Danger ahead

All successful investors have at least one skeleton in the closet - perhaps a punt on One.Tel, Westpoint or a technology fund - that they would rather forget. The trick is to use the experience to help spot investment landmines in the future.

Once you know what to look for, some investments almost scream at you: "Warning, do not enter." In a perfect world, you would simply avoid all hazardous investments, but it's not always so simple.

Sometimes sound companies lose their way, successful managed funds lose their best stock pickers or trusted managers turn out to be frauds.

One of the best protections against a dud is to diversify your investments so you risk only a small percentage of your capital in any one asset.

But everyone would prefer to avoid a loss if at all possible. So if you do come face to face with disaster you may be able to bale out before the crash if you can recognise the warning signs early enough. Here are just a few of the danger signs.

Eye-popping returns
Greg Tanzer, head of consumer protection at the Australian Securities and Investments Commission, says the first thing to look at with fixed interest investments is the return. If it's higher than 8.5 per cent, then take a cold shower.

Tanzer says a reasonable return for any asset class is 1 to 2 percentage point above the average for that asset class. So with the return on low-risk term deposits about 6 to 6.5 per cent, a rate of 8.5 per cent looks good and anything higher involves significantly more risk.

Of course, risk is not necessarily bad as long as you know exactly what risk you are taking and you take a measured approach, not risking all your capital.

Tony Lewis, of fixed interest specialist Lewis Securities, says some high-interest investments can be perfectly safe. High risk can bring high rewards for those with the stomach for it, but Lewis says you should seek professional advice and not risk more than 5 per cent of your capital in any one investment.

Tanzer's second piece of advice is to have a close look at the investment's prospectus or product disclosure statement. This means the investment is registered with the regulator and certain legal safeguards are built in. One of the key things to look for is unreasonably high commissions paid to advisers. This was one of the hallmarks of the failed Westpoint scheme, whereas a great investment doesn't need a hard sell.

Security is also important. You need to know where you stand in the line of creditors if something goes wrong. A first mortgage is preferable and the mortgage should be registered over the property in question.

"If it's not a first mortgage you need to know what the first mortgage is, because you will rank after [the lender] if something goes wrong," Tanzer says.

However, the existence of a product disclosure statement or prospectus should not give investors false comfort, because it can be extremely difficult to detect fraud from public documents.

"You can do all the homework you like and get advice but if management are crooks you will be left holding the baby," Lewis says.

The commission has a risk-and-return calculator on its website (www.fido.asic.gov.au) that allows you to key in the investment you are considering to see how the return stacks up against comparable investments.

Luxury advertisements
Newspapers and radio are brimming with ads that are long on promise and short on detail. Often the ad features little more than an attention-grabbing interest rate.

Kosher borrowers tend to raise money via licensed advisers and their clients. "[Advertising direct] means they haven't got on anyone's approved list so they go to Joe Public who doesn't get professional advice," Lewis says.

Tanzer says investments should not be vague or overly complex. "People think asking questions makes them look stupid but that's not the case. If you can't understand it, don't buy it."

Lewis agrees and urges investors to pick up the phone and challenge them to prove they are safe.

Most of the offending ads are for finance companies or mortgage trusts lending money to high-risk property developers who can't get funds from a bank and may involve a second or third mortgage.

"If everything goes well, you're fine, but if anything goes wrong the financier loses money and so do investors," Lewis says.

Poor cash flow
The first sign of a company in trouble is often an operating loss. This is not necessarily a portent of doom because in an otherwise robust company losses can be temporary. But if the loss is accompanied by falling cash flow then investors should take a long hard look at the numbers.

Greg Hoffman, research director at The Intelligent Investor, says a loss-making company with negative cash flow will quickly become insolvent unless it can raise money from banks and shareholders. Hence, rising debts and deteriorating interest cover (the number of times a company's earnings before interest and tax cover its tax bill) are also reliable warning signs.

If the company continues losing money its bankers and shareholders eventually will say "no more" and the company will go belly up.

To illustrate the point, Hoffman has singled out four companies he believes are treading on too many corporate landmines for comfort.

Winemaker Evans & Tate lost $64 million in 2006 and $73 million the previous year. As at June 30 this year total debts of $169 million exceeded total assets of $140 million.

Evans & Tate's banker has given it some breathing space but Hoffman doesn't hold out much hope for its long-term survival in its current form.

Electronic payments company ERG, Strathfield Group and animal antibiotic group Chemeq are similarly challenged, Hoffman says. All have made losses two years running and all have negative cash flow.

In addition, Strathfield and Chemeq have borrowings greater than shareholders' equity (total assets minus liabilities), another bad sign.

ERG and Strathfield have issued hundreds of millions of shares in recent years as they struggle to survive.

