When the writing is on the wall

Tuesday, 5th April 2011 15:33 - by Riddler

This latest sell-off in the markets, which began in earnest in... ...February, but was exacerbated by the events in North Africa and Japan, has been a warning to all that complacency can jeopardise our investments if we don’t maintain our rigorous attitude to due diligence and continuing vigilance to changing trading conditions. In the last week, there has been a return of that dreaded RNS which starts with the line “X Company has asked for the temporary suspension of its shares while it clarifies its financial position”. LDP (Leeds Petroleum) and SPMG (Sports Media Group) are the latest in a series of companies whose position is very uncertain and, in SPMG’s case, has led to administration. There are some basic screening tools one can use to identify if a company’s financial position may become a concern in the coming year. An easy measure is to compare a company’s ‘cash burn’ for the last 2-3 years; to see if the cash position and debt covenants can cover the same rate of ‘cash burn’ if the company is yet to make revenues and profits. Secondly, if the Net Debt of a company, or ‘gearing’, is becoming unmanageable and is eroding revenues, then this should be of concern. A stock which has used earnings to pay-down debt during the ‘Credit Crunch’ should have a far healthier Balance Sheet going forward; such as PSN (Persimmon Homes), which has been reducing its net debt for the last 3 years. However, some stocks have a gearing of 70% and above, which could become a concern if profits are dwindling and their ability to pay debts wanes. Many companies need debt to grow and expand, but one should look for cash-generative operations in solid, growing markets - otherwise debt will become a huge burden to shareholders’ cash reserves and, at some point, will become unsustainable. Many investors choose to ignore the ‘boring’ accountancy-based research and due diligence in favour of optimistic growth statements and ‘sexy’ market-speak. This is not to say that interim and full-year accounts should hold precedence over the ‘big story’ and future potential. Many AIM stocks which have accelerated growth have a period where accounts on their own would make many investors avoid a future success story, if they were read in isolation. Many exciting AIM stocks have 3 or 4 years of non-profit making activity while the business expands and lucrative contracts or agreements are negotiated. In the mean-time, Investors might be confident (through appropriate research) that the debt, overdraft agreements, or cash on the Balance Sheet can ‘support’ the stock through its formative years.