7investing Team Podcast: Identifying Red Flags - 7investing
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7investing Team Podcast: Identifying Red Flags

September 23, 2021 – By Simon Erickson

We’ve written quite extensively about what to look for when buying a new stock. Great management, a vast market opportunity, and scalable margins are all accolades to consider when evaluating a company’s future upside potential.

But while we always aspire to be long-term investors who buy-and-hold stocks indefinitely, it’s sometimes just as important to know when to head for the exits.

In some instances, there are clear signs of impending doom. SEC investigations of accounting fraud are never good news; nor is a CEO’s abrupt departure for unexplainable reasons.

Though in other cases, there may be good reasons to sell that aren’t quite so cut-and-dry. And being aware of these potential warning signs could save you a lot of future pain in your investing returns.

In our September Team Podcast, our lead advisors share the red flags that we watch out for as investors. We describe several warning signs — and several of them aren’t immediately obvious — that could indicate there is upcoming pain for a company and its shareholders.

Each advisor also published an article that describes the red flags they watch for. Here’s a list of those articles:

We also hold our own recommendations to the same high standard! In a recent premium update, we took a look at a few very specific red flags that we’ve noticed on several of our previous recommendations. If you’d like to see that report, please click here.

Publicly-traded companies mentioned in this interview include Altria and GoPro. 7investing’s advisors or its guests may have positions in the companies mentioned.

Timestamps

00:00 – Overview and Topic Overview

00:52 – Anirban Mahanti shares the warning signs he looks for

04:31 – Dana Abramovitz shares the warning signs she looks for

05:47 – Maxx Chatsko shares the warning signs he looks for

09:24 – Dan Kline shares the warning signs he looks for

13:02 – Steve Symington shares the warning signs he looks for

16:25 – Simon Erickson shares the warning signs he looks for

Transcript

Simon Erickson  0:00

Hello, everyone, and welcome to today’s 7investing team podcast for September of 2021. I’m 7investing lead advisor Simon Erickson, joined by my advisor team and we always at 7investing like to talk about the good things, we always like to pitch our favorite recommendations every month. Point out all the good things that we like about investing. But we’re gonna take the opposite perspective on today’s podcast and talk about some red flags that investors should consider. There are certain things out there that as investors we keep an eye on. And we want to make sure that we’re paying attention to that might mean that you’re in for coming trouble with an investment. With that said, we’ve got the majority of our advisor team here with us, I’m going to start with Anirban Mahanti, down in Sydney, Australia. Anirban this is something we all have a different perspective on but what’s one or a couple red flags that you tend to look for as an investor?

Anirban Mahanti  0:52

Yeah, I’m going to first Simon talk about something I actually don’t actively look to sell, which is very different. Because what I what I do is if I need to buy something, I don’t have cash, then I am looking actually to raise some capital, in which case in which scenario, I will actually look at something that needs to go to make room. And I don’t like to do this often, because it’s basically making two decisions, and I hate making two decisions back to back because it just reduces your probability of success. So that said, it doesn’t mean that I don’t follow the companies I would own or companies that we have on the scorecard, I would. So one of the big red flags in management turnover, in my opinion is always a red flag, right? If the CFO leaves for some reason. It can spell trouble. So that’s one.

And I think the other big one is, in my opinion for like, especially stocks that I look at companies I own, which are high growth, they typically tend to be high multiple companies as well, because the growth means the multiple just gets pushed up. In that context, it is important to see that the growth is maintained. A rapid deceleration of growth can spell trouble, it basically is an indicator of what might happen in the past. All that said, I would say that, you know, those two would be my my big, big flags. But all that said, I’d say that, you know, companies can have slow quarters couple of slow quarters, it does not mean the end of world has arrived. And, you know, there are companies which have been, you know, flatlining for three, four or five years, and then they are shot up, right? So patience is probably the most important thing. But those two things I’ll keep an eye on.

Simon Erickson  2:32

That makes a lot of sense. in year one, I don’t know that you like to look at cutting edge kind of growth companies. But if you see that deceleration, you’re thinking that’s kind of a red flag that maybe they’re not as far ahead of the pack as you might have originally thought.

Anirban Mahanti  2:44

That is right. Yes, thesis might have been wrong.

Simon Erickson  2:46

Perfect. Dana Abramovitz, let’s come to you next, you take a look at healthcare companies or Life Sciences, what’s a couple of red flags you look for as an investor?

