Avoid Investing in Companies With Attributes of Bad Business

In a recent post, we identified many of the traits that make a company a good investment. Today, we’re going to look at the opposite side of that topic, and consider some of the attributes of bad business.

In some cases, the bad attributes are simply the exact opposite of the good ones. But in others, they are completely unrelated traits.

Obsolete Technology/Declining Industry

Technology is changing quickly, and in the process, it’s changing entire industries. But one thing a company cannot afford to have is a large investment in obsolete technology. An example would be a company that is heavily invested in equipment that manufacturers videocassettes — with the widespread use of compact discs and other media, videocassettes simply have no future.

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If a technology or an industry is in decline, the entire sectors are best avoided.

Steady Money Loser

Companies that lose money year after year are not investment grade stocks. Until a company can become profitable, you should avoid it. The only possible exception — and it is a speculative one — is when the company’s stock price is in the basement, and a takeover is extremely likely.

No Strategic Vision

A company that is languishing has enough problems already. But if management doesn’t have a coherent plan to improve the company’s prospects, the company will eventually disappear. There has to be a strategic vision as to a) a better future, and b) a detailed and workable plan on how to get there. If that is not readily evident in the company’s annual report, and in the opinion of industry analysts, the company needs to be avoided as an investment prospect.

High Legacy Costs (High Cost Producer)

Many companies have brilliant products and even solid profit margins. But if the cost to produce the products is high, the long-term prospects for the company are not likely to be favorable. Unfortunately, this describes many manufacturing companies who are operating in an environment of relatively inexpensive foreign producers and increasing use of robotics.

A Commodity Based Product

If a company relies primarily upon its cash flow from commodity-based products, it will be subject to the whim of price swings in those commodities. Rising commodity prices can squeeze profit margins, while declining prices could indicate declining interest in the company’s product lines. Generally speaking, companies with commodity-based products tend to have short, sharp periods of high earnings, followed by years of distress.

It should also be noted that it’s far more difficult for a company to manage predictable growth with commodity-based products. Raw material price swings can make any future projections an educated guess at best.

Poor Corporate Governance

More than anything else, when you’re investing in a company, you’re betting on its management. While you may like a certain industry, ultimately the success of the company will come down to the strength of its management. If there is any indication that management is anything less than top flight, you’ll be better off looking at other companies as investment prospects.

Heavy Regulation

Some industries face very heavy government regulation. Not only is this something you should know before investing in a company, but you also need to carefully consider if you want to invest in a company subject to it. It’s tough enough for company to deal with competition, changing technology, shifting market preferences, credit conditions and labor issues without having heavy regulation as an additional and very heavy burden in the mix. A single significant regulatory change in an industry can undermine a company’s profit potential overnight.

The one consolation you have is that since the regulation affects the entire industry, it also affects the company’s competitors in the industry. However, certain legislation can have a greater impact on the company’s outlook than it does on the industry in general.

Prone to Litigation

Perhaps an even bigger variable is litigation. This is because litigation is generally centered specifically on one company and only rarely on entire industry groups. In addition, the magnitude of litigation, and its outcome, are very difficult to predict, measure, and prepare for.

In virtually every company in every industry are subject to potential litigation, but some industries are more exposed than others. The food and pharmaceutical industries are two such examples of industries subject to predictable litigation.

High Maintenance Capital Expenditures

Some companies and industries are what is known as capital intensive. If this is normal for an industry group, it may not be a problem for a company in the group (though other industry groups may provide greater growth potential). But if a company’s capital expenditures are high even for its industry, it could be a sign of distress.

Some companies are burdened by outdated or obsolete assets. This forces them to spend higher amounts of money in order to maintain the existing assets in working order and replace them. This can represent a drain on earnings for many years. A well run company is continually repairing, upgrading, and replacing its assets, so that it does not bear a disproportionate expense in a relatively short amount of time.

A Weak Balance Sheet

A weak balance sheet can expose problems in a company, and even its ability to continue as a going concern. Before investing in any company, first take a close look at its balance sheet. This will give you a better idea of the company’s true financial position, as well as identify any hidden surprises that could come up later.

A poorly run company can often increase both its revenues and earnings by “living off it’s capital”. Which is to say that it may be increasing liabilities at an excessive rate, and relying on a declining physical asset-base.

Excessive Reliance on Credit

Some companies finance their growth by issuing new stock, some fund it out of earnings and others rely on credit for expansion. There are pluses and minuses in each of these methods, but a company that relies too heavily on credit could be building future problems. Consider the following:

Credit creates fixed expenses, income fluctuates.Too much credit weakens the company’s balance sheet.Excessive borrowing could make it difficult for the company to obtain credit later.It could also scare off future equity investors, forcing even greater reliance on credit.It could create future liabilities that future income cannot cover.It raises the possibility of corporate bankruptcy at some point future.

Poor Market Position

If the company has a poor market position, but it is growing quickly and rising in the ranks, this may not be a problem. If it has been languishing in a low position for several years, or worse – seeing that position fall – it probably is not an investment grade company.

Poor Brand Recognition

When you are investing in a company, you are in reality investing in its primary product lines. If those product lines have poor brand recognition, you may have an insurmountable problem. It is a reality of the marketplace that the majority of competitors in any given industry are “me too competitors”. They are out in the market with a product line that is okay, or even pretty good, but not highly desirable or likely to attract increased future business.

Even if the company’s numbers are good overall, if it has poor brand recognition among its products, the company is best avoided.

Are there other attributes of bad business not listed here that you consider when investing in a company?