Investing is always fraught with uncertainty – it’s just the nature of the beast. No matter how precise and accurate your market analysis processes are, any number of things can go suddenly awry with the companies in your portfolio, sending their value downward.
It’s easy, then, to argue that spotting the signs of impending trouble is as important to an investor’s skillset as reading financial statements is. Indeed, there are a few telltale signs that you can check for yourself to figure out whether a company is headed for trouble. Thankfully, investor intelligence data can alert you to the possibility of trouble in a company.
In many cases, you can even short these companies and turn them into profitable pieces of your portfolio.
Here are the three biggest signs of trouble in a company that other investors might not notice, along with tips on how you can spot the trends before everyone else.
Lack of marketing efficiency
Sales and marketing are central to a company’s success. While product quality and consumer opinions about it occupy most investors’ minds, a sudden drop in the effectiveness of a firm’s marketing efforts can point to negative growth.
Thanks to almost every company selling products on the internet these days, discovering issues with marketing is relatively straightforward. Digital marketing is a metric-driven environment where everything is quantified. Data such as traffic, unique visitors, visitor engagement with content, and social media metrics make it easy for investors to check how a company is perceived in the market.
For instance, a company partnering with an affiliate that is a mismatch in terms of voice and brand positioning might signal it’s time to exit your investment. Other quality indicators include a tide of negative engagement with social media content, declining traffic numbers to product pages, and rising negative reviews on the web.
Correlating marketing trends with financial data can help you discover additional facets of these issues. How many new products has the company failed to launch successfully? What has management said about the market in the past, and what does their marketing data indicate when it comes to their understanding of how to correct their strategies?
A lack of marketing knowledge or competence usually signals trouble for a company, since it exposes a disconnect with its customers. Financial results often lag marketing and sales trends. This is why keeping an eye out for marketing issues will help you exit or avoid troublesome investments, especially if the markets are uncertain macroeconomically.
Related party transactions
The fall of Enron in 2001 brought to light a troublesome aspect of GAAP accounting that persists to this day. The company used related party transactions to inflate its cash flow and minimize debt on its balance sheet. Related party transactions have always been disclosed in 10-Q and 10-K reports.
However, investors rarely verify these transactions, since they’re buried in the notes attached to earnings statements. Interestingly, even professional auditors struggle to validate these transactions, since they tend to be byzantine. A large company will automatically have internal financial deals with subsidiaries and related product lines.
However, it’s possible to notice signs of trouble if you see revenues via related parties growing to the point where these transactions dwarf actual sales. Ironically, large companies tend to avoid large related-party transactions due to the scrutiny they face in the public. Smaller companies, especially those operating a group of companies under a single umbrella, are the ones you must watch out for most closely.
These companies might use a bogus related party transaction to inflate net income or reduce debt. These moves result in a boost to share prices and help the company avoid recording debt non-compliance on its balance sheet.
Given the difficulty in analyzing related party transactions as an investor, it’s best to correlate these datasets with other sources of information such as auditor opinions, trends in free cash flow, and net margins. When viewed as a whole, these datasets will reveal information about possible trouble that the related party transaction reporting is designed to mask.
Accounting policy changes
Accounting policy is a vast field that houses different sources of trouble for investors. For starters, revenue recognition guidelines offer investors insight into how accurate a company’s numbers are. For instance, should a SaaS company report revenue when a prospect makes an inquiry or upon signing a contract?
Equipment leases are also a source of revenue recognition impropriaties. GAAP and IFRS allow companies to recognize the present value of future lease payments as revenue in the period of inception.
In plain English, this means a company can record the entirety of their clients’ future lease payments as current revenue. This technique inflates current earnings. However, an analysis of cash flow to net income, with some raw data appearing in publicly traded companies’ quarterly earnings reports, will reveal these types of issues. Other accounting policy changes, such as switching inventory accounting policies (FIFO to LIFO or vice-versa) constantly might indicate issues within the company.
As always, you must correlate these datasets with other data to create an accurate picture of a company’s health. There isn’t a single metric that will magically unlock clues about a company’s performance.
Tough but worthwhile
The markets these days are more volatile than ever. As data proliferates the markets, however, the use of investor intelligence techniques is growing in scope daily. As an investor, you must keep your ear on the ground for potential trouble and exit your problematic investments as soon as you unearth potentially troubling trends.
Disclaimer: This content does not necessarily represent the views of IWB.