How to Spot a Stock About to Crash

Picking stock market winners consistently is very difficult, which is why even the very best professional investors rarely stay at the top of their game for ever

External Writer 4 December, 2018 | 9:20AM

In this Perspectives article, retired Artemis fund manager Tim Steer shares an extract from his book 'The Signs Were There' on how to spot an equity in trouble.

umbrella protecting investor from the rain how to spot a stock about to crash

Company share price disasters are like the plunges made by the high cliff divers of Acapulco. The 135-feet dives that these brave men make from the cliffs of La Quebrada, Mexico into the shallow waters below resemble what the share prices of companies do when they go spectacularly wrong.

For many companies, these share dives could have been predicted by little more than a browse through the annual report. But it seems that many in the world of investing do not bother to look, but instead blame the auditors – and increasingly the regulators – when things go wrong.

The collapse in January 2018 of Carillion (CLLN) is just one in a long line of corporate disasters where even a cursory look at the balance sheet indicated that the company was heading for a fall.  It experienced a very sharp deterioration in the quality of its current assets, leading up to a precipitous decline in its share prices – which should have come as no surprise to those who inspected the annual report.

Warning Signs

Northern Rock, the UK’s biggest mortgage lender at the time of its collapse, and Cattles, a doorstep lender to the less well off, had similarities too. Whilst Northern Rock’s financing weaknesses were exposed by the financial crisis of 2007, both companies were far too optimistic as to the great British public’s intentions to pay off their debts. This was clear from their annual reports. With both, lending to customers rose aggressively but their bad debt provision did not.

Autonomy, which was acquired by Hewlett Packard (HPE) in 2011, had the whiff of iSoft about it in the way it recognised revenue from the sale of software. The lessons of iSoft, the company at the heart of one of the world’s largest failed IT projects to join up the UK’s National Health Service digitally, were seemingly ignored by Hewlett-Packard.

Large accruals of income are warning signs.

Accruals of income are only estimates, and therefore dependent sometimes on over optimistic and enthusiastic management. I am being very kind here of course. There was certainly optimism and enthusiasm by management which resulted in trouble for iSoft, Cedar Group, Utilitywise (UTW) and  Slater & Gordon (SGH), which foolishly acquired Quindell’s personal injury business for an eye-watering £637 million in 2015.

Mitie (MTO) had parallels with now bust Connaught. There were quite a few accounting shenanigans at these two companies. Both capitalised significant start-up costs incurred in organising new contracts which allowed profits to be overstated. It told us this in their annual reports.

Beware Acquirers Bearing Gifts

Not all mergers and acquisitions add shareholder value. Matthew Clark, a doyen of the UK drinks sector, was acquired by Bargain Booze owner and new kid on the block, Conviviality. Conviviality had to have two bites of the cherry-ade as they reappraised and reduced the fair value of assets acquired at Matthew Clark some 22 months after buying it.

That told us all we needed to know about their financial nous.  It should have come as no surprise that Conviviality failed to account for tax and made mistakes in its forecasting.

It was obvious too that Slater and Gordon’s acquisition of Quindell’s personal injury business and Hewlett-Packard’s acquisition of autonomy were bound to destroy shareholder value because neither of the acquirees accounts stacked up – in both cases there was just too much subjectivity in revenue recognition. Neither Slater and Gordon nor Hewlett-Packard, it appeared, did the required level of due diligence expected of management.

Watch for a Spending Spree

At AO World (AO.), an internet retailer of washing machines and other white goods, a spike in spending on advertising with search engines – which was clearly shown in the company’s helpful IPO documents – indicated that there was a new cost paradigm in play and previous profits were going to be difficult to replicate.

That the trend of pedestrian growth in advertising with search engines like Google was over for this online retailer was either not seen by some investors, or just ignored. AO World has yet to report a profit since it floated.

Sports Direct dived like a swallow for 20 months after flotation, losing nearly 90% of its value. Of course, that could have been because England’s finest failed to qualify for the 2008 UEFA European championship and Sports Direct had forecast good sales of white shirts with the three lions, but a glance at the IPO prospectus showed an unusual adjustment to inventories in the year before the flotation that was worthy of question.

The Importance of Swerving Losers

Picking stock market winners consistently is very difficult – which is why even the very best professional investors rarely stay at the top of their game for ever. But avoiding stock market disasters – which is probably more important than picking winners – through the simple analysis of annual reports and the application of the Iceberg principle can be done regardless of what themes and trends are playing out in financial markets.

 

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The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Rating
AO World PLC127.00 GBX0.79-
Carillion PLC14.20 GBX-28.95-
Hewlett Packard Enterprise Co14.64 USD-0.68
MITIE Group PLC128.00 GBX1.35-
Slater & Gordon Ltd2.30 AUD0.00-
Utilitywise PLC5.30 GBX2.02-

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