Tom Gardner and I recently wrote an article whimsically titled Danger! Horror! Get Out! In it, we revealed some things that, well, scare us as small-cap investors. The article was simply a case study of one company, and I've since had requests for a more formalized and itemized list.
I'm happy to oblige by discussing three things we actively avoid at Motley Fool Hidden Gems -- three things that keep our returns flowing. These may not be the only things that can capsize a company, but they're among the biggest -- and they're pretty easy to spot.
This was the biggie in our previous article. We're concerned when a company's debt load is so excessive, and its payment terms so harsh, that it may never recover.
But we want to be clear that debt in and of itself is not a danger sign. Plenty of our Hidden Gems companies have it, including Mine SafetyAppliances. Carrying $54 million of total debt, it has returned 142% since we first recommended it in September 2003. And some large-cap stalwarts have been able to fine tune their businesses while carrying seemingly huge debt loads. Consider Anheuser-Busch
You'll want to be wary of companies with more debt than cash and an interest coverage ratio of less than 1.0. A few examples include Charter Communications, El Paso
The accounts receivable line on the balance sheet represents sales that have been recorded but not yet collected. We certainly want to see this line increase, so long as it's accompanied by a comparable rise in sales. But if, for example, you see accounts receivable up 80% and sales up only 10%, you'd better take notice.
There are a few troubling scenarios that could cause such a spike. It's a problem if a company is forced to extend more generous payment terms to its customers (from 30 days to 60 days, for example) in order to keep their business. And it's a problem when customers are dragging their feet and not paying on time -- or never pay. And it's definitely a problem when unscrupulous management forces more product through the distribution channel than its customers are able to sell. (This is known as "channel stuffing.")
In each case, the company is losing control. Some current big names with receivables growing 50% faster than sales are Home Depot
You'll find inventory right below the receivables line on the balance sheet. Just as before, we don't want to see inventory rising faster than sales. Why? Well, it could be a sign that a company's products just aren't selling as well as expected.
Or it could be a sign of obsolescence. Think of a high-tech business holding a load of product that's suddenly been replaced by something smaller, faster, and more powerful. Or think of a fashion retailer who finds it just can't unload those puffy pirate shirts. In either case, earnings will take a hit.
There's one exception to our rule, however. Inventory on the balance sheet is actually made up of three components: raw materials, work-in-process, and finished goods. While excessive growth in finished goods is bad, a spike in raw materials is usually a good thing, because it could be a sign that management is seeing more demand for its products and is gearing up production in order to meet that demand. A burndown in finished goods and an increase in raw materials is a beautiful situation that Thornton Oglove called positive inventory divergence.
Back to the issue at hand. We need to worry about any company with finished goods growing 50% faster than sales, including EMC
The winning difference
When these signs show up in our companies, we dig deeper. Sometimes there's a valid explanation, but we want to make sure the business isn't heading down the wrong path -- and we're not afraid to sell if we believe that's the case.
To find out which stocks we love, simply take a Hidden Gemsfree trial. You can read about all the small companies that have produced outsized returns -- 40%, on average, vs. 13% for the S&P 500. If you don't like it, you can cancel within 30 days without paying a dime.
Rex Moore helps Tom and team dig for Hidden Gems, and he owns shares of Anheuser-Busch. The Fool is investors helping investors . Anheuser-Busch and Home Depot are Inside Value recommendations. Amazon.com is a Stock Advisor recommendation. Read our disclosure policy here.