Dig out the dirt to avoid any nasty surprises when investing in a company

It's wise to do some research first, advises Rob Griffin

Shareholders are in revolt. Not only are they angry about the salary packages of executives, but also with the level of bonuses being awarded and the general attitude being displayed.

For senior figures in some of Britain's highest-profile companies it's a very uncomfortable time.

Powerful shareholder advisory groups, such as Pensions Investment Research Consultants (PIRC), have been putting pressure on household names like Barclays Bank and Aviva over the last few weeks, and their vociferous campaigns are expected to continue.

Their protests come at the same time as a report entitled Accountability in Business is released that highlights the widespread belief among corporate governance specialists and fund managers that executive pay has become disproportionate to performance. The study, published by The Share Centre, suggests that director-level remuneration in companies often bears no relevance to the business model or strategy of the organisation, and calls for far more sensitivity to be shown in setting both salaries and bonuses.

Sheridan Admans, investment research manager at The Share Centre, is not surprised by the mounting shareholder anger and expects to see an increasing number of such protests over the coming months. All investors really want, he points out, is a fairer deal.

"Companies generate massive profits and equity investors take on a lot of risk as if these firms collapse then they could lose everything," he said. "There's a wind of change as they believe more of the bonuses given to managements could be paid out to equity holders."

But while major protests against global multinationals by large, institutional fund groups will always grab the headlines, there is still plenty that private investors can do to dig the dirt on companies of all sizes in order to gauge whether they are likely to make sound longer-term investments.

Examine company communications

It's easy to overlook, but information published by the company itself is a tremendously useful source of information and the annual report and accounts should be studied first, according to David Kuo, a director at financial website, The Motley Fool. These can usually be downloaded from the company's website, although you can also request to be sent a paper version.

"The first thing to read is the letter to shareholders from the chairman who is supposed to be the investor's friend on the board and acting in their best interests," he said. "Read it once with an open mind and then again with a more critical eye to understand what it's trying to communicate.

"If it's very open and says how problems are going to be solved then you have an idea what the company is planning to do," he said.

"However, if it's not able to communicate then avoid it. There are more than 1,000 stocks you can buy in the UK so don't pick one where the management isn't open and transparent."

Understand the financial information

Cash flow is the lifeblood of any business, but analysing the balance sheet and profit & loss account is arguably the hardest role for any private investor, according to Julian Chillingworth, chief investment officer at Rathbones.

"A company needs to be cash generative as you want it to be able to reinvest in its business and pay you a dividend, so that means prospective investors need to have some knowledge of the report and accounts," he said.

"We spend a lot of time analysing cash flow statements because companies will try to hoodwink you from time to time."

A good starting point is looking at sales figures, suggests Mr Kuo.

"If you're investing in a business you want one with healthy sales growth," he said.

"Dividing profits into sales gives you the profit margin of the company. You can then decide if it is more profitable than now or whether it's only been able to maintain sales by cutting margins."

It's also important to look at the company's debt, adds Mr Admans.

"You ideally want companies that have a good stream of long-term debt as they are less likely to need to refinance and won't be held ransom by available rates in the market."

Consider their dividend policy

Brian Peart of the UK Shareholders' Association makes a point of looking at how much money a company has made in the last five years – and how that compares to the level of dividends they have paid out over that same period.

"If there's been a continual rise in dividends over the past five years, as well as an improvement in earnings, then you may think that it's a good stock," he said.

Investors must also decide if the dividend level is sustainable given the company's financial position.

Monitor director ownership

An often overlooked part of an investor's research is finding out how many shares individual directors have in the business – and monitoring when they buy or sell. Ideally, you want executives to own a lot of shares as it means their interests are aligned with your own, according to Mr Kuo.

"If the chief executive owns 10 per cent of the company then a shareholder knows that they will be hurting even more than them if the share price falls," he explained. "Anyone that has a big stake in a business will want to ensure the business continues to thrive."

Seeing executives selling company shares, therefore, can be worrying, but it's not necessarily a sign that something is wrong. For example, they might have been forced to cash them in to fund a personal expense, such as school fees.

"When a director buys or sells they have to notify the London Stock Exchange, but these transactions need to be looked at in the context of what they still own," Mr Kuo said. "Therefore, if they've sold a one per cent stake but still have a 20 per cent holding then the sale is insignificant."

Search out buried information

Important information may not always be immediately obvious, so examine the notes sections of annual reports, advises Mr Admans.

"There could be useful items such as a breakdown of the segments of a business – such as where they operate on a regional basis," he said. "Most companies keep an online archive of their reports so it's not too hard to go back a few years and monitor any trends.

"If a company isn't demonstrating evidence of the growth enjoyed by the sector you have to ask yourself why and whether this is now a defunct part of their strategy."

Monitor news flow

Contract wins, any guidance in terms of profits rising or falling, and external influencing factors such as the oil price should all be taken into consideration by investors, according to Mr Chillingworth, as should readjustment of numbers or the sudden departures of senior managers.

"They should also keep an eye on stock prices," he said. "If the price falls rapidly it may not be telling you that there is a problem in the company but it could raise the alarm that other investors are worried about something."

Be careful about subscribing to investing websites as a lot of information is available free. A good source is Investegate (investegate.co.uk), while it's also worth looking at others such as Digital Look. Simply tapping a company's name into a search engine such as Google may yield results. However, put anything you hear in context and check its veracity, advises Justin Modray, founder of website Candid Money.

"While the internet can be a great research resource it can also harbour speculation and dizzying amounts of distracting information, so it's important to stay focused," he said.

According to Mr Chillingworth, it's important not to overlook the benefits of doing your own research.

"For example, if you get on the London Underground and go through Oxford Circus at 5pm you are more than likely to see people get on the train with a Primark bag. This is a working example of how you can pick up anecdotal information," he said.

Conclusion

So where does all this leave us? Well, there's no way a private investor will be able to understand companies to the same degree as fund management groups with their banks of analysts, but don't underestimate the importance of your own research.

Tread carefully and don't get distracted by gossip, said Mr Modray.

"All the research in the world won't protect you from unforeseen stock market blips and crashes, but it should help improve your chances of successful, long-term investing."

Independent Partners; request a free guide on NISAs from Hargreaves Lansdown

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