The market is turning and many commentators are saying the best place to invest now is in beaten-down large-cap growth stocks.
But underperforming stocks bring added risks. This means balance sheets have to be scrutinized more closely than with momentum plays.
We’ve outlined a ‘crucial five’ checklist that investors should consider before taking positions in turnaround growth stocks.
It is based on the fundamental characteristics of solid companies: healthy cash flows and a lack of potentially crippling debt loads.
These are not strict rules, but if a stock is exhibiting some of the warning signs we’ve highlighted below, it is best to avoid it.
In coming articles we’ll look at some practical examples.
1. CASH FLOW
Every businessman knows that cash flow is the life blood of a company. It allows you to pay the bills on time, spend money improving the business, pay off debt etc. A healthy business has healthy cash flow. A beaten down stock should not be touched unless its cash flow is in a decent position, or at least is certain to improve. A good rule of thumb is that operating cash flow should be greater thanoperating profit (EBIT). There also shouldn’t be a massive deterioration in operating cash flow from one period to the next (quarter on quarter, or year on year). While profits are easily manipulated, cash flow is harder to fudge. Some fast-growing companies’ cash flow might be lower than EBIT, but with beaten down stocks it’s better to play it safe.
2. INVENTORIES
One of the key components of cash flow is working capital, which is made up ofinventory, debtors/receivables (money owed to the company) and creditors/payables (money owed to other companies). A major reason for a deteriorating cash position is a build up of inventory. Think of inventory as stuff in the process of being made and on its way to the shops. A build up of inventory can have a harmless explanation, such as a company ramping up production to meet burgeoning demand, or for services companies it may just be work in progress. But it can also be a strong warning sign. A build up of inventory can signal that demand for products is falling, causing product to be left on the shelf. That is costly because it has to be funded through cash flow. So check that inventories in one period haven’t had a huge increase with a resultant fall in cash flow. If inventories have increased, check whether the company is talking about tough market conditions and falling demand, or whether it is optimistic.
3. CREDITOR DAYS
Another sign that a company is under pressure is when its creditors (people to whom the company owes money) such as suppliers are demanding it pay them more quickly. This will show up as a fall in creditor days. To work it out divide creditors by cost of sales and multiple by 365 (creditors/cost of sales (or purchases)x 365). A company that has to pay their bills more quickly has pressure on its cash flow and could get into trouble.
4. DEBTOR DAYS
Companies are also owed money, mostly by customers. To keep cash flow healthy they need to collect money from people who owe them in a timely fashion. A bad sign is when debtors (people who owe money) are slow to pay, which could mean poor quality customers or that the company is desperate for sales and is extending lax credit terms. To measure debtor days, divide debtors by sales and multiply by 365 (debtors/sales x 365). What we don’t want to see is a big increase in debtor days.
5. DEBT
Nothing will kill a company that’s struggling faster than owing too much to banks. It largely depends on a company’s asset base, but a good rule of thumb is that net debt as a proportion of shareholders’ equity should not be more than 100 per cent. Of course for turnaround stocks, some people may want to tighten that to net debt not being more than 50 per cent of shareholders’ equity.
Some good resources on learning about balance sheets include:
An introduction to reading balance sheets and a Fool’s guide to working capital.
