Shares - by Russell Muldoon

Have you invested in a doomed stock? Take heart in the knowledge that businesses rarely collapse overnight, and when they do, the signs are usually there well in advance, for all to see. With a little know how and recognising the "8 signs of a doomed stock", hopefully you will be better positioned to recognise and avoid investing future capital in a basket case.

8 Signs of a doomed stock

1. Negative cash flows

Put simply, if a business continuously pays out more cash than it receives it will have negative operating cash flows. If this situation occurs over a number of financial periods, the cash outflow will need to be supported by drawing down any available cash at the bank. When the bank account runs out, the only choice available to a business is fresh injections of equity (capital raisings) and debt. Unless the business begins to produce positive cash flow it is not operating in a sustainable manner.

2. High net debt-to-equity ratio

(This calculation produces one of the most powerful ratios available when an investor wishes to avoid doomed stock)

It is calculated by taking total short-term and long-term debt financing employed, subtracting available cash and measuring this against the shareholders equity supporting that debt. Anything above a conservative level of gearing can put significant amounts of pressure on the business cash flow. Pressure which will likely be more pronounced for highly geared businesses or businesses in stress. As a guide, look seriously at businesses with Net Debt-to-Equity Ratios exceeding 50%.

3. Interest coverage ratio

The ratio simply divides Earnings Before Interest and Tax (EBIT) by the net interest expense associated with carrying debt. A lower ratio indicates that a business is highly burdened by debt expense and is likely to be suffering and vice-versa. If a business has an Interest Coverage Ratio of 2.0 or lower, serious questions should be asked as to its ongoing ability to meet interest expenses. It would only take a small fall in profitability or an increase in financing costs to put the business under real stress. Should the ratio fall below 1.0, the business is simply not generating sufficient levels of profitability to satisfy the cost of debt.

4. Negative or low return on equity

A negative Return on Equity (ROE) suggests the business is making a loss. It's pretty safe to say that businesses that make losses over sustained periods of time generally do not make great long-term investments.

Businesses with a history of low rates of Return on Equity (less than 8% or the current cost of debt) should also be avoided. Clearly an 8% return is undersirable given the risks and effort associated with owning and operating a business. Given this return is only slightly higher than what can be achieved in relatively less risky bank bills (using long-term rates) why would an investor take on the extra risk?

5. Profit warnings

Under ASX listing rules, if a business anticipates a 15% change in after-tax profits or is aware of a material item that will impact the business' result, it is required to report this to the market. If a business has ticked any one of the warning signs 1 - 4, a profit warning should be taken very, very seriously. Lower levels of accounting profits may also indicate that cash flows are set to come under further stress.

6. Sustained share price decline

Almost all listed corporate failures are preceded by a sustained decline in their share price. Look out for a steadily declining share price. Of course, a declining share price may also indicate a potential buying opportunity. But this only holds true if the business has solid fundementals and is just out-of-favour i.e. if it has none of the additional factors discussed here.

7. Insider trading

When substantial shareholders or business directors and executives buy or sell shares, they are required by the ASX to announce movements in their holdings to the sharemarket. These parties. also known as insiders, usually have an in-depth knowledge of the business and its future prospects. Increased selling pressure can therefore be a signal that "insiders" believe the outlook for the business is less than desirable.

8. Resignations and sign-off

Look out for significant changes and re-structuring of the business's board or the sudden departure of key staff. This also goes for the business's auditors. While a sudden departure may be completely innocent (each case should be investigated further), warning bells are the loudest when long-term serving directors with a track record of good management up and leave. The replacement of the firm's auditors or reluctance to sign off on the businesses accounts may indicate a deteriorating relationship and fundemental difficulties with the business.

These 8 signs of a doomed stock, if used correctly and continuously, will not let you down. Apply these same rules against the businesses in your portfolio. How do they stack up??

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A young accountant spends a week at his new office with the retiring accountant he is replacing.

Each and every morning as the more experienced accountant begins the day, he opens his desk drawer, takes out a worn envelope, removes a yellowing sheet of paper, reads it, nods his head, looks around the room with renewed vigor, returns the envelope to the drawer, and then begins his day's work.

 After he retires, the new accountant can hardly wait to read for himself the message contained in the envelope in the drawer,

particularly since he feels so inadequate in replacing the far wiser and more highly esteemed accountant.

Surely, he thinks to himself, it must contain the great secret to his success, a wondrous treasure of inspiration and motivation.

His fingers tremble anxiously as he removes the mysterious envelope from the drawer and reads the following message: