A list of shortcuts I use when screening/sifting through stocks and stock ideas.
Is management ethical?
In my opinion, companies with unethical management are almost never worth it.
- When the share price is low, management may do something to dilute shareholders. They may issue themselves a huge amount of options (e.g. Jemtec). They may buy shares of the company in a private placement (many mining juniors) or privately-arranged deal (e.g. Dryships, QXM/XING).
- They may steal from the company. In the case of QXM/XING, the CEO simply ran off with all the money and went dark.
- They may be lying about the value of the company’s assets. Most resource extraction companies do this.
Here are some easy shortcuts to determine the ethics of a CEO:
- It is usually a huge red flag if the CEO has significant net worth outside of the company in related businesses. For example, George Economou of Dryships privately owns many drybulk carriers and has numerous conflicts of interest with his publicly-traded company (which also owns drybulk carriers…).
- The related party transactions section of the financial statements often contain important details. Many CEOs will make deals that rip off shareholders. These deals may be disclosed in this section.
- Is insider salary reasonable? CEOs that overpay themselves tend not to be very ethical. Many of the part-time CEOs and CFOs in junior mining are overpaid in my opinion.
Is management good?
This is a very tricky question to answer and I don’t believe there is a great and easy shortcut to figure this out.
Ideally, the industry would be in your circle of competence. You would know which metrics are the most important. From there you could figure out which management teams are the best and the worst.
One vague proxy for the quality of management is the long-term track record of a company. The best management teams in any given sector tend to have higher growth in book value, higher shareholder return, etc. Having the highest returns on invested capital in a given sector may also be a sign of good management or some type of hard-to-duplicate economic moat/advantage.
Are the economics of the business good?
This is another tricky question. You really have to know something about the industry and its history. Cyclical industries (e.g. many commodity businesses) are sometimes traps as their future earning may be much lower than their current earnings.
I believe that it is extremely rare for stocks in declining industries to be good investments, so I tend to avoid researching stocks in declining industries. Of course, good investment setups can occur when fears are overblown (e.g. the Deepwater Horizon accident and oil & gas related stocks, Amex’ salad oil scandal, etc.) or investment interest in a particular sector is low.
Any stock with short interest above 15% is probably not a good long investment. The short sellers tend to be far more sophisticated than the rest of the market. Obvious shorts tend to attract a congregation of short sellers.
Any stock where the borrow is above 5% is also probably seriously flawed.
Segments of the market to avoid
- Pump and dump penny stocks. If advertisements for the stock contain disclaimers stating the amount of money paid to the stock promoter… it is likely a pump and dump stock.
- Leveraged ETFs
- Reverse Chinese mergers. I think that 99% of these will be revealed as frauds. There are bizarre exceptions such as Harbin Electric (discussed on Bronte Capital) but nonetheless the level of fraud is extreme.
- Most (though not all) resource extraction/exploration stocks are a waste of time. There are too many companies out there overstating reserves.
- Recent IPOs.
Constant equity raises
Companies that constantly sell stock are usually to be avoided.
Firstly, selling stock is usually very expensive. Suppose the all-in costs of selling stock is 6% (underwriting fees, stock promotion, paperwork and filing fees, etc.). If stocks have an expected return of 6-10%, 6% might be a year’s worth of performance. This is a huge cost especially compared to cheaper forms of financing (e.g. debt). Keeping expenses down is almost always a good business strategy.
Secondly, companies usually (though not always) tend to sell stock when the stock is overpriced. It is extremely rare for a CEO not to do this (e.g. Amazon did not sell stock during the tech bubble; it should have). If a company is selling stock… the stock is probably overpriced. There are probably exceptions to this rule but those situations tend to be very tricky. Some companies legitimately need to raise capital and may sell stock even though it is underpriced (Sirius XM is vaguely like this).
Issuing convertible bonds is somewhat similar to selling stock. Selling call options on your own stock is a good idea if the stock is overpriced. Another similar backdoor method of selling stock is to use it as currency in acquiring other companies. Sometimes there are very legitimate reasons to use stock to purchase another company (e.g. if the combined company has large financing needs, tax reasons, etc.) so the practice is not always a bad sign. Stock-based compensation is another backdoor method of selling stock, although there are many legitimate reasons to have stock-based compensation (e.g. alignment of incentives between a company’s officers to its shareholders).
Insider trading usually suggests something about a stock, but in my opinion it is not that reliable. Some insiders will sell for personal reasons (e.g. Bill Gates wants to fund his philanthropy and to diversify). Some insiders will sell undervalued stock because they needed the money… John Malone sold Liberty stock in the depths of 2008/2009 (likely due to margin calls) even though it was an amazing buy. And some insiders will make token purchases to try to promote their stock even though the stock isn’t underpriced.
Major shareholders leaving the board of directors
Many institutional investors will try to join the board of a company to make sure it doesn’t do anything stupid. Some investors feel that it is important to have partial control over a company to protect their investment. Whenever these types of investors leave the board of directors, it is usually because they are about to unload their shares. The Ontario Teachers Pension plan did this when their nominee left Maple Leaf Food’s board and sold their shares in a secondary offering. Leaving the board lets major shareholders avoid the reporting obligations of being an insider (and any restrictions against insider selling). Shareholders who plan on selling their shares tend to be very quiet about leaving the board. Of course, it is not guaranteed that major shareholders will sell their stock after leaving the board. Generally, I think that it is sometimes a bad sign, sometimes it doesn’t mean much, but it is never a good sign.