Reading the red flags

The red flags on each company page are automated checks against specific thresholds in the latest filings. They are questions, not verdicts: a triggered flag means 'look here', never 'avoid this company'. Excellent businesses trigger flags during transitions and bad years; fragile businesses can pass every check right up until they fail. The flags' value is direction — they tell you where to spend your investigation time — and their limits come from their construction: most compare only a year or two of data, and none knows why a number moved. The why is your job. What follows is each check, its threshold, and how to pursue it.

Revenue declining — latest fiscal-year revenue more than 3% below the prior year. The threshold exists to skip rounding noise and catch real contraction. Costs never shrink as fast as sales, so revenue declines compress everything downstream with a lag. Investigate the cause in the 10-K's management discussion: divestitures and currency are mechanical and mild; cyclical downturns are survivable if the balance sheet is strong; lost customers or a product in secular decline is the serious case. A first down year after a long climb is an event to explain — a third consecutive decline is a trend to respect.

Negative free cash flow — operating cash flow failed to cover capital expenditure. The company consumed cash, and the shortfall came from reserves, debt, or new shares. The critical decomposition: if operating cash flow itself is negative, the core business loses money before any investment, the most serious reading. If OCF is positive but capex overwhelms it, you are looking at an investment program — judge it on the returns the spending is likely to earn. Check how many of the last ten years were FCF-negative (the quality score's consistency component shows this) and how long current cash covers the burn rate.

Net loss — negative net income in the latest fiscal year. Beyond the direct signal, a loss disables the P/E and earnings yield and makes the company dependent on external capital, a dependency most dangerous when markets tighten. First check the cash flow statement: a net loss alongside solidly positive free cash flow usually indicates heavy non-cash charges — acquisition amortization is the classic case — and is far milder than a loss with negative cash flow. Then check frequency: one loss in a profitable decade is an incident; repeated losses are the business model.

Heavy debt load — long-term debt above five times free cash flow. At five-plus years of cash flow, debt drives outcomes: refinancing becomes a recurring bet, and a downturn that halves FCF doubles the ratio overnight. Three things determine severity: the maturity wall (debt due soon is acute risk; long-dated fixed-rate debt is soft), cash-flow stability (5x on a regulated utility is routine, on a cyclical it is dangerous), and the trend (leverage rising to fund buybacks at high prices is the worst pattern). Check cash-to-debt for the net position — a company with debt fully offset by cash is differently placed than one without reserves.

Heavy stock compensation — SBC above 30% of free cash flow. Because SBC is added back in the cash-flow statement, reported FCF at that level materially overstates what accrues to existing shareholders: roughly a third of the 'free' cash is financed by issuing shares. Restate the numbers yourself — subtract SBC from FCF and recompute the yield — and check the share-count trajectory: a flat count despite heavy SBC means buybacks are absorbing the issuance at real cash cost; a rising count means dilution compounds the problem. Falling SBC ratios as a company matures is the healthy pattern.

Shareholder dilution — diluted shares growing more than 2% a year over five years. At that pace your proportional ownership shrinks about 10% in five years, a compounding tax the income statement never shows. Identify the source: compensation issuance (recurring; read with the SBC flag), acquisition currency (judge the deals bought with it), or financing raises (at a cash-burner, expect more). Because we split-adjust historical counts, the figure reflects genuine issuance. The constructive resolution is a management that names the problem and commits to net reduction.

Distributions exceeding FCF — dividends plus buybacks above 100% of free cash flow. The excess came from the balance sheet: falling cash or rising debt. Separate the components, because they differ in stickiness: dividends are near-commitments, and an uncovered dividend is a structural problem that often ends in a punished cut; buybacks are discretionary, and a one-year surge past FCF can be deliberate opportunism. Determine whether FCF was temporarily depressed or the payout has permanently outgrown generation, and watch debt-to-FCF for confirmation that over-distribution is being borrowed.

Margin compression — gross margin down more than 5 points versus three years ago. Gross margin is where competitive position surfaces first, and erosion this size usually means price cuts to defend volume, a mix shift toward lower-value revenue, or broken pricing power. The three drivers differ in prognosis: input-cost spikes can reverse; deliberate mix shifts can be strategy; price competition is the structural case that precedes decline. Management's explanation in the MD&A, and whether erosion is decelerating, are the evidence to weigh.

Two closing disciplines. First, flags compound: any single flag has an innocent explanation, but three or four triggering together — say declining revenue, compressed margins, and distributions above FCF — describe a company under real strain, and the innocent explanations must all be true simultaneously. Second, absence of flags is not endorsement: these checks read history, and a richly priced company with a pristine record can still disappoint purely through valuation. The flags police the business; the valuation metrics police the price; an investment case needs to survive both.