Red Flags!

Investing is as much about finding opportunities, profitable companies, and sound management as it is in avoiding fraudsters, ill-thought business ventures, or any of the other risks that rip investors’ faces off. Incidentally, Frank Partnoy’s books all detail flags that investors should be wary of. They’re also a fun read.

I wrote an article some time back discussing how investors go through a process of learning how to become better at their professions.  In this process Mark and I have found some nitty-gritty details which today I’d like to discuss.

In the investment world the presence of the SEC is much more a detriment to investors than it is a detriment to criminals. You stand a real risk of having the criminal steal your money with a smile on his face, and the odds are he/she will get away clean. Remember Allied capital and the SEC response to President and founder of Greenlight capital, David Einhorn’s allegations?

He was not only demonized and shunned in the media but was investigated by the SEC. Rare Chris, rare. Alas no. Lehman, AIG, Bear Stearns, Enron, Worldcom…

Oh well at least we can rely on the rating agencies if not the regulators heh! I mean look S&P just downgraded US debt. Clearly they’re onto something. The smartest minds in the business for sure. I mean never mind that the ONLY time any nation on this ball of dirt we call home has managed to repay a truly humongous debt was between 1815 and 1900 when the Brits managed to set the record after their total debt to GDP reached a whopping 260%. Mind you took an industrial revolution to help them along.

A little factoid you might wish to consider: Total debt to GDP over 260% has NEVER EVER been repaid before ANYWHERE ANYTIME.

Next little factoid: Countries presently exceeding this magical line in the now digital sand include Germany, Canada, United States, Switzerland,  Italy, France, Japan, South Korea, Spain, United Kingdom. Just saying.

So, if we are not to rely on a governmental regulatory institution or rating agencies to guide us and prevent fraud, scamsters and their ilk from coming anywhere near our portfolio, we must rely on ourselves.  To that end I present the following lists, which are far from complete, but provide a DD101 checklist to consider.

Flags to look out for (Public companies):

  • Stock splits/share rollbacks (reverse splits). Institutional money managers instinctively shy away from penny stocks. Companies can and do avoid being lumped with other penny stocks by stock splitting. After having worked with fund managers at some of the world’s largest financial institutions I can tell you that the amount of DD done at times before purchase is truly abysmal. You’ve been warned!
  • Name changing. You screw up. No problem, change your name and fleece some more investors under a different moniker. Heavy marketing associated with all of the above. Like feces and flies you’ll often find them together.
  • A name change accompanied by a rollback and you’re likely looking at a great company… to short!
  • Pump and dump: Stock alerts from newsletter writers, or worse – emails telling you to “buy this stock now.” Take a look at whether any financings have been done, or are being done, and who is getting paid. An “analyst” that gets paid fees for raising capital is an analyst’s bottom. Promoters that get paid in stock or cash to sing a company’s praises are biased, period.
  • Following closely on the heels of the previous point. Excessive PR statements which amount to fluff and bull (a technical term).
  • Officer/Director resignations. Unless he/she won the lottery or has a dreaded disease, beware.
  • Failing to file financial reports in a timely manner.  Somethings amiss, don’t wait around to find out what it is.
  • Upwards revised capex year after year. Ok, we get it. You’re incompetent. Fine just don’t expect any of my money. This happens a lot in the mining and construction sectors but certainly isn’t exclusive to them.

Startup or early stage investing:

  • No competition: When I hear an entrepreneur tell me this it has been always 100% wrong. Don’t be fooled. There is always competition.
  • Entrepreneurs who don’t invest their own money in their business.
  • Entrepreneurs with pre-existing debts. Debt is a noose around anyone’s neck and when not controlled it causes people to make erratic and dangerous decisions. Not only is excessive personal or professional debt an indication of poor money management, but the incentive for good guys to turn bad is high. Your angel capital could very easily be misappropriated to settle debts. Don’t even go there
  • Predicting hockey sticks. Without exception every explosive growth story I’ve researched has been one where founders never predicted the outcome. Sure they were positive; one needs to be if beginning a business, but expectations of exponential returns in a particular product are unrealistic. The only area that I feel this doesn’t apply to is that of macro-economics. Things such as predicting the coming Bond collapse in government debt markets, the explosive growth of certain economies.
  • Entrepreneurs who are dictators. These guys want to control everything. They typically lack any board of advisors, believing that they can and will do it all themselves. They’re pig headed, stubborn and will either make billions or you’ll lose your shirt. Risks are too high. We like balanced individuals who understand that in order to grow their business they will need to bring knowledge and skills to the business which they don’t posses.
  • Lack of financial information. Even if you’re dealing with the smallest fruit stand on the side of the road, a business that doesn’t keep track of their finances is DOOMED!
  • Entrepreneurs setting up business in a foreign country which they have little experience or knowledge in, and where they have not engaged local advisors or partners – customs, bureaucracy, legal environment, business standards… I could go on but essentially if you’re unfamiliar with a sector, country or business climate you’re at a disadvantage.  (Mark’s note: Personal experience with this one)
  • Lastly the biggest no-no. Lying. Call it an “omission”, call it a “mistake”, call it whatever you like, but don’t call me. I’m gone.

There are more, no doubt, but the above are those I’ve dealt with most recently.

If you’ve got any other important ones you can think of plug them in the comments section.

Now I’m going to go and buy my beautiful kids an ice cream they don’t need, in weather that calls for hot chocolate. Why? Why not?

– Chris

2 quotes today since I think both are equally valid.

“Test fast, fail fast, adjust fast.”  Tom Peters

“People who don’t take risks generally make about two big mistakes a year. People who do take risks generally make about two big mistakes a year.”  Peter Drucker