How Effective are Red Flags in Investing

The term "red flags" is synonymous with "bad things are going to happen," and, for investors, they are a sign that you should likely stay away from that investment. However, all this talk of red flags being able to predict that a company is going to do poorly makes you wonder, does it work?

Just how telling are red flags?

The term “red flags” is synonymous with “bad things are going to happen,” and, for investors, they are a sign that you should likely stay away from that investment. However, all this talk of red flags being able to predict that a company is going to do poorly makes you wonder, does it work?

To start, let’s take the red flag score from the “Synopsis with Red Flags” tear sheet which contains 13 different comprehensive red flags. I apologize for the size of the following photo.

Without getting into too much detail, in the event you can’t read the photo clearly, the score looks for the following thirteen items –

  1. Bad Accruals
  2. Current Accrued Expenses are increasing faster than expenses
  3. Two bad days in a row with a 4.5% drop in share price each day
  4. Close has decreased over the past 20 days
  5. The company has a low Cash Flow score
  6. The company has a low Piotroski F-Score
  7. Outperformance while EPS 1Y is decreasing
  8. Average market cap is in the top ten companies
  9. RawClose is less than $2/share.
  10. EPS T12M has fallen by 25%
  11. Price is a third of its all-time high
  12. Cash is rapidly decreasing annually
  13. Cash is rapidly decreasing quarterly

If you decide to run this screen yourself, it will take some time do to the complexity of the parameters we are looking for. Though there are 13 different parameters for the score, I think that we can get the results we need to prove the effectiveness of red flags by simply looking for companies with a red flag score of greater than 3.

Since we pulled the red flag score from the Synopsis tear sheet, all of the red flags are automatically plotted in the results.

Take AXON for example. They are a large company worth over $2 billion dollars in the fascinating sector of biopharmaceuticals. What you wouldn’t usually know off the bat, is that AXON exhibits four of the thirteen red flags. That may not seem like a lot, but let’s see how well this screen performs over the past twenty years.

That chart is all over the place and is pretty much unreadable. Let’s go ahead and put it on a log scale to make the data more comprehensible.

That’s much better, and just what we hypothesized would happen at the beginning of the article. It may seem self-explanatory that “red flags” would result in poor performance, but it may not have been foreseen that a company with as few as four red flags could result in the loss of 99.85% of your initial portfolio. At the end of the day, a Red Flags score is just that, a red flag to tell you to stay away from something or jump ship while you still can. Personally, to be on the safe side, I would overlay a plot panel(which has been prebuilt into the software, meaning all you have to do is select it under the trading rules tab) to the screen to quickly identify companies with a large number of red flags and shorten my analysis time even further.

About Tyler McCain

A student of finance at Georgia State University, Tyler has had a passion for the world of finance for as long as he can remember. Joining the Equities Lab team in 2015 he attempts to juggle the perfect mix of school, work, and giving back to the community. When he isn't working at Equities Lab he can often be found helping teach programs at the Rosen Family Foundation - a non-profit that teaches financial literacy to middle and high school students.

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