As an investor, it's important to inject a degree of reality into your investment decisions and be able to spot what are commonly known as red flags. There are numerous different types of red flags, which are very often easy to spot in hindsight - perhaps not so easy in the moment!

 

Overly optimistic earnings projections

 

If you see a pattern emerging of companies initially being overly optimistic about earnings projections, leading to frequent downgrades and missed earnings targets, this should be seen as a potential red flag for the future.

 

Price volatility

 

Excessive price volatility for no apparent reason can often be a red flag, or sometimes it can be a positive flag. If the price is falling, this may suggest that something is going on behind the scenes that is detrimental to the company's trading.

 

Unsustainable dividend payments

 

There are two main ways to support a share price: prospects for the future and an attractive dividend yield. It's important to balance a company's short-term dividend payments against its trading. If trading is struggling and does not improve in the short term, these dividend payments may be unsustainable.

 

Management turnover

 

We've all seen the announcements of directors and management leaving for "personal reasons," which can sometimes cover what may be going on behind the scenes. If there are continuous high-level resignations within a relatively short space of time for no apparent reason, this should be seen as a potential red flag.

 

Aggressive accounting practices

 

Many analysts prefer to use actual financial figures rather than the adjusted figures often published by management. While these accounting practices may be perfectly legitimate, if they are too aggressive, they may be hiding potential issues that could eventually impact the company's balance sheet.

 

High debt-to-equity ratios

 

This is an interesting topic because it should be seen in relative terms. After all, some industries operate on a high debt-to-equity ratio. However, it's also important to realise that excessive leverage can be beneficial but can also potentially decimate a balance sheet in depressed markets.

 

Insider selling

 

It's essential to recognise that insider selling, the legitimate sale of shares by directors, differs significantly from insider trading. However, if there is a constant flow of insider selling, this could indicate that the prospects in the short term are possibly subdued - a potential red flag for traders!

 

Single product companies

 

Again, this is an interesting topic because some single-product companies will go on to expand their product range and services, many being very successful. However, long-term dependence on a single product/service will eventually attract competition, which will likely erode margins. Be careful!

 

Market hype

 

We only need to look back to the tech boom at the turn of the century to see how some companies, potentially loss-making for years to come, were pushed to astronomical valuations. When reality hit, many of these companies suffered huge share price falls and never recovered. Be very wary of overhyped companies and sectors.

 

Poor corporate governance

 

Whether it is a lack of transparency, a lack of guidance from the board, or potential conflicts of interest, weak corporate governance can erode a company's value from the inside. On occasion, this can also lead to mismanagement and fraud, from which many companies will fail to recover.

 

Summary

 

These are just a small number of potential red flags for investors, which are often "obvious" in hindsight but not so apparent in the moment. Over time, you will develop a gut feeling about investments, company announcements, and potential red flags. This is a very useful skill!

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