Insights for Investors by Investors

Five steps to avoid ‘lemon’ stocks

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It is never a good feeling seeing the value of your shares tumble uncontrollably. Even worse is doing nothing about it until it is all but too late. This sometimes arrives in the blink of an eye; sometimes it’s a gradual process, almost unnoticeable. Even in a rising market, there is always a basket of stocks that no-one wants to touch.

Once a stock drops by a certain percentage, the maths of percentages kicks in. As a loss gets larger, the percentage gain required to get back to break-even increases at a much faster rate. A loss of 25% requires a 33% gain to get back to break-even.

The name of the game is being able to avoid (or at worst sell-out of) a stock before it turns into a lemon i.e. before the percentage loss becomes too great. While there is no guaranteed way to prevent a loss with 100% accuracy, there are ways to minimise losses. And ultimately, avoiding the worst 10% or 20% of companies each year can be enough to outperform the index significantly.

With the help of Aoris Investment Management’s report, “The bottom 20%. Staying clear of the equity market disaster zone,” we have put together five easy financial ratios, to make sure you haven’t bought a potential bomb.

  1. Return on Invested Capital (ROIC) – Often referred to as the company’s profitability. Measured by dividing profit after tax by the sum of debt and equity. According to Investopedia, this ratio is used to assess a company’s efficiency at allocating the capital under its control to profitable investments. The return on this invested capital gives an indication as to whether the company is investing its money to generate a positive return or whether the company is spending like ed capital ratio gives a sense of how well a company is using its money to generate returns. In this case, the higher ROIC the better.
  2. Earnings Per Share (EPS) – Divides net earnings available by the average outstanding shares over a certain period of time. It shows the company’s ability to produce profit. The EPS figure should be used to analyse against similar companies in the same industry but isn’t necessarily transferrable across sectors. A higher EPS indicates better profitability.
  3. Price momentum – Is used as a predictor of future price performance based on momentum a company’s share price is travelling. The theory is that positive price momentum indicates a company performing well and the high probability that it will continue to do so in the future. (The opposite is true with negative price momentum.)
  4. Cashflow Margin – The profitability of a business solely in the context of cash movement over a given period. As they say, ‘cash is king’. The formula measures how well a company’s daily operations can transform sales of its products and services into cash; profit can be easily manipulated. Cash is an important part of the business. Knowing the company has significant firepower and can continually improve its margin is valuable and a key indicator of performance. Cash flow margin = (Net profit + Non-cash expenses + Changes in working capital) / Revenue) x100.
  5. Quick Ratio – Is the last line of defence. This ratio compares short-term assets to short-term liabilities to assess whether the company has enough cash to pay its immediate liabilities. The ratio disregards current assets that are difficult to liquidate quickly. A result of 1 equates to normal value. A result of less than 1 or negative suggests the company may not be able to fully pay off its current liabilities in the short term. A result greater than 1 suggests a company can fully pay off its liabilities.

Just applying these five profitability ratios to a company’s financial data will help reduce the chances of buying a company that is on a path to financial strife. As well as using the above ratios as a checklist to help identify bad companies, sound judgement is also required, where an analysis of all sides and viewpoints be carefully weighed and considered.

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