Waseem Sayegh

Last week’s “Finance Course with Finance Practitioners” guest lecturer was Tullio Cedraschi, the CEO of CN Investment Division. During the lecture he handed out “Tullio’s 20 Red Flags”. These flags are meant to help investors with their investment decision making. According to Tullio these flags have stood the test of time. Before going into the flags let’s make sure that you’re clear on the following rules:

1-3 red flags: probably no problem
4-5 red flags: watch out
6-20 red flags: sell or do not do the deal

Here are Tullio’s 20 Red Flags:

1. Creative accounting: High reported earnings with large deferred expenses. Accounting too complicated for even the most knowledgeable analyst.
2. Unfocused business strategy: The company enters unrelated businesses on a whim. The oil company entering the real estate business, the real estate company entering the computer business. Nobody can be an expert in all industries.
3. Promise of assured high returns without risk: Risk-free high returns on business are a sure sign of fraud. The business world is very competitive. High returns mean high risk.
4. Speed of deal making: Management is involved in too many deals at once.
5. Share structure with voting and non-voting common stock: A controlling shareholder who can control the company through a small number of voting shares can be tempted to disregard the interest of the non-voting (or low voting) shareholders in his action.
6. Excessive taste for leverage: Too much debt. Because of low interest, attention has been removed from this critical fact: Excessive debt can lead to bankruptcy.
7. Excessive tax avoidance: Tax planning is, of course, very much a part of the modern corporation but when tax evasion becomes the raison d’etre of the corporation, it is possible that shareholders will also fall victims to the schemes used to defraud governments.
8. Lying and excessive hype: The company bends truth about its products and markets, and hypes itsadvertising far beyond the quality and usefulness of its products.
9. Too much litigation: Too many court cases pending against the corporation. Constant hassle with security commissions and stock exchanges.
10. Conflicts of interest: Management or controlling shareholder dealing their assets or buying from the company at non-market values, or leasing personal real estate to the company.
11. Too many insiders on the Board: How can the Board judge management if it is stacked with Vice-Presidents and close personal friends of th CEO?
12. Nepotism: Too many family members of the CEO in the top management.
13. Excessive indulgence by management and Boards: Personal use of corporate jets; business meetings held at only the best resorts.
14. Excessive executive compensation: There is nothing wrong with very high management compensation. Indeed, any company should attempt to attract the very best – and pay to keep them. But consistent, very high compensation, combined with steady deteriorating shareholder value, signals a problem.
15. Lousy investor relations: Refusal to answer legitimate questions from analysts. Painting too rosy an earnings picture followed two weeks later by profit warning. Erratic disclosure of important corporate events. Systematically misleading the financial community about the outlook of the company’s business. Leakage of information to related shareholders.
16. Insider information: Trading by management and board members reflecting abuse of insider information.
17. Disorderly corporate books and meetings: Contracts not properly documented. Board meetings called and canceled. Management late for meetings. Minutes do not reflect decisions taken.
18. Megalomania: CEO has a Napoleonic streak, acts like a dictator, does not tolerate dissent. He sees himself running a Fortune 500 company, when presently his is a small cap company and should remain small.
19. Complicated corporate structures: Corporate legal structure too complicated for an outsider to understand. Large number of intricate and non-transparent offshore holding companies involved with the listed public company.
20. Doubtful history of main promoters: Promoter or CEO was previously invovled in shady deals, associates with suspicious characters. New management appears in town, without anyone knowing where they came from or their previous history.