How to avoid investing in a company that goes bust
The art of successful investment is as much about avoiding the losers as it is about bagging the winners. After all, I would no more expect to invest in the stock market without having a few setbacks as I would to play football and get the odd kick in the shin!
Fortunately, though, simple mathematics means that while the potential gain on any investment is unlimited the maximum you can lose is 100%. Mind you, that hurts!A recent example of this is Fidentia, which was plundered by executive chairman J. Arthur Brown’s spendthrift ways.You need more than a bright idea for a company to be successfulA study by Nick Hood, senior London partner of business recovery, and restructuring specialists Begbies Traynor, showed that one in 16 AIM companies (AIM companies being equivalent to our AltX shares in South Africa) were involved in a formal insolvency process in the last five years.Analysing the results, Hood and Traynor found that the highest number of formal failures traded in highly competitive markets, such as telecoms, IT, software and engineering. To some degree, this reflects the boom and bust of the technology sector. The fact that investors were so entranced by its growth prospects that they forgot technology businesses can be capital intensive, that barriers to entry are low and for every software program that sits on your desktop, hundreds more have been developed but have never caught on.Another vulnerable group included restaurants, pubs and breweries, which again require capital investment up front and are notoriously vulnerable to fickle fashion.Often these companies start out as nothing more than a bright idea, a clean sheet of paper and the presumption that a few years spent sitting in judgement over other companies qualifies the individual to successfully run one.Beware the managers who let success go to their headsHood explained: "Many of the problems are essentially in the mind and attitude of the people who run the companies."
"Once they’re in the public arena, their attitude can undergo a subtle change. They find distraction and temptation. Their inhibitions are broken down, and they think somehow that as they’re quoted on the stock market they’re indestructible. They’ve raised money from investors and, although they still have large personal shareholdings, the company's money no longer feels like their own. It soon starts to burn a hole in their pocket and they feel under pressure from brokers, fund managers and the media to be seen to be active." This sounds very much like the reasons given for the poor performance of Verimark last year.
As with all AltX listings, they're obliged to forecast the remaining year of listing and provide a forecast for the next year – in effect they're obliged to state some kind of targets to investors and are then under immediate pressure to meet them.
This pressure manifests itself in various ways. Companies plunge into dubious acquisitions, and others, says Hood, "forget the old rule - top line vanity, profits sanity". So they go flat out for sales growth, but at a cost to profit margins. And they forget that working capital has to rise in line with turnover. Often this is where the cracks start to appear.The more transparent a company, the betterIt's especially hard to be under the spotlight of the stock market when things start to go wrong. As Hood explains: "There is a real dilemma for public companies that find themselves in what we call the twilight zone -that period when companies have to run their business not for the benefit of shareholders, but to meet the demands of creditors. How much dare they reveal?"Nobody likes having to admit failure. But, whereas a private businessman can have a quiet word with the bank manager, anybody running a public company knows that the faintest whiff of a problem will hammer the share price and scare off customers and suppliers. So there are some lessons here.Beware companies that are in too much of a hurry. Watch out for executives who spend too much time courting the public - and those who love the headlines. As Nick Hood concludes: "Remember that all companies, however good they are, inevitably have periods when things don't quite go according to plan. They must face the fact early and take stringent measures to cut costs or drive sales."Best of all, you can TRY Red Hot Penny Shares for a whole month before you commit a cent on our service. Start your 1 month trial today!
The past is not a guide to future performance. Trades in stocks recommended by Red Hot Penny Shares are small company shares. By their nature, such investments can be relatively illiquid and, as a result, hard to trade. This makes such shares more risky than other investments. Please seek independent financial advice if necessary. Profits from share dealing are a form of income and subject to taxation. Levels and bases of, and reliefs from, taxation are subject to change, and depend on individual circumstances.
