art of Investing". If it helps you, envision how 835 pages (Kindle version) would help you. It could be the best $10 you ever spend.

The above is an abstract from my book "Complete the Art of Investing" which is available from Amazon.

I challenged to have the best-performed article in Seeking Alpha history, an investing site, for recommending 5 or more stocks in one year after the publish date. The concepts for that article are discussed in this book.


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