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Investors should watch out for red flags

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By Sola Oni

Investment in stocks is both art and science. Every analysis of a company has a qualitative and quantitative perspective. Therefore, the role of securities dealers narrowly referred to as stockbrokers, cannot be ignored, especially by investors.

There are warning signals that every investor must watch out for in order to avert avoidable risk. This explains why some investors smile to their banks often, irrespective of the mood of the market while others go on endless fasting and prayers for losing money daily.

It is settled in financial management that there is no investment without risk elements. Government bonds called gilt edge and crowned as risk-free is merely theoretical. Although the risk level is significantly low, compared with ordinary shares, that does not remove risks entirely.

A government bond, with all its benefits, is subject to inflation risk, interest rate risk and opportunity cost risk among others. But risks are more pronounced in corporate bonds, of which the biggest are default and liquidity risks. While default risk refers to the possibility that the company may not be able to redeem the bond’s principal at maturity, liquidity risk is a lack of demand for the bond when the bondholder is willing to sell.

There are key issues that every investor must monitor prior to purchase or sale of shares. They are usually referred to as red flags. Every investment decision is impacted by red flags and failure to watch out for them may turn a profitable investment to mere gambling.

A company’s management should be examined before investing in such an organization. For instance, an investment game-changer of all times, Warren Buffett, will never purchase shares of a company whose management lacks integrity, skills and competencies.

Before an investor buys into shares of a company, he must study the trend of earnings. Shrinking profit margins and decelerating sales growth are signals that the company’s business model is probably failing. The share price of such a company is vulnerable to volatility. Let me quickly add that volatility is part of every stock market. But understanding how to play around it separates men from boys in the art and science of investments.

It is normal for a company to raise debts to expand its operations, introduce new products or invest in Information Technology. But excessive borrowing can lead to financial risk. Therefore, an investor should be wary of a company that is high geared.

Some companies pay extra-ordinary dividend which is far above their peers in the same industry. For instance, if other companies’ dividend yields range from 3 kobo to 10 kobo, any company that ends with dividend yields of 25 kobo in such an industry could be a bubble trap. In the same vein, avoid a company that usually cuts its dividend. This is a sign of instability or distress.

An investor should avoid putting his hard-earned income on a company that indulges in the use of hype as a publicity strategy. This could be a way of creating artificial impressions that all is well. Such a company can lure unsuspecting investors into buying its shares only to discover that the purchase is not based on any fundamental.

Avoid comparing the performance of companies in different sectors. An apple should not be compared orange. Do not place a purchase order on shares of a company where directors are offloading shares. The Directors may be acting on insider knowledge that the company’s future is bleak. Keep a tab on the activities of these insiders because of their privilege information.

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There are situations when analysts may emphasize the positive efforts of the management in order to revive a dying company while they play down critical challenges. This is a red flag. Be careful and endeavour to get more insight before you make investment decision on the company.

News of abrupt management change in a company calls for cautious optimism. An investor must tread softly so as not to get his fingers burnt. The abrupt changes often affect strategic focus of an organization.

There are instances whereby capital market regulators such as the Securities and Exchange Commission (SEC) may decide to investigate a company, thus leading to trading embargo on its shares by The Exchange. Such investigation can drag for a long time. This is a warning signal for the company’s investors to either offload or adopt wait and see attitude.

This column has consistently harped on the essence of going through a securities dealer for investment decisions in the capital market. He is the professional that does research on quoted companies.

Securities dealing firms, also referred to as stockbroking companies, are obliged to conduct extensive analysis on companies’ earnings growth, stability, debt-to-equity ratio, relative strength in industry, price-to-earnings ratio and other relevant investment ratios to provide professional investment advice.  The broad objective of watching out for red flags before purchase or sale of shares is to enable an investor to maximize his returns and minimize risks.

Oni, an award-winning financial journalist and Chartered Securities Dealer can be reached on onisola2000@yahoo.com

Vanguard

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