Earlier this month Radio Shack filed for bankruptcy. In January, it was beleaguered teen retailer Wet Seal. For those who follow the sector, these headlines were about as surprising as news of a Kardashian break-up.
But according to Scott Fearon there are a handful of similarly doomed companies still out there – “Dead Companies Walking” he calls them in his book – that are at just as much risk of an untimely demise. While Fearon isn’t advocating picking these companies out for shorts, he does think investors should be on the lookout for signs of trouble to avoid.
“A lot of companies have made the same mistake through the decades that have led to their failures,” Fearon told Yahoo Finance’s Jeff Macke in the above video. He went on to list some of the telltale signs.
“Debt is what leads to bankruptcy nine times out of ten,” Fearon said. We’re not talking average corporate debt, either, but “excessive debt loads that a company can’t either pay interest and or principle on,” he said.
Some companies Fearon points out with large debt loads include retailers like Sears (SHLD) and JCPenney (JCP). We should note that stock-wise, JCPenney is having a much better time of it than Sears, up some 35% in the past year as investors seem happy with the company's progress following the return of Mike Ullman. Sears hasn't been so lucky, going essentially nowhere in the past 52 weeks.
Related: Amazon going old school?
But even healthy companies have debt. Which means the real question here comes down to a company's ability to pay its debt: revenue.
“Great companies have rapidly growing revenues,” said Fearon. “Companies that go into bankruptcy don’t.” Yes, it really may be that simple.
“As an investor, you need to look very closely at the cash flow, the revenue growth or lack there of, and the level of debt and where it was, say, a year or two prior.”
Going back to the two previous examples, Fearon points out JCPenney and Sears are both dealing with stagnant same store sales, not ‘rapidly growing revenue.’ That’s one of the reason he advises investors not to look at these companies’ cheap stock prices as a buying opportunity. He also put Wet Seal and Radio Shack in this category... and we saw how those played out.
Growing too fast
This last warning sign might seem counter-intuitive to us nowadays. We’ve all gotten used to the tech model of rapid expansion of user base, something that can be done quickly and with minimal resources. We forget that many old school companies can’t and shouldn’t grow that fast.
“In brick and mortar retailing, and in a lot of industrial manufacturing, if you grow very, very rapidly your product quality might be dropping, you can be burning up your balance sheet,” he said. “Rapid growth can also quickly lead to problems down the road.
Related: Stocks rise after strong jobs data; Sprint moving into Radio Shack stores
Remember Crumbs Bake Shop? The small New York City cupcake joint launched in 2003 and expanded at a rapid clip before IPO-ing in 2011 and then declaring bankruptcy last July. The company has since re-opened a handful of stores as part of a restructuring that will diversify the brand beyond cupcakes.
Fearon also warns investors against companies that are in risky business (fads like, say... cupcakes) or dying businesses (like video rental – sorry Blockbuster). While history doesn’t always predict the future, there are some lessons to be learned from the telltale signs of trouble.
“There are common mistakes, not learning from history, not focus on your customers, getting caught up in a mania, or getting caught in an industry that’s sunset-ing,” Fearon said. “Avoid these companies as an investor.”