For want of a better title, this post is about how stakeholders affect a company even though the company itself may be fundamentally strong. The truth is this recession and sudden sharp downturn has revealed to me that companies which were once “strong” can quickly see their fortunes reversed due to many factors, some of which are beyond their control. As investors, even though we are unable to predict exactly how bad things can get to the extent of how adverse the economic environment can degenerate to, we should nonetheless be aware of risk factors which may crop up now and then to make us more careful before we put our money down.
I would like to explore several aspects of stakeholder influence on a company which may cause concerns once the economic environment worsens. These are by no means an end to itself and it may open up a can of worms as readers may wish to comment on other aspects which make a company “vulnerable” as well. But my motive is to highlight some aspects which I think have been revealed in the recent recession and which I feel may have a bearing on out investment decision-making going forward. After all, it’s supposed to be continuous learning and learning from others’ mistakes is a good way to avoid committing the same ones yourself.
CUSTOMERS – The loss of a major customer due to bankruptcy, or inability to pay in a timely manner can severely affect the future of a business. In the semi-conductor industry, Chartered faced problems when main customer Motorola saw a drop in orders, which in turn tricked down to lower demand for Chartered’s products. Heavy reliance on one customer is risky as most of the revenues will be hinged on that one customer, and even if a company has a good Balance Sheet; it may be affected by the customer who cannot pay in time. This would have a bearing on the Cash Flow Statement of the company and may lead to severe cash burn. Some companies are able to recover from this but others may either file for bankruptcy or be forced to raise funds through a dilutive rights issue (as in Chartered’s case).
SUPPLIERS – On the flip side, the financial problems affecting a major supplier can also have a huge and adverse impact on a company. To give a hypothetical example, imagine if a dumpling company’s supplier ran into trouble and could not supply most of the pork and flour required for their dumplings. Assuming the company only had one major supplier, this would mean they are vulnerable to “supply shocks” and thus would have problem fulfilling customer orders. Hence, it is risky for a company to rely solely on one supplier or even one major supplier for its raw materials. Even if a company was perfectly healthy, a collapse in one or more of its suppliers could spell big trouble unless it can quickly look for substitutes. In specialized industries, this is made tougher than for commodity industries.
FINANCIAL INSTITUTIONS – With the severity of the sub-prime crisis, once untouchable banks in the USA are now falling like a house of cards. Once lauded as the largest bank in the world by market capitalization, Citigroup has been reduced to tatters and now requires a few rounds of Government bailout in order to stay alive. The health of a financial institution is instrumental in determining if a company can obtain sufficient financing. This problem is difficult to mitigate, however, as the current crisis has shown that almost ALL banks have been hit and financing has more than dried up. This has taught me to watch out for highly leveraged companies as this means it gets harder to refinance short term debt. A case in point in Ferrochina which had a leverage of about 300%. I will comment more on this in a separate post on gearing, debt and leverage for companies.
MAJOR SHAREHOLDERS – By now, most people would have read the cases of major shareholders of the company pledging their shares to obtain personal loans. With the advent of the financial crisis, these stakes have been forced sold due to margin calls on the shareholders’ personal loans, thereby causing chaos with respect to the ownership of the company. The latest victim of this is Sino-Environment which has seen the founder’s stake reduced to a mere 6+% as a result of many rounds of forced sale of shares. I feel that this can be mitigated if SGX publishes which companies’ shares are being pledged for loans; but so far this is still not a mandatory requirement.
The list above shows some of the ways in which one can get “tripped up” even though one has analysed the company from top to bottom. Stakeholders have a major influence on a company and thus we cannot avoid studying these influences in order to arrive at a fair conclusion as to the risks and rewards relating to a potential investment.