Screening S-stocks 6 comments

DanielXX's intro: The below is extracted from the Nextinsight share investors' site, a no-nonsense website whose founders include a former business journalist and a head of a well-known local investor relations agency. The article is written by Sim Kih. The writeup was in turn based on a lengthy JP Morgan report on the dangers of S-stocks.

The reason for my highlighting this article is that it offers many key insights on what things to look out for when stockpicking S-chips, or so-called "warning alerts". An article worth archiving for future reference. It is my belief that once you know what red flags to spot and what stocks to avoid, you will have controlled your downside pretty well. Why else do you think JP Morgan is one of the survivors, or some might even say a key beneficiary, of the current credit crisis?

One thing to note: the valuation screens used can be moving targets. There is no reason to claim that say, a PE<10 means a good stock pick, if most other peers are trading at <5X. In other words, one has to watch the relative valuations available on the market and cannot use rules-of-thumb blindly.

(P.S: The following were extracted from another source and is not my original work.)

Considering the risky nature of S-chips, what are some potholes to avoid when stock-picking from the “bargain department”?

There are 10 barometers that suggest to seasoned investors there’s more than meets the eye. Many of these include detailed checks on cash, which is harder to manipulate than earnings.

Does your 'bargain gem' fail any of these 10 warning alerts?

Readers should note there could be sound reasons behind some of these “warning alerts”, so the discerning investor would investigate further before writing any stock off.

10 warning signs for troubled stocks

1. Extremely low deposit rate for cash

This is a major warning alert.

Using China’s annualized cash rates as an example:

0.72% Demand deposits
1.8% 3-month time deposit
2.5% 12-month time deposit

It is thus reasonable to expect interest on bank deposits for S-chips to exceed 1%.

JP Morgan screen:
Deposit rate for cash <1%
Total cash/market cap > 5%

2. High cash reserves, but high debt

A high-cash and high-debt scenario indicates poor financial discipline since companies can logically cut finance costs by paying down their debt with excess cash.

Investors begin to wonder there is “balance sheet management” around the book closure date, or in the worst case scenario, a possibility of fraud or embezzlement of cash.

JP Morgan screen:
total debt/market cap > 30%
total cash/market cap > 30%

3. Much higher capital expenditure for the same capacity

If a company's fixed asset investment per ton of production capacity increases sharply over its expansion schedule, investors begin to wonder if the increasing depreciation expense that shows up on the profit and loss statement could in fact be excesses in other operating expenses.

Inability to sustain growth

4. High gearing, high working capital requirement

High working capital requirements, low net margin and high gearing will slow growth.

JP Morgan screen:
High net working capital to sales ratio (>20%)
High gearing ratio (>35%)
Net working capital to sales ratio – net margin > 15%

5. Frequent fund-raising

JP Morgan screen:
Issues of new shares or convertible bond more than twice during 2004-2007.

Changes with key officers

6. Hit-and-run

When a controlling shareholder dilutes its stake to below 50% within a few years of listing, there may be reason for investors to ask questions.

Another situation would be a passive investor holding the controlling stake.

7. Resignation of key managers, directors or auditor

Most auditor replacements in Asia are related to unsettled disputes on accounting practices.

Investors should be alert if senior managers resign without a proper reason.

If the company was doing well, why would they leave instead of enjoying the corporate spoils?

Often, the resignations potentially indicate corporate governance issues that investors were unaware of before, said JP Morgan.

Poor corporate governance

8. Acquisitions that do not make sense

Investors require acquisitions to show synergy, and a fair acquisition price.

This is especially so if the seller is an interested party or an affiliated company. Volume and size of transactions could mask sharp unwarranted jumps in certain accounting items.

9. Lack of sufficient disclosure

This could include failure to disclose large payments related to subsidiaries acquired from a related party, and such payments were subsequently highlighted by independent auditors.

10. High cash reserves, but low dividend payout

JP Morgan screen:
net cash/market cap > 10%
rising cash level in the past two fiscal years
dividend payout ratio < 20%

(The above was extracted from Nextinsight with their kind permission)