Dana Abramovitz  2:54

Well, you know, so similar to what Anirban said, definitely the leadership, you know, I, when I look at something, I look at the fundamentals of how the business is being run. And, certainly, the leadership that’s running it, and if there is a change in that, or in the chain, if there’s a change in how they’re running the company. And so, you know, oftentimes I’ll look at the SEC filings and just kind of look at, how much inventory they have their accounts receivable, you know, like, where they’re investing money. So, you know, like, where their expenses are, just to kind of see and make sure that it’s going along with what my initial investment thesis was. Like, in that area of growth that they initially said that they were going in? And then the other thing that I look at is, is the market, you know, is there a significant change in the market, such that the company’s products and, and their vision, you know, might change or may no longer support that market need. So just kind of looking at those things. Yeah

Simon Erickson  4:10

Could you maybe double click on that a little bit Dana? I mean, obviously, every company with Investor Relations, wants to put their best foot forward, always wants to make it look like they’re doing all the right things, and then have a great vision for where things are heading. Is there anything specific you look for that might be the red flag that says, hey, maybe they’re not managing this company quite like I want this leadership team to be doing?

Dana Abramovitz  4:31

Yeah so I’ll look at net revenue, you know, quarter over quarter, year over year. Again, the accounts receivable, you know, if they’re made, especially in in health care companies, just because, you know, the way the sales cycle is, and, you know, a lot of times revenue comes in, in the form of reimbursement. So, you know, there’s a delay on that. So if it’s an extended delay, then that kind of indicates that, you know, whoever is, you know, reimbursing? You know, so be it private insurance or Medicare, Medicaid, you know, there’s some failing there. So that, you know, just those are just quick glances at the financials can, you know, kind of pop up to me and just be like, Oh, that’s something to look into. And then you can kind of look at the notes and see what’s really going on what’s happening here.

Simon Erickson  5:31

That makes a lot of sense. a ballooning, accounts receivable balance might be a sign that things are out of whack, especially if reimbursement delays or things behind the scenes are impacting that a Maxx Chatsko, you cover healthcare as well, what’s something that’s a red flag that you look for out there?

Maxx Chatsko  5:47

Yeah, so one of my frameworks that I use to invest in companies when it’s drug developers mostly, so I look at companies that have technology platforms, because they’re more insulated from risks, they can spread risk around a little bit easier. Other companies have durable advantages, whether that’s in their technology, or maybe the talent they can attract that tends to pay dividends. I also look for companies that are solving important pain points within their industry, or within a certain market or maybe a disease and indication. Sometimes that could be dosing or convenience, or price or anything like that. Now, I tend to invest mostly in earlier stage companies, so I’ve learned to just be a little more comfortable with volatility. Because a lot of companies I’m trying to – I’m investing them much earlier.

So maybe they don’t do a lot in their share prices for maybe a year or so or even longer. But there’s certain call points that I look for, right, I call them de risking events, as Dan knows. And, with a technology platform, that’s nice, because you know, even if one pipeline asset fails, or doesn’t hit the mark, usually there’s many others in the pipeline. So one failure is really not a big deal. It’s quite a bit different from other drug developers that don’t have technology platforms, but you still have to, you know, be able to read results in such a way where, you know, you have to make sure management’s not really spinning the results, or over time, if too many losses pile up, or maybe the technology platform is not delivering quite as you would hope, it helps, in this case, for me to have a good read on the competitive landscape.

So if you’re investing in a technology platform, and maybe if it’s passing clinical trials, but you see other things that are, you know, are there maybe a year or two behind elsewhere in the industry, maybe they’re more convenient, maybe they’re gonna have different dosing regimens, maybe they are going to be more effective, right? And they’re maybe there’s a little further behind, you do have to kind of be objective, and, you know, understand when it’s time maybe that maybe your thesis on that technology platform isn’t gonna work out. So it is gonna become more important going forward with, you know, genetic medicines tend to mostly be technology platforms, right, looking at RNAi, or RNA editing, or gene editing, or base editing, or mRNA. It really changes things. So I think some of these frameworks really come are going to be much more valuable going forward.

Simon Erickson  8:07

Yeah, I know that a lot of the companies like you mentioned, Maxx are such early stage that it’s okay, if things don’t always work out, because you’re so far ahead of things sometimes, you know, phase one, phase two, and trials or things like that. But you’re saying that the that’s not the risk you’re looking for, you’re more of comparing it to what else is going on out there. You said it’s competitive, kind of looking at how they’re performing versus other drugs or other companies that are also in trials and kind of getting a feel for where they stand in the bigger picture?

Maxx Chatsko  8:34

Yeah, so I mean, you know, let’s say, you’re invested in a company that makes monoclonal antibodies or something, right, and they get good results. And maybe that drug even gets approved. But if there’s another platform, maybe in base editing that’s coming up behind it in the same indication, maybe it is more convenient, maybe it does work. And you know, at the end of the day, you’re still investing in companies are generating revenue and profits, right, or one day will be. So here’s the thing about the commercial risks to maybe that the company you’re invested in is going to earn an approval and sell their drug. But maybe that you know, market potential is much more limited, because something else is coming up right behind it. So you do have to always be objective and keep the competitive landscape in mind.

