The commotion surrounding Muddy Waters and Olam has been the latest talk of the town. Muddy Waters said that Olam has accounting discrepancies and it has since released a 133-page report on why it feels as such. Olam retorted and defended itself in a 45-page report. Muddy Waters has said in its report that Olam is a “black box” just like Enron, which collapsed in 2001. The purpose of this post is not to dissect the reports, as many other capable accountants and analysts have already done that, but rather to educate readers on how to avoid investing in such companies.
I’m not surprised that Olam has attracted the attention of Muddy Waters. The debt levels of Olam are astronomical and cash flow from operations and free cash flow has been negative for a long period. Only in two of the past 11 periods has free cash flow been positive. The table below shows some of the figures for six periods from 2007 – 2012:
Olam’s CEO, Sunny Verghese, has told The Edge recently that Olam attracts many traders who short the stock due to their financial numbers. How can an investor protect himself and invest in a company that does not attract the attention of Muddy Waters and the likes?
One way is to invest in a company with a clean balance sheet. This means investing in companies with zero or negligible debt. Having lots of debt presents problems. Take the “Total debt” and divide it by “Net Income”. Ensure that it this value is below three (zero would be the best). This ensures that the company is not over-leveraged. Companies with lots of debt will face re-financing problems when a recession strikes. In the worst case scenario, the company might go into bankruptcy.
The company must also have positive Cash Flow from Operations. Preferably, the numbers should be increasing yearly. Furthermore, the company must have Cash Flow from Operations higher than Net Income. Cash is king in any company and scrutinizing the Cash Flow Statements is more prudent than scrutinizing the Profit & Loss Statements. Net Income does not provide an accurate picture as some revenues are booked even though the cash has not been received physically by the company yet.
The above are some of the matrices one has to look into before investing in a business. Avoid investing in companies with lots of debt and negative free cash flow for long periods of time. It is better to stay away from such businesses entirely than be sorry later!