According to Hoffman, corporate failures are seldom the result of a sudden misfortune. Instead, they tend to be the gradual and inevitable result of poor underlying economics, giving investors the clues to look for better opportunities elsewhere.

And if the boss has no faith in the business and hardly any stakeholding in it, investors should probably follow suit, he says.

Managers jumping ship
Managed funds tend to be seen as less risky than investing in direct assets such as shares or property, but they are far from failsafe. Not only are managed funds held captive to the performance of the markets they invest in, but they also rely on the skill of the people managing the fund.

Phillip Gray, of research house Morningstar, says one of the first warning signals is often an exodus of the people managing your money. "The fund will say it's the management process that's important, not people, but people are extremely important," he says.

Sometimes key staff jumping ship can be a symptom of ego clashes that could ultimately cost investors money.

Thanks to the amount of superannuation money flowing into managed funds and booming share markets, there has been an unprecedented period of growth for managed funds and a blowout in the salaries and egos of the best-performing analysts.

One example of the perils of ego was the experience of BT Funds Management in the late 1990s. A strong personality overruled the concerns of compliance staff and made large bets on a small number of Australian stocks.

Key staff left but it wasn't until the tech crash and the fall of One.Tel, one of BT's big gambles, that investors began to bale out. Many investors were badly burnt.

BT has since got its house in order and now takes a more conservative approach to stock selection, spreading its money and its risk over a larger number of shareholdings.

Another warning sign is a fund manager who is not able to perform consistently well in a market environment conducive to its investment style.

For example, if a value manager performs poorly in a market crawling with overlooked bargains, or a growth manager limps through a market boom, then something is wrong.

A third sign that it could be time to cut your losses is when a fund's after-tax return lags behind comparable funds for a few years running.

Complex products
An ageing population and a growing demand for income-producing investments has led to an explosion of fixed-interest products with increasingly high returns.

In order to produce these returns products are becoming increasingly complex, with a high degree of financial engineering, often with the inducement of a capital guarantee, low transparency and layers of fees that can be difficult to tease out.

Gray calls this product complexity risk and says that often the seemingly high returns do not adequately reflect the risk involved.

Many fixed-interest funds include high-risk investments - and high-sounding jargon - such as collateralised debt obligations, interdebt funding and mezzanine or subordinated debt. If you're scratching your head wondering what this means, don't fret: you are not alone.

The golden rule is, if you don't understand it, don't buy it. And don't be shamed by aggressive marketing appealing to "sophisticated" investors. Sophistication is no protection if a high-risk investment blows up in your face.

The fact that you've paid through the nose for sophistication will just add insult to injury.

Property frenzy
Safe as houses? Don't believe it. This rule could apply equally to all asset classes but it's particularly pertinent to residential property in a country in love with bricks and mortar.

The West Australian and Darwin property markets are going crazy at the moment, a sure sign that caution is warranted.

Four years ago Neil Jenman, property writer and consumer advocate, was recommending both markets, but no longer. "These are two places to avoid like the plague because people are going crazy," he says.

Three years ago Sydney and Melbourne were booming but the news from those cities today is more likely to be about rising numbers of distressed sales and repossessions. The same is inevitable in Perth for people who buy at the top of the cycle.

A tale of two cities, Sydney and Perth, could not be starker. According to figures from BIS Shrapnel, the median house price in Perth rose 34 per cent in the year to June compared with a fall of 1 per cent in Sydney, three years after the bubble burst.

Gross yields - that is, rental income as a percentage of house prices - on three-bedroom homes in Perth are 3.1 per cent, down from 5 per cent in 2001, a symptom of rising house prices. Jenman says anything below 5 per cent is a danger signal.

Yields in Sydney on three-bedroom homes are 2.7 per cent. Once interest and other costs are taken into account, Sydney property investors are earning a zero return on their investment.

Jenman says the two yardsticks to measure a property investment against are yield and affordability. "Buy when [gross] yields are above 7 per cent and the affordability factor is less than 20 per cent," he says.

Affordability is measured by taking the average mortgage payments as a percentage of the average wage.

National affordability is 33.2 per cent, or pretty unaffordable, compared with a reasonable 17.7 per cent in 1997 before the latest property mania took hold.

According to Jenman, the affordability factor in Sydney today is about 45 per cent, pricing many first home buyers out of the market. If you bought in 1997, take a bow. If you've just bought in Perth, fasten your seatbelts for a crash landing.

'You can do all the homework you like ... but if management are crooks you will be left holding the baby.' - Tony Lewis, Lewis Securities

'People think asking questions makes them look stupid. If you can't understand it, don't buy it.' - Greg Tanzer, ASIC

'Buy [property] when [gross] yields are above 7 per cent and the affordability factor is less than 20 per cent.' - Neil Jenman