Simon Erickson  9:15

Sounds great. Dan Kline, Maxx gave you the shout out when he says that you were familiar with those de-risking events he was talking about, what’s a couple red flags you look for in the investments that you make?

Dan Kline  9:24

Yeah, so this isn’t one I’m consistent on. But sometimes you own a stock, and they do things that maybe don’t change their business, but make you feel yucky about owning it. And I know this can be and I’m sorry to use a technical term, like yucky, but I know that this can be personal that some people don’t really care, the ethics or how a company behaves. But sometimes there’s a stock I own and I watched them repeatedly do things maybe treat their employees poorly, maybe show a disregard for you know, the greater good or there’s no particular rhyme or reason to it, but the one time I’ve sold this year, one or this last the past eight years.

To be fair, the one time I’ve made a sale, was just a company whose business I believe in. But I simply don’t like the culture. I don’t like how they treated people, I don’t like how they treat their employees. And in my case, there are sometimes just other opportunities. Like, I’d rather look at my portfolio and be excited about everything and want to be a customer of those brands. And again, I know that’s not how everyone does it, some people make your money and then invest in the things or have the experiences that bring you joy. And in my case, they tend to mix quite a bit, I tend to buy things that are places that I like to be part of, or brands that I like to own however it works.

Simon Erickson  10:38

We hear conscious capitalism kind of tossed around a lot these days. Dan, it seems like there’s a movement that what you’re describing is finding its way into investing portfolios. Is the yuckiness factor is that just kind of a sign that management has stopped caring about the things that really should be focusing more on?

Dan Kline  10:54

Well, you know, I’m very sensitive, let’s say I own a restaurant chain, and I find that I don’t, they’re just so example, there’s a farcical example, and that restaurant chain was keeping employees under 35 hours, so they don’t qualify for health benefits. That might just make me feel bad about the chain. You know, it’s that type of thing. And there’s no specific because, look, there are companies that I’m a holder of, or a big fan of, that maybe don’t have the greatest reputations in some areas. So it can be very subjective. But when it is very clear that as a company policy, and it’s coming from the top, that particular company I sold has a bully culture, and I just really didn’t like it. And, you know, I know the CEO a little bit not personally, but indirectly. And I believed it. Like I knew enough to feel like Yeah, not only is this person letting people off, he doesn’t feel bad about it.

He’s not doing it – like a lot of company has to lay people off, I had a friend who got laid off and very proudly got called back this week, you know, at a well known company. So there are ways to handle things that are humane, that still address business concerns. And there are ways and we see this and I get it as a shareholder, you should want your company to make as much money as possible. But during the pandemic, I forgave some of the companies I own for not making as much profit if it meant holding on to workers. And we’re going to see that in the long term, if you’re a growing company, retaining workers was absolutely the way to go. It is an advantage for say Southwest Airlines to have not laid a ton of people off.

But they did have a lot of early retirements. Because if you return to growth, you know what, it’s not easy to find? Skilled workers who could run new locations or fly new planes or you know, I don’t know, make a really good Margarita at your restaurant chain. Like there there is going to be big value, I actually think that’s going to be one of the stories of the coming year is the sort of ongoing value in retaining workers. We’ve seen that with some companies paying for college and things like that, you know, so have seen your company, really do the opposite made me not want that in my portfolio anymore.

Simon Erickson  12:55

Great points on that. Thanks very much, Dan. Steve Symington, let’s come to you. What are a few red flags to look for as investor out there?

Steve Symington  13:02

Oh, man, I’m kind of along the the feeling yucky lines. One of the first things that comes to mind is fraud. I mean, that’s it seems like that would be a red flag that should turn you off forever. But the startling number of investors are willing to stick with the company even after it’s been caught. You know, making fraudulent statements or actually, you know, overstating financial results that require restatements after they’re caught and they say yeah, it’s fine. Now we’re not going to do it anymore. Insider trading, you’re lying about a product’s capabilities, you know, Theranos and Nikola come to mind, right? The the the trial that’s in the news, and then the fake truck demo that was rolling downhill that they’re like, well, we we just said it was in motion. It wasn’t, you know, we never said it actually had an actual engine, like come on. Like, those are the sorts of things that will I’ll go, like, not gonna touch you with a 10 foot pole.

But I mean, I’ll cheat a little bit by by adding a secondary, maybe more nuanced set of red flags, is when I see businesses pivoting, like their core business pivots for the worse. And that bothers me. But it’s one of those things where you have to determine whether the pivot is actually an astute move, or whether it’s something they’re doing just because they have to, and in one company that kind of comes to mind is GoPro, back in 2018. You know, a lot of people were really excited about the potential for them entering relatively big total addressable market with drones like the Karma drone. And then they had some recalls with the Karma drone.

