We're all aware of our own mortality, and we often take preventative measures to fight against it. Similarly, there are many ways that companies can die, and if we're smart, we'll be on the lookout for some of the warning signs as we assess interesting companies we run across.
In a recent issue of Outstanding Investor Digest, respected fund manager Bruce Berkowitz offered a handy list of how companies can die:
Here are the ways you implode: You don't generate cash, you burn cash, you're overleveraged, you play Russian roulette, you have idiots for management, you have a bad board, you de-worsify, you buy your stock too high, you lie with GAAP [Generally Accepted Accounting Principles] accounting... But you can't lie about how much cash you have.
Let's take a closer look at these warning signs and how they play out in some real-life examples.
Bad boards Bad signs for a board of directors include things like lack of experience in a particular industry, as well as when directors have too many commitments, including sitting on a number of other corporate boards. Bill Ackman, currently engaged in a proxy fight with Target (NYSE: TGT), recently criticized its board, arguing that none of its directors have executive-level knowledge about either the retail industry or credit cards and real estate, which are crucial to Target's operations. Ackman also pointed out that directors serving on as many as four corporate boards left them overcommitted.
Similarly, when Bear Stearns collapsed last year, some of its directors had other companies to worry about as well. At the time, three of Bear Stearns' 12 directors served on the boards of at least four other public companies.
Warren Buffett has warned of boards where directors receive a substantial portion of their overall income from their board duty. In such cases, the director may be more interested in keeping that gig than in serving the best interests of the shareholders.
Too much leverage Overleveraged companies are ones with hefty debt loads. That can crush a company by demanding much of its cash and preventing it from applying that cash to other important needs. Here are some companies that popped up when I ran a screen at our Motley Fool CAPS community for one- or two-star companies (out of a possible five stars) with debt-to-equity ratios of two or more:
Company CAPS Rating Total Debt-to-Equity
Of course, not all debt-laden companies are in any imminent danger of going out of business. It's important, though, to keep an eye on companies with high debt levels, to make sure they earn enough to maintain their debt payments.
Cash flow problems To learn how much money a company has, you can check its cash level on its most recent balance sheet. But that will only tell you part of the story. It's helpful to compare that with recent quarters and years, to see whether cash levels are rising or falling.
You can also check to see exactly where the company's cash is coming from -- its operations, financing activities, or investments -- by examining the cash flow statement. Calculate its free cash flow by taking the cash from operations and subtracting capital expenditures. If that's a negative number, consider that a red flag.
Subpar investments You can also look at a host of other factors and numbers. Return on invested capital (ROIC), for example, reflects how effectively the company is investing its money, whether in new factories, additional advertising, acquisitions, or what-have-you. Below are some companies with ROIC numbers that are markedly different from their historical levels: