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Red flags and investor targeting

14/04/2016

The aim of investor targeting should be to ensure the managers of the largest possible pool of money know enough about your business that they are either already shareholders, or ready to invest at the right price. Companies often forget the low-hanging-fruit of reducing their red flag count, meaning action or inaction that turns off certain sections of the investor universe. This can be far more fruitful than a complicated targeting campaign. The hollowing out of the sell-side and time constraints of the buy-side means that investor sensitivity to red flags is getting more and more apparent. Be careful relying on your existing shareholders for advice.  In this Insight we provide an objective list of red flags that you can apply to your business. As always, do contact us if you’d like discuss any of these points. 

The universe of both private and public investors is huge. All have different approaches to building their portfolios in terms of style of investing, level of fundamental analysis, sensitivity to news flow, predicting “the quarter”, valuation methodologies, and investment timescale.

Even within investment houses, these approaches can differ markedly. While some have consensus based approaches (Capital Group springs to mind), others give individual fund managers autonomy (Fidelity would be an example here). Blackrock, the world’s largest asset manager has over 135 investment teams in 70 offices around the world.

Investor targeting is not just about trying to add more institutions to your shareholder register. It is about your businesses being understood by as broad a section of the potential investor base as possible. You should aim for their always to be buyers for your shares should an existing shareholder take profits, or in the event of an unexpected share price dip.

Companies often turn to their largest shareholders for advice, or find themselves on the receiving end of advice from those institutions. Dialogue is certainly a good thing, but they are already shareholders so whatever is holding back new investors is not something that they will necessarily understand or find important.

The Oakhall red flag list has been compiled from what investors have told us would prevent them from continuing to work on a potential investment.

Disclosure red flags

  • frequent changes to disclosure
  • acquisitive companies failing to disclose organic growth
  • failure to update on acquisition synergies
  • lack of focus (in analyst call or slide deck) on cash flow and balance sheet
  • over focus on EBITDA (see Warren Buffet link below)
  • overstatement of EBITDA by high capitalisation of development costs (IFRS)
  • focus on adjusted figures that are not reconciled back to GAAP accounts
  • publishing interim year-to-date rather than interim period figures (e.g. many continental European companies will publish 9-month rather than Q3 figures which investors have to spend time decoding into the underlying Q3 numbers)

Policy red flags

  • optimistic revenue recognition
  • share buybacks at any cost, and failure to cancel buyback shares
  • frequent auditor change, different auditors in different countries
  • poorly thought out executive remuneration targets
  • frequent M&A and M&A adjustments coupled with poor disclosure
  • inconsistent story (often coincides with frequent changes in disclosure)
  • persistent over-promising leading to multiple profit warnings
  • hoarding cash

Illogical accounting red flags

  • cash flow materially different from profit over time (often driven by optimistic rev-rec)
  • other financial ratio warning signs such as rising DSOs or DIOs, or falling depreciation to fixed assets. (see James Montier’s “Cooking the Books” link below for the signals astute investors avoid)

Adjustment red flags

  • too many adjustments (“earnings before bad stuff”)
  • recurring restructuring costs
  • recurring non-cash write-downs (indicating over-paying for acquisitions)
  • poor reconciliation back to GAAP/IFRS figures
  • adding back share based employee payments to adjusted profit but buying back shares off the income statement to compensate

There is also a shorter list which management cannot act on but can aim to address in the longer term:

  • company is loss-making
  • company does not pay a dividend

Investor targeting is a beloved activity of financial PR companies and some IR departments, but by far the best way to target the widest possible investor audience is to minimise your red flag list.

Related Links
Warren Buffet on EBITDA
Fortune Magazine – Earnings Before Bad Stuff
SocGen / James Lamont Cooking the Books
Oakhall – buybacks
Oakhall – growing equity research gap
Oakhall – better IR websites

Oakhall was established in 2015 by award winning equity research analysts to provide smart financial analysis and articulation for European public and private companies. Founder Andrew Griffin spent almost two decades as a technology equity analyst, ultimately as managing director of European technology equity research at Bank of America Merrill Lynch, before working in investor relations, corporate development and market intelligence for a UK listed software company.