How This Simple Check Helped Me Avoid Quindell plc

Let me start by saying I am not here to say I told you so.

But whenever Ive lost money on a share, Ive always found it useful to see exactly where I went wrong.

Indeed, after lots of setbacks in my portfolio over the years, Ive devised a few rules to keep away from what could be bad investments

And if you have lost money on Quindell(LSE: QPP) this year, I thought it might be useful to disclose the simple way I avoided this high-profile disappointer.

It took me just 2 minutes to rule out this share

Quindell is a 358m AIM-traded business that provides various services to the insurance industry. Im sure many of you have already seen the firm hit the headlines this year for all the wrong reasons

From what I recall, there was that botched attempted move from AIM to the main market, a scathing review from US short-sellers Gotham City Research, and most recently misleading director share dealings that caused boss Rob Terry to stand down.

So far this year, the shares have slumped about 70%.

Anyway, I never was tempted to buy Quindell shares following a two-minute glance at its annual report.

You see, the simple check I used to avoid Quindell was by looking at a certain part the groups accounting.

Sure, I recognise reading company accounts is not everyones cup of tea.

But if you want to be successful in the stock market by avoiding losers as well as picking winners then I do feel you have to make an effort to study the numbers.

Heres my simple checkthat often spells T-R-O-U-B-L-E

My simple check was to look at cash flow. In my view, businesses should always be able to generate cash profits as opposed to just accounting profits.

What I do is to compare operating profits to operating cash flow.

You see, a critical aspect of determining whether accounting profits are underpinned by cash flow is by checking the movements in working capital.

In my experience, companies heading for trouble often have terrible working-capital characteristics, as their stock goes unsold, customers (debtors) refuse to pay and suppliers (creditors) demand earlier payment.

Importantly, Ive found customers and suppliers can both cause difficulties at a company long before management admits to problems.

These red boxes show the crucial cash-flow numbers

Heres how I saw things at Quindell.

The first sign of major cash-flow trouble occurred within the interim results of 2013. The important numbers are in the red box below.

Essentially, that (54,676) figure in the table above represented cash due from customers increasing by 54.676m.

The big worry is that, when you compare that 54m figure to the 44m operating profit figure at the top of the table, it meant relatively little actual cash (2.3m in fact) was produced from Quindells operations during that six-month period.

The same story occurred for the full-year results of 2013. Again, the important cash movements are in the red box.

This time, cash due from customers increased by almost 138m.

When you compare that 138m figure to the 109m operating profit number at the top of the table, it meant (once again) that relatively little actual cash (10.4m) was produced from operations.

Moving onto the half-year results of 2014, the same cash-flow worries continued. The red box shows those all-important movements:

This time, cash due from customers increased by an extra 225m well above the 154m operating profit reported at the top of the table. As such, Quindells cash flow during the six months was in fact a negative 51m quite a concerning development.

No hindsight here this article from 2002 highlights the potential dangers

Now there could be all sorts of genuine reasons to explain these cash-flow movements. Indeed, Quindells customers are large insurance companies, who can be notoriously late payers as anyone who has ever submitted an insurance claim may already know.

Still, the whys and wherefores of the adverse cash-flow situation are not important. What is important, though, is that the situation exists and in my experience often leads to shareholder trouble.

Heres some evidence of how badly things can become.

This article, written 12 years ago, highlights five shares that had very poor working-capital movements.

What happened next is quite instructive

Health Clinic: Within six months of the article, this business had owned up to accounting issues and cash-flow forecast errors. The firm went under soon after.

Innovation Group: Within six months, Innovation had announced revised accounting standards that would knock prior profits from 4m to 1m. A major profit warning occurred soon after, with the shares losing more than 90%.

Minorplanet Systems: A year after the article, revised accounting policies reduced aggregate profits from previous years by 27m. The shares were suspended in 2010 for a total loss.

Sanctuary: Five years after the article, Sanctuary owned up to overstating past profits by 54m. Results for 2006 were qualified by the auditors and a takeover in 2007 locked in an 80% loss.

Warthog: There was no subsequent announcement of revised accounting policies, but the company ran out of money anyway and the shares were suspended for a total loss in 2007.

Cavalier accounting prompted massive shareholder losses

Looking back, the theme that hit four of the five shares in that 2002 article was accounting issues. Reported profits were eventually found to be calculated in a very cavalier fashion and shareholders suffered massive losses as all the bad news came out.

I guess thats what can happen if reported profits have nothing in the way of cash flow backing them up.

Anyway, given that article and subsequent events, it was an easy decision for me not to invest in Quindell earlier this year. I merely thought the cash flow looked very poor and recalled those disaster stories from all those years ago.

Let me finish by saying I am not sure what will exactly happen at Quindell in the future but I am not optimistic.

Of course, whether you agree with (or even apply) my simple rule is up to you. But as I say, whenever Ive lost money on a share, Ive always found it useful to see where I went wrong.

Maynard Paton has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don’t all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.