From Blue Skies to Stormy Waters: Five Red Flags for Long-Term Investors
Investing can be confusing, maddening even. When the sky is blue and cloud-free, they tell you to buy investments for the long run, touting the powerful benefits of buying, consistently adding to, and holding quality stocks. But the sky isn’t blue forever, and when ominous storm clouds emerge on the horizon, the advice suddenly pivots to panic-driven short-term maneuvering.
Mixed messages confuse investors already battling human nature, which has evolved to make long-term investing challenging. Market corrections and bear markets can be excellent opportunities for long-term investors, but how do you know when to keep buying specific stocks or sell?
I’m a long-term investor. When I buy a stock, I intend to hold it for years (or even decades). But I’m not a fortune teller, and sometimes things don’t go according to plan, compelling me to rethink a position in the weakness of a bear market, freeing up funds for higher conviction positions.
Here are some red flags that would cause me to do extra digging. One, or even multiple of these, isn’t always cause for alarm. Occasionally, there are justifiable reasons for these conditions, but understanding them can help determine if you should continue marching forward or change course.
Declining Gross Margins
Gross Margin = (sales) — (cost of goods sold) or, in layman’s terms, money earned minus the cost needed to make the product (or provide the service).
When a company’s margins suddenly shrink, it could be an omen predicting poor growth prospects.
Increasing competition — competition drives prices lower as producers compete to capture customers. This is a great thing for consumers, but if a company finds itself in a fierce price battle with competing companies, it can mean markedly lower profits moving forward.
Fading demand — some products have staying power while others are quick fads, and it’s hard to tell the difference at first. Declining margins could indicate that consumers are moving on to something else and aren’t that interested in the product. Sometimes this is just a bump in the road; others, it’s a permanent shift in consumer demands.
Slight margin declines can result from broader economic conditions or be short-lasting events. More serious margin declines can be a warning shot. Try to determine the causes of the change: is it due to economic factors that are likely won’t last, or have consumers discovered something better?
Deteriorating Balance Sheet
The balance sheet is one of three core financial statements that public companies regularly prepare. It reports its assets, liabilities, and shareholder equity — a snapshot of the company’s finances in a given period.
When comparing one period to another, stable or rising cash and stable or lowering debt is preferred— indicating a steady or improving financial position. A deeper dive is merited if cash is declining and debt is increasing.
There could be reasonable explanations like a recent acquisition that will help the company grow more quickly or significantly lower its costs. Or, it could indicate a build-up of inventory (decelerating sales) or other concerning developments.
Net Income is Drastically Higher than Free-Cash Flow
When investors talk about the bottom line, they mean net income (NI). NI is calculated as revenues minus expenses, interest, and taxes and is found at the bottom of the income statement (hence the phrase). Accrual accounting calculates net income, which smooths things out over time.
Accrual accounting calls for expenses and income to be recognized when they occur, not when the payment is made or received. This makes sense in a lot of analysis but can distort the actual money flows of a given period. That’s where free cash flow (FCF) can help.
FCF adjusts the income on a cash basis (not accrual), leaving less room for financial engineering, manipulation, or distortion. Sometimes a company will be in a better cash flow position than the net income would indicate (depreciation and amortization charges can lower net income while not requiring a cash outlay). In other situations, net income can be much higher than net income, meaning a cash crunch might be incoming.
Pay extra attention when you see a net income that is significantly higher than FCF. What is the company spending on? Why is FCF so much lower? Remember, when times get tough, cash is king (not the promise of cash later).
Rising Inventory to Sales
Inventory management is fickle. You don’t want too little inventory, creating missed sales due to unavailable products. But you don’t want excess inventory piling up in a warehouse, tying up cash that you could deploy more productively elsewhere.
Something might be amiss if the inventory is building more quickly than sales. It could indicate shrinking demand or poor forecasting. When reserve stock gets too large, discounts often follow, pinching margins. Ouch.
Excessive Goodwill
Investors usually don’t spend much time on goodwill when reviewing a balance sheet; it’s typically glossed over as investors rush to look at seemingly more significant numbers. Goodwill represents the premium (above fair market value) that a company pays for an acquisition. A small amount of goodwill usually isn’t a problem, but when eye-popping numbers appear, it demonstrates that management wasted a lot of capital, destroying shareholder value.
It’s not just the write-down and financial impact that’s important. Why did management overpay? Is the core business weak? Is management desperate to grow through M&A? Acquisitions can be highly risky. Even though they are en vogue, you should examine them skeptically because they can lead to future impairments and underperformance.
Investing is nuanced, and we have difficulty ignoring our tendency to mimic those around us. During bear markets, most investors are especially vulnerable to poor decisions as our fight or flight instincts activate, urging quick action with little analysis. People around us begin panicking, and the media quickly capitalizes on the hysteria, sensationalizing current events and making doomsday predictions.
Often, the best thing to do is nothing. But during bear markets especially, it’s worthwhile to spend some extra attention, especially when red flags arise.
Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from James Vermillion, and all rights are reserved.
