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Some Thoughts on Investing Red Flags

I am well aware that investing is not a precise science. It is an art. We will never be 100% accurate when trying to place a value on businesses.

With this in mind, I've built my investment strategy around a core set of principles. These principles are designed to help me sniff out some of the warning signs of bad businesses, as well as the most typical qualities of good companies.


By using the system, I believe, I can significantly increase my chances of avoiding losers and picking winners.

A set of red flags

I have a set of red flags I look for when evaluating potential investments. These red flags consider both a company's financial situation and quantitative factors such as management and company strategy.

To start with the quantitative factors, I would never invest in a company with a high level of debt. Deciding how much debt is too much is crucial when trying to answer this question. Generally, I am happy to invest in businesses with debt of as much as 50% of assets, as long as these assets are so-called hard assets, primarily real estate and equipment.

If the company does not have a lot of real assets on the balance sheet, then I will concentrate on cash flow and debt maturity. For example, does the company generate enough cash to meet its obligations to creditors for the next two to three years if credit markets close? But I generally like to avoid indebted companies, unless they are really cheap.

Cash is king

The second quantitative red flag I am on the lookout for is cash flow. Profits are relatively easy to manipulate. Indeed, CEOs and managers often adjust profits to justify their bonuses. Cash flow isn't easy to manipulate, and as cash is king in business, this is the metric I concentrate on above all else.

Therefore, I tried to focus on cash and cash generation when valuing businesses. I think this gets straight to the bottom line without having to spend extra time worrying about profitability, Ebitda reconciliation, and other accounting. If a company looks cheap on a cash flow basis, I'm interested.

Management quality

Those are two of the quantitative red flags I am looking for when analyzing investment opportunities.

On the qualitative said, my initial focus tends to land on management. You can tell a lot about the quality of a management team by the amount of information they give to shareholders and how they treat their shareholders.

This is something I've learned from Warren Buffett (Trades, Portfolio). If a management team tries to mislead shareholders with over-optimistic forecasts or reported financials, it can be a warning sign that the managers do not have the best interests of all stakeholders at heart.

Managers should be open and honest with their shareholders, even if that means presenting bad news occasionally. Footnotes in company earnings reports can also be a valid source of information on management intentions. If managers try to hide losses or off-balance sheet vehicles in the notes, it can mean that they are not entirely honest with shareholders.

Another red flag I'm on the lookout for is what I like to call "empire building." For example, a lot of companies want to buy rather than build. More often than not, this is a waste of money, particularly when most large deals occur at the peak of the market.

I like to find out if a company has completed any acquisitions recently, and how they have turned out for shareholders. If the business has a mixed track record of buying other companies, it is certainly something to consider. I'm also wary of companies that have diversified into other companies or other countries that are neglecting their home business at the same time.

This is just a selection of the warning signs I am looking for when evaluating potential investment opportunities. It is by no means a comprehensive list.

Disclosure: The author owns no share mentioned.

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This article first appeared on GuruFocus.