Is Your Stock In The Danger Zone? Here's How to Tell
(FORTUNE Magazine) – There is no easy way to spot financial trouble before it occurs, but there are telltale signs that the risk of a rout is higher than a company's stock price might suggest. And you don't necessarily have to be a number cruncher to get that sinking feeling that something isn't quite right. Sometimes it takes little more than common sense to avoid getting clobbered, which brings us to Greenberg's Rules for Recognizing Risk.
--The veering-from-the-herd rule. One of my favorite warning signs is when a lone brokerage analyst breaks from the crowd and downgrades a popular stock to "sell" or "hold." These defectors are often early, but they usually have a good reason. You can find out who they are through institutional services like Baseline or Bloomberg (if you have access to them) or through the "upgrades and downgrades" section under company profiles on Yahoo Finance. You can actually get many of the reports (for a fee) from First Call (www.firstcall.com) or Multex (www.multex.com). Many others, however, are available free from the brokerage firms or from online brokers that offer reports from various firms. (Don't try calling the analysts, however; they won't take your call.)
--The tape-measure rule. The thicker the investor package provided by the company, the less legitimate the company. Examples: Exxon and Mobil have thin packages. By contrast, every little oil and gas company that blew up after the oil collapse in 1980 had fat investor kits with a zillion press releases about wells and drilling prospects that never materialized.
--The CFO-revolving-door rule. It's really not a good sign when a company is churning through a chief financial officer every year or two. CFOs are the guardians of the financial gate, so when they leave, it's a good idea to know why. What's more, if a company is losing CFOs or other top execs with any frequency, you might also want to check local courts for wrongful-termination suits. Years ago I was tipped off that a former CFO of Supercuts, the hair-cutting chain, had filed a wrongful-termination suit against the company. He had, and it was full of allegations of improprieties. Turns out that CFO's predecessor filed a similar suit a year earlier. Supercuts' stock crashed, the CEO was kicked out, and the company eventually was sold.
--The size-counts rule. Look to see who the auditors are. Companies with big accounting firms get in plenty of trouble, but one red flag can be a public company's use of a non-brand-name accounting firm to handle its audit--especially a firm that it may have used when it was private. I'm not slighting the accountants here, but when a company chooses a lower-profile auditor, my trouble sniffer perks up.
--The C-word rule. Be wary anytime a company uses any variation of the word "challenge" in a press release. Historically, I've found "challenge" to be a euphemism for "We're having a heck of a lot of trouble, and we're not sure whether we can pull it off." Example: Pillowtex, known for such brands as Fieldcrest and Cannon, ran into serious trouble last year. When the stock was in the 20s, the president made the mistake of saying, in an earnings press release, that many "challenges" remained. The curse of the C-word: Subsequently Pillowtex disclosed serious financial troubles. Its stock now trades at around 5.
--The shorts-are-the-enemy rule. If a company has large short interest, and the CEO has waged a public war against the shorts and the company's critics, sharpen your pencil. It is almost always a sign of desperation. No company wants short-sellers putting pressure on its stock, but companies that don't have a problem typically ignore the shorts because fundamentals usually win out. You've never seen John Chambers of Cisco take off after shorts, have you? On the other hand, CHS Electronics CEO Claudio Osorio publicly declared war on short-sellers when they slammed his company's stock. That was in June 1998, when CHS stock was around 25; it's now around 1 1/2.
--The cash-flow rule. (This one is for number crunchers and comes from Andrew Boord, an analyst at A.G. Edwards.) "Look at cash flows from operations, on the cash-flow statement. If it is negative and net income is positive, there is a problem. If it is weakening while net income is growing, then there is a problem. From here, you can scan the cash-flow statement to find the problem(s). For instance, you might see receivables are up huge or prepaid assets are ballooning. It should be noted that this does not work well with financial companies, such as banks and insurers, but it works with tremendous accuracy on nonfinancials."
--The it's-all-in-the-fine-print rule. First, scan a company's filings with the Securities and Exchange Commission. (Here I'm talking about 10-Qs, 10-Ks, S-1 filings, and amendments.) Then use the "compare" function on Microsoft Word to match up the actual text in the "risk factors" and the "management discussion and analysis" sections with prior versions. Just for fun, see how the risks are phrased more subtly in the latter areas. Years ago, this dual-language game led many to realize that 3Com was headed for trouble.
--The YMBI rule. That's the Yahoo Message Board Idiocy rule. And this one's as simple as can be: The more zealous the message boards on Yahoo, the higher the chance of trouble. Period.
HERB GREENBERG is a senior columnist for TheStreet.com. He can be reached at firstname.lastname@example.org.