Red Flag Pink Flag

13th Nov '17 by matylda

8 comments 3310 reads

Hi All!

A wee bit of spare time so outlined my basic Red Flag / Pink Flag Checklist - Don't mean it to be excessive or anything like that but wondered what other Red / Pink Flags others had.

I come at this from the perspective when I find a share I like and want to buy - I like to try and identify any high level negatives.

The main thing apart from this is checking Stocko comment history for any underlying fundamental flags identified by the SCVR guys and other Stocko members - Cause I'm not smart enough for that kind of depth.

Anyway, here we go - Perhaps I will do a final list in a few weeks after input from all, if there is in fact any interest and input at all!

2 Red Flags = Seriously consider not investing
1 Red Flag and 2 Pink Flags = Seriously consider not investing
4 Pink Flags = Seriously consider not investing

Red Flag

PER < 6 or PER > 40
No Revenue
No Profit
Dividend Cut
Net Debt > 25% Of Mkt Cap
Spread > 10%
AIM Listed Abroad

Pink Flag

PER < 8 or PER > 25
Revenue down or forecast to be down
Profits down or forecast to be down
EPS down or forecast to be down
Operating Margin down
Operating Margin below Sector average
ROCE down
ROCE below Sector average
Dividend flat
Dividend cover < 1
Net Debt > 10% of Mkt Cap
Spread > 5%
Broker EPS forecasts revised down
Change of Financial Director

Do remember this is a kind of final run through sanity check I use before taking the plunge to keep me (hopefully) out of trouble!

All comment and input is most welcome and appreciated.

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The Phoenix

13th Nov '17

Excellent post

HollandSmith

I wish the stocko screener could handle an "or" function so this would be possible to screen

Couple more average shares in issue increasing year on year red flag crushes earnings per share, operating cash flow per share less than eps normalised every year one or two of the last five on stocko is acceptable but every year is a red flag.

JohnEustace

I would add change of CEO to the list along with change of FD. Personally I would have them in red rather than pink.

I also filter out anything sub 50 mil generally to illiquid.

Awk

14th Nov '17

Hi Matilda - I always look at the Shorttracker which in this context would be pink.

https://shorttracker.co.uk/

Carcosa

You seem to be constructing a list that is likely to create a value investing list of shares rather than a 'flag' system which generally applies to identifying companies that are actively mis-stating the true position of the company. There is also some duplication in the list and the need to define what you actually mean by some of those terms. 'Profit' being the most abused term, for example.

However, what is more important is at least having some sort of sanity check-list.

FWIW consider: Excessive debtors, non-organic growth and Current Ratio being on your Pink Flag list.

Mark Simpson

I think you have to define what you mean by Red Flag. What you have used here is some useful rules when you would not want to invest. Usually however Red Flag is used as a more specific terminology to describe indications that a company is intentionally misleading investors through it's financial or non-financial statements.

Financial Red Flags are usually related to the quality of earnings. Which is how likely a company's earnings are to be reflected in the operating cash flow of the business now or in the future. A dishonest management want to move cash form your bank account to their bank accounts and they can do that through high salaries or bonuses funded through equity raises despite not generating shareholder value or in extreme cases fraudulent related party transactions. So the number one red flag is always cash flow doesn't match earnings. The problem is that genuine companies can have these qualities too (at least over the short to medium term) hence why we are looking for a pattern of behavior not a hard and fast rule. (Although the Beneish M-Score attempts to codify this it isn't fool proof. However reading each M-Score criteria and understanding why it is there would add a lot of understanding to this area.)

There are also good books (Financial Shenanigans, Quality of Earnings, Accounting for Growth) that go into the accounting details. Generally though financial red flags show up around three areas:

Revenue Recognition - i.e. when is a sale a sale. Tricks in this area involve booking a sale when no real sale has happened by billing a customer that is unlikely to pay (see recent Carillion (LON:CLLN) receivables write-off), inter-company sales, selling to a distributor that is actually controlled by the company (as has been alleged to have happened at £TCM), or booking the whole of a sale or outcome when there is still uncertainty to the outcome (e.g. Quindell & their hearing loss court cases.) This trick almost always appears as 'Red Flag' of a rapid build up of trade receivables.

Cost recognition - when is a cost a genuine cost. Look out for companies that are always presenting adjusted figures, particularly when they adjust things like cash flow e.g. Quindell) Companies that capitilise large development cost to intangibles are also ones to be wary of since they may be genuine but generally they have moved salaries out from the cost of sales which is open to abuse. Tracking Profit - exceptionals - capitilised development over the long term is a good way of seeing if the company is really generating shareholder value. e.g. Dialight (LON:DIA) see my comment here: https://www.stockopedia.com/co...

Takeovers - buying a company or certain sized stakes give a lot of leeway around both revenue & cost recognition. Be particularly wary of highly acquisitive companies, related party transactions and companies that buy increasing stakes in subsidiaries at ever higher prices (Quindell did this regularly.)

Non-Financial Red Flags tend to be based around management's attitude & the gap between what they say and what they deliver. They management tend to be:

- Overly promotional relying on non-standard metrics e.g. trustpilot scores
- Pushing unrealistic brokers notes such as DCF with low discount rates based on tenuous assumptions.
- Have a big story and small delivery (e.g. £AVN)
- Have a history of corporate failure in past ventures (e.g. Purplebricks (LON:PURP), Quindell)
- Sometimes have a history of fraud (e.g. former CEO of £TCM)

A couple of final notes on this topic:

- Having prestigious customers means nothing. If I offer to provide a commodity product below the cost of production to a large company they will happily sign me up until I am no longer the lowest cost or have exhausted my shareholders capital.

- Develop your own sense for the suitability of an investment. There will always be someone claiming to be an expert in the area, or an experienced investor, or has met management and why you should ignore all the red flags. Listening to them will usually cost you money.

- If in doubt get out. Better to be a non-holder and re-assess the company objectively without loss aversion & ownership bias getting in the way.

Disclaimer: I am not accusing any companies or managements mentioned here of any form of inappropriate behavior. All examples are purely where I personally consider there is an issue that may need further research into the suitability of that investment.

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Matylda

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