When a stock is not a buy (6)

Fotolia_54867638_XS_7Readers who have followed this series will know that when I am considering purchasing a stock or share there are six tests I will apply to see whether there are any warning signs that might suggest that the stock is not a buy.

Five tests have been covered in previous posts and these were the Good Value Test, the Cash Flow Test, the Business Model Test, the Debt Test and the Product Diversity Test.

In this final post in the series I stress the importance of putting the business and management under the microscope with what I call the ‘One Trick Pony’ Test.

The ‘One Trick Pony’ Test:

A business should never depend on one product but nor should it be over-reliant on one personality or one customer. So with the ‘One Trick Pony’ Test I check to see whether there is an over-dependence anywhere on one single source; be that a product, a person or a customer.

A ‘one trick pony’ increases risk substantially. It’s that old investment mantra, “Avoid putting all your eggs in one basket.” If a company has all its eggs in just one basket then that spells danger for the investor. Should they lose what they depend on then they’re in trouble.

So I will take a close look at the Chief Executive Officer (CEO). If the CEO is a big, high-profile personality who has been in place for a number of successful years then you have to ask yourself, “What happens when he or she goes?” Inevitably the CEO will go eventually, if only due to retirement. There are plenty of examples of where companies have imploded once a successful CEO leaves.

For instance the British electronics firm Marconi. Formerly GEC, it was very successful under Lord Weinstock and it built a strong reputation for competence and caution. Once he retired the firm was run into the ground by a Board of Directors who insisted on spending cash on taking the firm away from its roots. The result is that the firm no longer exists, certainly not as anything other than a brand.

My point here is that I will always try to judge a company’s management team. The question I ask is whether it is well placed for a change of CEO as and when required. I will also try to judge how much their success is down to the strength of the CEO’s personality and how much is down to a good all round management team.

A CEO’s longevity and corresponding success can make it difficult for his or her successor to emulate. Whilst Sir Alex Ferguson was not the CEO at Manchester United, he was the main man as far as team and therefore commercial success was concerned. Sir Alex had achieved a remarkable degree of success over a quarter of a century. Following him would be tough for anyone. So for me his departure would have been a warning sign if I’d owned shares in Manchester United or if I’d been considering buying them.

Similarly with customers; where does the company’s revenue come from? For example if say the revenue derives heavily from a single government contract then what happens at the end of the contract or if the company were to lose that contract? The implications for the business could be very serious.

To some extent all this can be quite subjective in practice and it’s not always easy to judge what is happening within a company of course. However I do think it’s important to take a close look at the business and management and ask yourself whether there is anything that would give you cause for concern.

As I have said before, I want to be confident that the company can sustain and grow its dividends and I’m relying on the business and management to do that for me if I invest.

Read also:

When a stock is not a buy (1)

When a stock is not a buy (2)

When a stock is not a buy (3)

When a stock is not a buy (4)

When a stock is not a buy (5)

© RJ Sutton and Mann Island Media Limited 2014. All Rights Reserved.

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