Nobody rings a bell when a stock reaches its peak price and brokers are notoriously reluctant to advise their clients to sell shares that they have previously been recommending. So astute investors will need to do their own homework.
First of all, some internal factors. The quality of a company’s direction and general management can probably best be judged by its results. Furthermore, the market’s perception of the board and the management team will have a considerable effect on the price of its shares.
Specific danger signs to watch out for include splits in the board of directors, frequent and/or unexplained changes of chief executive and directors sitting on too many other boards.
More measurable factors of concern are a declining market share for the company’s main products, falling profit margins, a declining earnings rate on the funds employed, inadequate research and stgelopment expenditure and excessively generous management contracts.
Imprudent overexpansion and a propensity to be excessively involved in litigation would be two other telltale signs of potential problems, although these involve value judgements which are difficult for most outsiders to make.
But something that shareholders can easily judge for themselves is the quality of the company’s site on the World Wide Web and the board’s handling of legitimate questions at annual general meetings. In some cases shareholders can also see how well they are being treated as customers.
If the annual report shows that all the directors own reasonable parcels of shares in the company then there is a greater chance that their interests will parallel those of other shareholders than if they do not. Correspondingly, small parcels demonstrate a lack of faith in the company. However, the absence of large holdings by well-qualified but not necessarily wealthy individual directors should not automatically be held against them.
Investors should be particularly wary of companies which make vague official announcements or keep issuing reports by directors which are full of excuses for poor results, blaming everybody but themselves.
Typical excuses refer to government action or inaction, excessive regulation, adverse weather conditions, computer problems, trade union intransigence, customers not being loyal, unfair criticisms by consumer groups, a failure to get or retain business licences or activity by environmentalists. Some boards even blame “the advent of unexpected competition”!
Trends in the relevant industries
Next, some external factors. Many entrepreneurial companies are involved in more than one industry. Whether the industries in which a company operates are growing or declining will obviously affect the market’s perception of the company. For example, many forms of manufacturing are adversely affected by high labour costs and by import competition.
Potential weaknesses include a lack of growth potential, past overproduction and/or excess capacity, inadequate returns on the equipment used and competitors from overseas setting up in Australia regardless of the short term cost of doing this.
Some practical issues
Unfortunately, many warning signs come to investors’ attention far too late to be of any practical use. By the time shareholders get to hear of them the price of the relevant shares will have already fallen. In fact, often the market overreacts to bad news, actually creating a buying opportunity!
Typically, bad news announced too late will include profit downgrades and/or dividend reductions, a falling market share for the company’s products or services, unfavourable tax rulings or adverse legislation.
Ironically, historically low stock exchange prices for a company’s shares can sometimes lead to takeovers at attractive premiums, so that investors who panic out of a stock which has lost its shine are always running a risk.
Sometimes companies issue shares to institutions by way of placements at a discount to the market. Naturally, this can lead to perceptions that this lower issue price is the “correct” price for the shares concerned – another factor which is made public too late to be of much use.
Finally, a misconception. Some investors get alarmed when daily turnovers rise above their traditional norms, concluding that this must mean that knowledgeable investors are quitting the stock. But this overlooks the fact that for every seller there is a corresponding buyer, so that such trading activity proves nothing.