To avoid trouble, look at these red flags

Earnings-expectation games, unclear pay practices and opaque results can signal danger ahead

ALFRED RAPPAPORT

The following is reprinted with permission of The Wall Street Journal, Copyright 2002, Dow Jones & Company, Inc.

Looking for winners among the thousands of actively traded stocks is a daunting task. Even deciding when to sell stocks already owned can be a challenge. But it is possible _ and, these days, even imperative _ to make both tasks more manageable by identifying companies with obvious red flags.

Ambiguous business models, opaque financial reports and earnings-expectations games all can signal a company whose stock price is headed for a fall. So can price wars, value-destroying mergers and acquisitions, uneconomic share buybacks and executive-compensation practices that are unfriendly to stockholders.

Avoiding such stocks is only the first step to investment success, of course. It takes detailed, time-consuming analysis to isolate companies with positive prospects that aren't already reflected in their current stock prices.

Ultimately, the only way to become a successful investor is to have a view that is meaningfully different from today's market expectations _ and be right. That means correctly foreseeing shifts in technology, consumer confidence, competitor behaviour, regulation and other forces that shape a revised outlook for a company's sales, costs or investments.

It's a tall order. No wonder so many investors rely on mutual funds and other professionally managed portfolios. Index funds, which merely seek to match the performance of some broad sector or the market as a whole, have an obvious appeal.

But for investors willing to put in the work necessary to manage their own portfolios, I suggest looking for red-flag warnings that offer valuable clues about potentially damaging downward revisions in market expectations. Here are seven red flags that may signal that you should avoid or sell a stock.

AMBIGUOUS

BUSINESS MODELS

It seems all too obvious, but it is constantly worth reminding ourselves that we shouldn't invest in a company if we don't know how it makes money.

Recent experience with high-flying Internet and technology stocks suggests that even the best investors struggle to understand and value new kinds of businesses. Investors also find companies that transition from one business model to another difficult to analyse. Enron Corp, which moved from selling natural gas to trading energy, is a case in point.

Individual investors aren't alone in stampeding to buy euphorically priced but little-understood stocks. Some of the largest and most prestigious mutual funds, hoping to participate in the seemingly endless price escalation, joined the party with meaningful purchases of their own.

You can't always depend on management to explain its business model _ that is, how it proposes to create value for shareholders. Even when management does disclose its business model, you should be constructively sceptical and assess whether the model makes economic sense. For example, will Amazon.com Inc's move from trying to sell everything itself to partnering with bricks-and-mortar retailers such as Target Corp, Circuit City Stores Inc and Toys 'R' Us Inc enable it to develop a sustainable value-creating business?

If a company's business model seems credible, you can then go on to assess whether the expectations embedded in the current stock price represent a buying or selling opportunity.

OPAQUE

FINANCIAL REPORTSThe lethal combination of ambiguous business models and opaque financial reports increases the likelihood that unpleasant surprises lie ahead for investors. Financial reports are opaque when footnotes are too dense to interpret and when companies engage in accounting practices that tend to hype or hide rather than to inform.

Investors should be alert in bull and bear markets alike. Often, underlying problems don't surface until the economy weakens, exposing the company's vulnerabilities.

The uncritical acceptance of reported earnings is particularly risky in industries that have considerable discretion in how they compute earnings. For example, finance companies can defer showing losses on uncollectable loans by extending repayment schedules or rolling them over into new loans. Astute investors don't wait for companies to write off their uncollectable loans; they look for signs of weaknesses in loan portfolios well in advance.

Companies that engage in particularly aggressive earnings-increasing practices often do so to mask fundamental downturns in their operations. Accounting discretion is no substitute for genuine operating cash flows.

Sooner or later, investors figure out the difference and show their displeasure by shrinking the share price. It is best to avoid companies that are consistently mired in controversy about their financial reporting practices.

