When to exit a stock: a few flying lessons - Equity Market

When to exit a stock: a few flying lessons

Look into a company’s balance sheet and the reason why its share is falling. Get the basics right and in case of doubt, get out of the firm

Striking employees, a clueless management, grounded aircraft and restless bankers summarise the state of Kingfisher Airlines Ltd (KFA) today—a stark contrast to when KFA was a “five star” airline, a symbol of rising mass affluence in India and a preferred choice of business class. However, it is always difficult to fly high on borrowed money and time as both come to an end at some point, as always, and it ended for KFA as well.
While the management of KFA finds answers to the questions posed by shareholders, and banks look for ways to recover their money, there are lessons to be learned by investors as to how they should avoid getting into such companies in the first place and even if they got into it, how to spot warning signals and get out in time to restrict the damage. Although KFA is an extreme case, there could be companies in your portfolio that are in different stages of decline, though their fate may not be as dramatic as KFA. Here are five red flags that you should be careful about.

FALLING STOCK PRICES

If the price of a stock in your portfolio is falling, while the rest of the market is stable or rising, it is time to take a deeper look and find reasons. “At times price and news may not reflect the true fundamentals and by the time the true picture emerges, it could be too late,” says Rajesh Jain, head, retail research, Religare Securities Ltd.
If a stock has corrected by 10-15%, the investor may choose to get out and enquire into the cause. Re-entering the stock even at a higher price would make sense if one is convinced about the fundamentals, says Jain.

PROFITABILITY

Businesses are run to make profits. If your company is unable to do that, it is time to look for better options. Even if a company is able to improve the sales numbers, but is not improving on the profitability front, there may be something wrong with the business.
“It is important to look at the operating profit, which indicates whether the company is making money through business operations, as it can bump up the net profits by selling assets or other activities,” says Devang Mehta, vicepresident and head, equity advisory and sales, AnandRathi Financial Services.

CASH FLOWS

A business has to generate cash for its shareholders. Investors would do well by differentiating between profits and cash generation. “One should always be careful about rising receivables and see the cash flows as some companies may declare profits, but may not be able to convert it into cash,” says UR Bhat, managing director, Dalton Capital Advisors (India) Pvt Ltd. It is possible that companies book revenues and show profits but are not able to generate cash. It is possible that a company dispatches goods but agrees to take payment at a later date. This will increase the need of working capital in the company, which has a cost. Also, it is possible that the cash realisation never happens.

RETURNS RATIOS

It is important to keep an eye on ratios such as return on capital employed (ROCE) and return on equity (ROE). Return on equity refers to return of shareholders’ money, while a return on capital employed reflects how efficiently is the company using the capital. “If the company is not able to generate ROE in excess to at least 13-14%, it is a red flag,” says Mehta.
High return ratio is one of the reasons why some companies in the consumer durables sector enjoy high valuations.

BALANCE SHEET ISSUES

The balance sheet of a company shows what it owns and what it owes. Rising debt levels could be a warning sign. However, debt is not a bad thing always as appropriate levels of leverage could boost ROE. But after a point it can become a problem. The company may find it difficult to service it as was the case in KFA. Therefore, one should be careful about debt levels.
Those who follow the basics of investing would have never got into KFA and other such firms in the first place. Even for those who entered, there were plenty of indications of where things would eventually lead. However, there is lot of subjectivity that comes into play with these conditions. “There is no mechanical formula to identify a non-performing company,” says Bhat. “Things may eventually improve.”
Therefore, it is important to read indicators carefully, though it does not change the most important aspect of equity investing: that you need to be confident about what you own. If you are in doubt, get out of the company.