How to Tell a Company Is In Trouble
When kids are about to get in trouble, the signs are a cinch to spot. The cookie jar lid is loose. Unfinished homework assignments peek out from notebooks on the hutch, not far from the cookie jar. Fifteen Justin Bieber downloads pop up in your iTunes account. (The trouble associated with picking this artist is another concern.)
Among the corporate elite, juvenile behavior isn't all that much different. Over-the-top toga parties pry the spending lid loose. Cooked books peek out from under the earnings statement, not far from the toga party invites. Justin Bieber, a buddy of the CEO, is named to the board of directors. (The trouble with placing a pop star with a bad-boy reputation on the board is another concern.)
Case in point: Tyco stock tanked nearly 80 percent in 2002, as CEO Dennis Kozlowski and other senior executives looted the company. Kozlowski's abuses made headlines when footage surfaced of a $2 million toga party in Sardinia he hosted for his wife's birthday. It featured, among other things, an ice sculpture of Michelangelo's David urinating vodka.
Uh oh ... trouble.
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OK, so that's the obvious kind. But what of caution flags borne of more commonplace sources that can lead to the same terrible results? The kind of trouble that, even now, could be doing the David-with-the-vodka trick all over your investment stash?
For all the lurid details of its flameout, Enron offers a classic example of how almost everyone missed some pretty clear, everyday signs. Long before the energy giant began its nosedive into investor infamy, Enron reported diversified growth that was too good to be true.
Yet arguably, any distress signals were lost in a fog of media fawning. Fortune magazine named Enron "one of America's most innovative companies" for six years straight, an annually blown call of "Dewey Defeats Truman" proportions.
To be fair, trouble signs aren't exactly on anyone's radar when the company has its name emblazoned on a Major League Baseball stadium, or doubles its share price between New Year's Eve 1999 and 2000. Still, "Enron had been expanding far too rapidly into too many new areas," says Phyllis Ezop, a strategy consultant and president of Ezop and Associates in the Chicago area.
Despite Enron's accolades for innovation, "tackling all those new areas requires immense investment for startup and for developing expertise with the new businesses," Ezop says. And while Enron went the way of the dodo by 2002, current investors who fail to learn from that example could find their earnings extinct.
Indeed, companies that stay laser-focused on a singular transformation strategy may have a much better chance of staying out of harm's way.
"Our analysis of about 900 companies between 2010 and 2015 reveals those that focus on fewer, bigger programs are more effective for their shareholders," says Greg Portell, partner at A.T. Kearney and based in the St. Louis area. "Companies with 'big bang' programs generate market cap growth of 78 percent -- outperforming the S&P at 55 percent and serial transformations at 26 percent."
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Another key sign to look for, experts say, is the state of a company's debt.
"Equity investors, especially individuals, often fail to notice or even follow the patterns of borrowing that companies take on," says Jay W. Sukits, a clinical assistant professor of business administration finance at the University of Pittsburgh's Katz Graduate School of Business. "Sometimes this might mean a slightly higher cost of debt, or it may be a situation where a company becomes a 'junk bond' if its rating falls below investment grade."
In the former case, the debt rating of ExxonMobil Corp. (XOM) was lowered in April from AAA to AA+ by Standard & Poor's, one of the major rating agencies of publicly traded companies. "That's not a big deal since a AA+ rating is still excellent," Sukits says.
Yet the junk bond situation "may have catastrophic consequences for the company's access to capital," he says. "In the worst cases, companies fail to pay their debt service, and they are forced into bankruptcy." So a company's debt rating, while it likely won't dive bomb overnight, could follow a trajectory that gradually casts it into bloodier waters.
"Debt is not 'printed' like stock prices, and all of the lending and bond trading takes place in an institution-to-institution marketplace," Sukits says. "But debt downgrades tend to be an early warning signal that something is amiss with a company's revenues, earnings per share or cash flow." Just ask institutional investors, who follow ratings agency activities very closely.
So it's often not the sexy stuff of headlines -- scandal, corruption or a Tyco-sized soiree -- that will tell investors what they need to know before they get hurt. Nor is it necessarily something more grounded: the recent drop in energy-related stocks, for example.
The crucial distinction comes down to this: When an entire sector is in trouble, it's very likely to bounce back, unless it's all about making buggy whips for motor vehicles. And so the high-octane gloom-and-doom over your favorite energy investment tanking may well amount to so much fumes.
BP plc (BP) and Suncor Energy, for example, have had similar trajectories. Between September 2014 and 2015, both lost a third of their share price but have recovered some ground since: Suncor is up 6 percent, BP 14 percent.
But suppose one of them truly were in trouble? To begin with, the shenanigans some greedy CEOs are determined to hide isn't something any investor can control, or blame themselves for missing once the illegit hits the fan. As Portell puts it, "Fraud is difficult to catch outside an organization."
Yet it doesn't take a detective to spot sliding debt, scattered strategy or a sticky-sweet overdose of positive media spin -- just an investor who's cautious and vigilant. For at the very least, a combination of those signs points to a portfolio pothole ahead.
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And if it's a sinkhole, the worst time to find out is once you've fallen in.
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