HELP FOR INVESTORSHow to spot trouble
Scott W. Schoelzel is a very successful investor. As manager of the Janus Twenty Fund, he boasts a three-year average annual return of 28%. Even with this year's rocky market, he has managed to post an impressive 21% gain through August. One reason for his success: The $9.3 billion fund is limited to holding about 30 stocks, so he has time to carefully monitor each one. As a result, he managed to dodge such bullets as Sunbeam Corp., selling his shares long before the collapse that lopped off 86% of its value.
So what are the tricks of the trade? While no one--not even a savvy investor such as Schoelzel--can spot the sort of accounting fraud that led to the collapse of Cendant Corp.'s stock, there are plenty of places investors can check to test how healthy a company really is. If you know where to look in the financial statements, it's not that hard to spot the kind of aggressive accounting that can lead to a financial meltdown. And if you know how to carefully read analysts' reports, they too can be packed with useful information. Here's a short guide on how to look for those elusive clues to a company's changing fortunes.
WATCH THE CASH FLOW
COMPARE REVENUES AND RECEIVABLES
GET OUT THE MAGNIFYING GLASS
Companies total their in-process R&D write-offs under ''operating costs and expenses'' on the consolidated statements of income. But there should be a detailed footnote, too. The details are often minimal, though that can change when regulators are watching. After the Securities & Exchange Commission started asking questions about such charges at Envoy Corp., management penned five pages of explanation about three deals, points out Pat McConnell of Bear, Stearns & Co. That kind of information can help you assess whether management has made a smart move or just blown a lot of cash.
CHECK BEYOND EARNINGS
BEWARE INVESTMENT-BANKING LINKS
Be especially wary of early recommendations in the case of initial public offerings. The first recommendations usually come from the firm or firms that lead the underwriting. Kent L. Womack, a finance professor at Dartmouth College, says these bullish reports from the investment banker's analyst are usually issued when the stock is below the offering price. ''That's why we call them booster shots,'' says Womack.
If an IPO starts to look like a winner, other analysts will start coverage. Womack studied stock- price behavior on the day buy recommendations were issued. Buys from analysts uninvolved in the underwriting resulted in a 3.5% price gain vs. a 1.5% gain for those from the underwriter's analyst.
DECIPHER THE RATINGS
Some, like A.G. Edwards & Sons and Merrill Lynch & Co., use a five-rung ratings system: two levels of buy, a neutral, and two levels of sell. Many more stocks earn top grades than the bottom. Right now, 543 of 3,825 Merrill Lynch analyst recommendations are in the top rating. Only eight have an outright sell.
Some firms, like Morgan Stanley Dean Witter, use a four-part system: strong buy, outperform, neutral, and underperform. Notice that the system gives more prominence to telling investors to buy than to sell, which is couched as ''underperform.'' It means the same thing. Who wants to hold a stock that's expected to be an underachiever?
At first blush, a hold, or ''neutral'' or ''market performer'' doesn't sound so bad. What's the harm in holding it, especially if the company is still sound? Maybe no harm if you're a long-term investor. But in the short run, the stock may get clobbered. Institutional investors may dump the stock. Their goal is to beat the market, so they can't afford to hold on to a stock that's only expected to match it. That's why many pros consider a hold to be a sell.
WATCH FOR DOWNGRADES
Big institutional investors know the analysts' pronouncements are not always what they seem. But unlike individual investors, they often meet and talk with analysts. ''A wink, a nod, or some other body language tells more than the report,'' says Kevin Landis, portfolio manager of the Firsthand Technology Value Fund. ''It's the individual investors who are most susceptible to misreading the ratings,'' says Bill Gurley, an ex-technology analyst, now a partner at Hummer Winblad Venture Partners. But if the individual knows how to look under the company's financial hood directly, chances are he or she will come a lot closer to getting the professionals' edge.
By Nanette Byrnes and Jeffrey M. Laderman in New York
Updated Sept. 24, 1998 by bwwebmaster
Copyright 1998, Bloomberg L.P.