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Danger Signs

Buying stocks? Look out for these red flags.

Gordon Pape warns of danger signs.By Gordon Pape, Editor and Publisher

Investors are taking a positive view of the future, at least if we are to believe the stock market. We haven’t fully recovered from the March lows but we’re getting there.

As of the time of writing, the Dow was up 37% from its March 23 bottom, although it was still well down from its February record high. Other North American indexes show a similar pattern except tech-heavy NASDAQ, which is actually ahead year-to-date.

The strength of the rally is impressive, especially given the fact the pandemic is still killing thousands of people daily, the economy is in shambles, and a vaccine is many months away.

Is it real, or an illusion? Personally, I believe it is the market rally is premature. The virus is not done with us or the economy yet, not by a long shot. But, as retiring Bank of Canada Governor Stephen Poloz said last week, these are “unknowable times” and we are living in an era of “unparalleled uncertainty”. Stocks may continue to rise – or the indexes could plummet again and retest the March lows. No one knows.

What we do know, however, is that these are many dangers lurking in the markets. Companies are going belly-up, including retail giants like J.C. Penny and Neiman-Marcus. Investors need to be cautious when adding a new stock to their portfolios.

Here are the flashing caution lights I look for when assessing a company these days.

Revenue decline

Sales are the lifeblood of any organization. If people stop buying your product or service, you cannot survive. It’s as simple as that.

So, when quarterly reports are issued these days, the first line I look at is revenue. How is the company doing compared to last year, pre-pandemic? A major drop in revenue indicates trouble.

Look at the first-quarter results of Vermilion Energy (TSX, NYSE, VET). Revenue came in at $328.3 million, down almost 32% from the same period in 2019. Vermilion and other energy companies were hit by both COVID-19 and the oil price war. The revenue numbers show how extensive the damage was. Vermilion suspended its dividend and last week its CEO resigned.

Stretched balance sheet

Heavily indebted companies are having a tough time, and things are not going to get easier until the economy starts to improve. Interest rates are at all-time lows, which helps ease the strain. But many companies are carrying older debt with higher rates, including issuers of bonds and preferred shares.

Many investors don’t pay attention to balance sheets, perhaps because they don’t know how to read them. But you only have to look at two numbers to get a general idea of a company’s position: the total amount of debt and the shareholder equity. If the debt exceeds equity by a significant amount, that could spell trouble. A debt to equity ratio of less than 1.0 is usually an indicator of financial strength.

Dividend cuts

Companies are loath to cut their dividends. When they do so, it’s a sign of serious financial trouble. CEOs will try to spin it as improving liquidity and strengthening the balance sheet, but the underlying message is that the company is under pressure.

There have been a lot of dividend cuts in the past few months. The energy sector and REITs have been among the leaders in reducing payments to shareholders. But it doesn’t stop there. Even the biggest companies are vulnerable: Jamie Dimon, the CEO of JPMorgan Chase, recently warned that his company could suspend its dividend in an economic worst-case scenario.

Dividend cuts may be prudent in today’s circumstances, but they are one of the strongest signals of economic stress that a company can send. Think carefully before buying shares in these companies.

Inflated yields

When Canadian government ten-year bonds are yielding only 0.55 per cent, a stock with a yield of 10 per cent or more may look very attractive. And there are several of them out there.

But beware. No one gives away money for nothing. A disproportionate yield says the market does not believe the dividend is sustainable and a cut is coming soon. Sometimes the market is wrong on this. Most times it isn’t.

Wrong place, wrong time

Some good companies are simply in the wrong place at the wrong time. Oil producers are one example. Even though prices have bounced off their lows, demand is well down as commuters work from home and airlines slash schedules.

Shopping mall REITs are another mismatch when it comes to the coronavirus. They were already feeling pressure from e-commerce, now they find themselves in a similar position to the dinosaurs when the asteroid flashed across the sky.

Airlines, cruise ships, and hotels are among the other companies that fall into the wrong place, wrong time category. Someday, they will recover, and today’s share prices will look cheap. But you’ll have to be very, very patient.

These are some key points to look at when selecting a specific stock. But also pay attention to the overall market. If we get another correction, there will be a lot of quality bargains available. Save some cash, just in case.