Avoiding capital killers

If recent business history has taught us anything, it is that boards and management can be wonderfully creative. Some have and others continue to invent new and creative ways of destroying and losing vast amounts of shareholder money, while being paid handsomely and expropriating funds for themselves.

Stocks from companies like these are called capital killers and can sneak into investor portfolios if the warning signs are not detected. Avoiding these stocks will increase portfolio value and save to effort of putting a stop loss on each stock position. Australian investor Howard Coleman suggests the following three indicators to keep capital killers out of portfolios:

1. Past business performance:

Take a full economic cycle of ten years into consideration when looking at a company’s business performance. Watch out for the following warning signs:

  1. Not very profitable business (Low Return on Equity)
  2. Owner profits not growing (Low Earnings per Share over cycle)
  3. Unpredictable future earnings
  4. Business has too much debt (High Debt-to-Equity ratio)

2. Business model:

In order to understand a company’s strategy and how it drives profits and losses, it is essential to thoroughly understand the current business model. Companies exhibiting the following tendencies are potential capital killers:

  1. Hard to understand or damaged business model (What is exactly the model?)
  2. New technology (Trying to prove something new)
  3. On-going turnaround (Trust us!)
  4. Great story (But no profits in sight)
  5. Consumes capital (Our money)
  6. Takes a long time to deliver (Time risk)

3. Management motivation

People run businesses and that is what you’re investing in. As an investor, you need to feel 100% comfortable with the business’ strategy, focus and goals. It’s important to understand what motivates the management. Avoid boards and management teams exhibiting these management capital killer characteristics:

  1. Strategy not clear (What is the strategy?)
  2. Untrustworthy management (Did not deliver on previous promises)
  3. Empire builders (Acquisitions and building extravagant landmark headquarters)
  4. Overpaid management (Check compensation reports)
  5. Management always wins (No negative repercussions for failing to meet targets)

Summary

Remember to carefully look at past business performance, the business model and most importantly board and management motivation to detect and keep capital killers out of your portfolio.

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