Seven small and mid-cap stocks to avoid

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Seven small and mid-cap stocks to avoid

It's never easy to spot where the next profits warning or company alert is coming from, which is why analysts at Liberum have come up with a red flags checklist that might help.

Until now, this has been limited to top-flight companies based on 13 areas that signal business risk. The worst offenders in the FTSE 100 Sinners note have consistently underperformed in the each of the last three years.

So, it's only right that this version of accounting red flags has been extended to cover the small and mid-cap sector, with some interesting results.

The broker groups the red flags into five categories - Profit Smoothing (from exceptionals to bad debtor provisions), Working Capital, Cash Uses, Academic Models and Misc. & Governance.

Overall, seven companies flag five times or more, with Hunting (HTG) and SIG (SHI) screening most frequently with six mentions. Balfour Beatty (BBY), Cape (CIU), John Wood (WG.), Serco (SRP) and UItra Electronics (ULE) complete the list with five flags each.

It's the screening tool, not Liberum, that's flagging these concerns because the broker has buy ratings on both Balfour Beatty and Ultra Electronics.

With the exception of John Wood, the consistent use of exceptionals crops up as a repeated red flag. This concerns Liberum because adjusting profits higher year-in-year-out could be a signal of low earnings quality.

Hunting's other flags are an increase in doubtful debtors and in receivables days, which have increased from 67 to 84 over the last two years. The energy services provider also screens for a significant increase in inventory days, a poor cash dividend cover and an ageing asset portfolio.

In the case of building supplies firm SIG, which is on Liberum's sell list, the screening notes an increase in amounts recoverable on contracts and an increase in trade payable days - from 40 to 52.8 over the last three years.

However, the company has stated on a constant currency basis the average credit period taken for trade purchases is 39 days, one day higher than 2015.

Other red flags for SIG include low cash conversion associated with its restructuring, which has weighed on the cash dividend cover.

This factor was also mentioned in the case of Balfour Beatty, which has shown recently that it is back on track after a restructuring led by CEO Leo Quinn.

Liberum said: "Weak historic cash flows are not a secret as Balfours took on contracts with unattractive terms and prices in the downturn.

"The dividend was suspended in 2015 and resumed in FY 2016. The more interesting question for us is whether Balfours can return to generating strong cash flows in the future."

Energy services company Cape was flagged in five areas, including the size of CEO compensation as Liberum said the total figure was almost 5% average EBIT over the last three years.

Wood Group screens for an ageing asset portfolio, having seen capital expenditure fall markedly behind depreciation, according to today's analysis.

Serco triggers five flags, including for the size of CEO compensation and its cash conversion rate, which has been depressed over the last five years due to onerous contract provisions.

Ultra Electronics is on Liberum's buy list, with the broker encouraged by its guidance to improve capital expenditure to £15 million in 2017 and £18 million in 2018.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.