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6 ways top investors avoid losing companies

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To grow massive, compounding wealth over time the most important task is to avoid wiping out along the way.

If you are investing in individual companies this can be easier said than done.

As much as we would like to believe all companies are well managed, moral agents for investor return, the reality is that there are all manner of miscreants out there operating in their own self-interest.

So I believe deeply in understanding the warning signs that a company could wipe me out. Recently I’ve developed a weird obsession with studying successful short sellers. These people are the absolute masters in detecting important warning signs.

Short sellers profit when share prices fall, so have a strong incentive to identify symptoms of fraud, mismanagement, operating failures and other business risks. There have been a lot of recent examples on the ASX with companies like Retail Food Group Limited (ASX: RFG), GetSwift Ltd (ASX: GSW) and Quintis Ltd (ASX: QIN) being called into question.

I’m still early in my research, but there are certainly some common warning signs that top short sellers look for:

  • Reported earnings not matching cash-flows
  • Earnings dependent on management assumptions
  • Obscuring earnings growth through acquisitions and equity raising
  • Off-balance sheet financing arrangements
  • Businesses with no competitive advantage and a weak market position
  • High turnover of management and directors

On their own any of these points could be innocent enough. But start adding them together and alarms should start sounding.

In the case against Quintis, for example, short sellers strongly questioned the sustainability of the company’s business model, reliance on ‘non-cash gains’ for reported profitability and the assumptions used by management to forecast future cash flows.

A common thread binding many of the case studies I’ve looked at is companies with complex business structures and opaque financial arrangements. If you’re not fluent in financial statements it’s a good reminder to obey the “don’t buy companies you don’t understand” rule. Great businesses don’t have to be complicated or built on jargon.

It is easy to start putting these tests into practice. You can pick any company in your portfolio and work through the list to eliminate them one at a time.

It won’t guarantee a successful investment, but it may help you to avoid getting a nasty surprise down the track, allowing the companies you own to do the heavy lifting to grow your wealth.

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Motley Fool contributor Regan Pearson has no position in any of the stocks mentioned.

You can follow him on Twitter @Regan_Invests.

The Motley Fool Australia owns shares of and has recommended Retail Food Group Limited. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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