And then they realized it was really hard to compete with some of the bigger players DJI, I think, and, and then they finally announced that in 2018, that they were leaving the drone market and discontinuing drones altogether because it had a, I think, regulatory headwinds in the US and Europe that were going to reduce its total addressable market. They said not worth it for us and, and basically huge incremental revenue opportunity – gone. And sure they pivoted to do some more high margin kind of software services. But the core business is narrow enough and slow growing enough and seasonal enough that it kind of makes me just say, why would I really want to own this company at this stage? So, yeah, when when their core business pivots hard for the worst, that that’s a big red flag for me.

Simon Erickson  15:23

Yeah so we’ve got, of course, the fraud, which is that, like fraud is, of course, a red flag for everybody. But I think that, Steve, that the nature of what you’re saying here is when companies tend to be a little too marketing or tend to overly pitch, something that they’re pivoting in isn’t really what they do so much, but they’re trying to convince everybody that that is the right thing for them.

Steve Symington  15:42

Yeah. And it’s not so much like just delays in a core business, which we’ve seen, you know, with some of the more prominent like, space companies out there, for example, you see some that it’s you takes long because but there are a lot of those, their core business trajectory kind of remains intact, even if it takes longer. But when you have a company like Nikola that that is basically caught red handed, rolling a truck downhill, and implying that it moves and then saying we will we never actually said that it works. Yeah, those are those are bad. And that, to me is fraud. But I think he actually just got indicted on securities fraud recently, the CEO of that company, but as a result, but anyway, yes.

Simon Erickson  16:25

Well, I think is a perfect segue Steve to the one that I wanted to mention, which I think is kind of related to what you said to which I’m going to call mine poor capital allocation. We see capital allocation is the link between business results, and investing results. Sometimes companies do this really, really well. Like when Disney acquired Marvel for $4 billion. It got a tenured franchises that it can monetize through through movies and IPS, and intellectual property. Amazon when acquired KEBA robotics for $775 million – has these cute little robots that are making all of its warehouses much more efficient now, but the opposite is true too, that it seems like sometimes companies kind of like you just mentioned, Steve are really trying to stretch beyond their circle of competence.

And the best example of a terrible capital allocation decision in my mind that came to mind was Altria. This is America’s largest cigarette manufacturers, the largest cigarette maker that goes out in late 2018, and acquires a 35%, in an e-cigarette maker called Juul. And it spent $12.8 billion for that stake because it was just so excited about the adjacent markets of vaping and E-cigarettes as what it was calling a compliment to combustible tobacco. Even though at the time, there are a lot of people kind of raising flags and saying, Hey, are you sure you want to do this? Isn’t there a lot of controversy about teens that are vaping and the health impacts of this and regulatory concerns, and this is kind of outside of your market anyway.

And long story short on this – between the FTC filing a lawsuit against Altria against school districts filing lawsuits against Juul for mysterious loyal illnesses and a variety of other things. This was really breaking the core competency that Altria had of just paying dividends and buying back stock. It went out there and it said we’re going to spend almost $13 billion on what was questionably an overpriced acquisition at the time in a pool that was having sharks swimming all around it with potential issues and concerns. And when you look at how they wrote down the acquisition to the entire Juul stake being worth only $1.6 billion, less than two years later, it’s it’s very clear, this is a terrible acquisition that went wrong on so many different counts.

In fact, had they just paid out that amount of money as a dividend, rather than the impairments that they had with the Juul acquisition within a two year period, it would have amounted to a 12% yield for capital for all of its investors, they wrote down an 1/8th of the company’s market cap just by making a really terrible acquisition.

So again, to kind of recount all of these just mentioned about poor capital allocation decisions, stay away from fraud, or things that seems deceitful or overly marketed. Stay away from the yucky companies that have turnover and training that you have to really want to keep the expertise of your labor pool. Look for it’s okay to have small mistakes or trials that don’t work out for small biotech companies. But make sure we’re taking the bigger picture and the competitive dynamics into account when we’re looking at those. As we’re looking at healthcare companies to make sure that we look at kind of things that might not seem right – reimbursement delays, or how leadership and fundamentals are actually running the company at the top line. And as Anirban said in the very first piece, watch out for management turnover and especially for expensive quote unquote overvalued companies. We want to make sure that we’re seeing solid revenue performance and growth that justify those valuations.

There’s a couple of things we’ve given you to look at that hopefully kind of, you can keep in mind as you’re investing in companies and look for a couple of these red flags. It’s always hard to hit the sell button when you’ve made an investment in a company. But sometimes if you see these problems in advance, it can save you a whole lot of issues further down the line. So thanks very much to Maxx, to Steve, to Dana, to Anirban, and to Dan. For perspectives on this month on when it we might be seeing red flags as investments. We hope you tune in next month for yet another one of our 7investing team podcasts. We are here to empower you to invest in your future. We are 7investing.

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