Reported earnings that are significantly greater than a company's cash flows may also offer an early warning of problems ahead. This was the case for Enron over the past five years. Though overstated earnings played a role, the company was ultimately done in by the cash-devouring combination of rapid growth and low returns.

The lesson is straightforward. A company that grows while earning a rate of return below its cost of capital is a red flag even in the face of impressive reported earnings.

EARNINGS-EXPECTATIONS GAMES

Wall Street loves playing the earnings-expectations game. Analysts forecast a company's earnings each quarter, often with guidance from management. The process ends up with a consensus estimate. Managers feel compelled to meet the estimate to avoid disappointing the market and triggering a drop in their company's stock.

Companies that skillfully play the quarterly earnings game manage expectations, manage earnings or do both. To manage expectations, they guide analysts to an earnings number that the company can beat. If a company can't meet or beat expectations, then it can either manage expectations downward or manage earnings.

It's no coincidence that 78% of companies typically meet or beat consensus earnings estimates, according to Thomson Financial/First Call. Interestingly, 15% beat the consensus by just a penny in last year's third quarter.

Under the circumstances, investors find it very difficult to separate companies that genuinely achieve better-than-expected performance from those that skillfully manage expectations and earnings. Because even credible short-term earnings tell us precious little about a company's long-term cash-generating prospects, the best advice is to quickly exit this game.

Beware of management teams so devoted to the earnings game that they mislead themselves. The smooth progression of reported earnings can hide serious business problems that require urgent managerial attention. Left unattended, these problems inevitably lead to declines in market expectations and the stock price.

PRICE WARS

Though stock prices are sensitive to shifts in expectations for volume growth, particularly for highly profitable companies that enjoy significant economies of scale, revisions in selling-price expectations typically have a greater impact. That's why you should try to anticipate price wars before their destructive consequences are reflected in lower stock prices.

Price wars almost invariably break out in commodity businesses, where companies find it difficult to differentiate their products from their competition other than by price. Add slow growth and excess industry capacity to the mix, and all the ingredients for reduced investor expectations and share-price erosion are in place.

The personal computer has been a commodity product for a number of years. In contrast to the double-digit growth rates of the 1990s, personal computer sales declined for the first time last year.

Dell Computer Corp, the undisputed low-cost leader, gained market share at the expense of Gateway Inc, Compaq Computer Corp and others by starting an aggressive price war in late 2000. Dell's stock price rose by 56% in 2001, while Gateway and Compaq shares fell by 55% and 35%, respectively.

Because it was clear by the start of 1999 that the PC was a commodity and that market saturation was fast approaching, a look at three-year price performance is more revealing. Over that span, Dell stock fell by 26%, while Gateway and Compaq fell by 69% and 77%, respectively.

Be alert: Today's growth businesses may well become tomorrow's price-war combatants. Be particularly wary about investing in companies that are not industry leaders.

VALUE-DESTROYING MERGERS

AND ACQUISITIONS

Here are the sobering facts about mergers and acquisitions. First, a majority of them don't work. About two-thirds of all acquisition announcements trigger declines in the buying company's stock price, and the market's initial reaction usually corresponds to the buyer's relative stock performance over the next year.

Second, corporate boards rarely vote against the acquisitions that their chief executives endorse. Finally, shareholder rejection is about as rare as sightings of Halley's Comet. In other words, there is not much of a safety net for value-destroying deals.

An acquirer creates value for shareholders only if the expected benefits or synergies are greater than the acquisition premium it offers. Most companies disclose the size of the synergies they expect. Compare the value of the expected synergies with the premium. (Detailed tutorials and downloadable spreadsheets to help you conduct this analysis are available at the web site www.expectationsinvesting.com)

In many cases, even management's often-optimistic synergy estimate is insufficient to offset the premium. As a result, management's guidance unwittingly triggers an immediate, and warranted, drop in its stock price. Management's willingness to pay an acquisition premium that exceeds its own assessment of synergies should be an obvious red flag to shareholders and prospective purchasers of the acquiring company's shares.

