In today’s financial markets, there are thousands of different public companies and millions of investors trade their shares. As an investor, not all companies are worth investing and you can learn this lesson in a hard way by investing in a company with bad fundamentals and lose your money. Although every company is unique in its operation and financial structure, there are common signs which you have to look and if you find them, it’s better to stay away from them. It doesn’t mean that every company with these signs are going to get bankrupt or are bad companies in their sectors. Many investors might even make money out of them but these signs indicate a bad fundamental for the business. There might be a lot of people buying the shares of these companies but their decisions are risky and their actions are more of speculation rather than investments.
Here are five, out of many, alarming signs which upon detection, you should stay away from the company.
The first thing you should consider is the fact that the company should make money. The amount of money it makes is important but first, it should make some profit or in other words, it should cover its own costs.
It is completely normal and natural for a startup (especially in the technology sector) to lose money for many years before turning to profit and many investors (angel investors and venture capitalists) have gained considerable profits from these investments. However, unless you are an angel or VC, you most likely are not going to invest in a startup and the companies which you consider are at least a few years old and public and if they are not making any money (and are not going to, in a very near future) you should forget about them.
There are four types of companies which may show you this alarming sign.
Although it is inevitable to see changes in the management of every company, a rapid and major change in the leading team is almost never a good sign.
Obviously, some managers may retire or leave their job for some personal reasons but if the reasons are professional, it is mostly for better. The manager who is leaving the company was either very bad at the job or very good and both scenarios can have bad results for the company. The manager could be very bad at the job and the board has found a better person which is a bad news because we will continue to see the bad results of the previous manager for a while, not to mention that the new manager may fail to improve the conditions. The manager could have been very good at the job and he or she is recruited by another company leaving a void in the company which again is not a good sign.
Unless the company has a better person in the line of succession, a change in the management is almost never good and investors are advised to stay away from companies with rapid, repeated and major changes in the management team. After all, they know their business better than we ever can.
Every company is run by a group of people who also own some shares in the company or in other words, some of the shareholders are working in the key positions. The members of the boards and key managers of every company, know their business and financial status better than anyone else and if they don’t trust their own company, why would we?
You can find the information on the shares sold by the employees of a company in EDGAR database.
In many cases, the key managers are also the key members of the board and they have all the power to make decisions. If these managers do not care much about the business, they will use their power to gain unusual and quick profits. Such managers do not care about the business and naturally, will fail to lead the company to a bright future.
One way to detect such managements is to look at their salaries and rewards. Unless they are the members of Avengers, literally saving the world (by creating a lot of money for their shareholders, of course,) they do not deserve such high monetary gain in most cases. Take Snap, Inc. as an example. The company is fairly new and it has never been profitable. However, after its IPO in Q1 2017, the CEO of the company received $636.6 million rewards in stock compensation.
Investors are advised to search the financial reports of the companies to find such huge and absurd salaries and rewards to understand the mindset of the managers.
Regardless of the age and the past performance of a company, the business model can be flawed. A business should have a sound model which provides a cushion of safety.
Three major flaws in a business model are:
Sometimes, businesses are designed to have one major customer (a government-dependent business for example) or rely on one because it has failed to attract more major customer and if that customer fails financially or changes its policy or strategy, our little precious company will be left without any business.
Just like the previous problem, if the one product that the company makes does not sell any longer, the company will have nothing else to offer.
Legal loopholes which enable businesses to make money in a particular way appear from time to time and many companies use them. However, if the entire model and plan are solely based on the loophole, the business would collapse once the loophole closes, as they all do.
It doesn’t matter how well the company has performed so far or how popular it is, a flawed business model makes the business extremely risky and investors should consider the fact before risking their capital.