Management may also be sending an important signal by its decision to pay for an acquisition with stock rather than cash. Research consistently finds that the market takes stock issuance as a sign that management _ a group in a position to know about the company's long-term prospects _ believes that the stock is undervalued. Ironically, the same CEOs who publicly declare their company's stock price to be too low, which suggests that they should use cash for the deal, often issue the ``too low'' stock to pay for their acquisitions. Actions speak louder than words: The market responds more favourably to announcements of cash deals than to stock deals.

UNECONOMIC SHARE BUYBACKS

Many investors believe that when a company announces a share-buyback programme, it's automatically good news and, certainly, no cause for a red flag. After all, in most cases the announcement is greeted by an increase in the stock price. It would, however, be a mistake to accept all buyback announcements as unambiguous positives.

A company should repurchase its shares only when its stock is trading below management's best estimate of value and when no better opportunities to invest in the business are available. When management follows this golden rule, continuing shareholders benefit at the expense of selling shareholders, assuming that management can estimate value better than the market.

But beware of management overconfidence. Managers almost always believe that the shares of their company are undervalued, and they rarely have a full understanding of the expectations embedded in their stock price. History is littered with companies that bought back ``undervalued'' shares only to see business prospects deteriorate and their stocks plummet.

When companies repurchase shares to manage reported earnings per share at the expense of increasing shareholder value, it's again time to raise the red flags. Many companies _ including prominent ones like Dell and Microsoft _ buy back shares largely to offset the earnings-per-share dilution from employee stock-option programmes. Others employ share buybacks to boost earnings per share in the mistaken belief that this creates value. Companies that buy back stock to offset dilution or to increase earnings per share may unwittingly reduce the value of the remaining shares if the stock is overvalued rather than undervalued.

SHAREHOLDER-UNFRIENDLY

COMPENSATION PRACTICES

In the early 1990s, as boards began placing greater weight on shareholder value, they became convinced that the surest way to align the interests of managers with those of shareholders was to make stock options a large component of compensation. But as the long-running bull market fuelled extraordinary gains not only for executives in superior-performing companies, but also for below-average performers, stock options were properly criticised.

Over the past couple of years, a new problem has emerged: Many executives have seen the value of their options evaporate as their companies' stock prices have plummeted. This has triggered the challenge of retaining and motivating key people when their stock options are hopelessly underwater.

Many boards have responded by granting restricted stock, offering more options or lowering the exercise price of existing options. These shareholder-unfriendly initiatives rewrite the rules in midstream. They undermine the executive stock-option incentive by turning it into a heads-I-win, tails-I-win arrangement.

Moreover, there is some evidence that repricing options may not reduce executive turnover. Companies are also increasing cash compensation _ salary and bonuses _ to make up in part for the reduced value of stock options. This retreat to a pre-1990s compensation approach, with its weak link between pay and performance, can be bad news for shareholders.

If these changes in compensation were confined to relatively few companies, it would easy to red-flag them. Unfortunately, they are commonplace.

I would red-flag companies that have reverted to cash compensation and that also have poison pills and other anti-takeover defences in place. These companies not only lack shareholder-oriented compensation schemes, but also are run by entrenched managers protected from the market for corporate control.

Look for the first few companies that adopt indexed option programmes, which link exercise prices to movements in either an industry index or a broader market index like Standard & Poor's 500.

These programmes align the interests of managers and shareholders seeking superior returns in bull and bear markets alike. Indexed option programmes have the support of a growing chorus of institutional investors, but management continues to view them as too risky an incentive.

- Alfred Rappaport is the Leonard Spacek professor emeritus at the J.L. Kellogg Graduate School of Management, Northwestern University. He is shareholder-value adviser to L.E.K. Consulting. Dr Rappaport is a co-author with Michael J. Mauboussin of `Expectations Investing: Reading Stock Prices for Better Returns', published by Harvard Business School Press in September 2001.

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