Investing Tip:

Avoiding Stocks With Accounting Problems

Over the last few years there has been a great deal in the press about accounting problems at major companies. First I'd like to remind everyone that 99% of the companies out there are pretty straightforward about their accounting. But with 10,000 listed stocks, that's 100 bad apples, which is quite a few. Here are a four rules you can apply to help you avoid problems.

  1. Avoid companies with high debt levels. A company with a lot of debt (i.e. Worldcom) has no room to disappoint. For them it's not just about bad earnings. It's about violating bank covenants in their debt agreements. They end up with a big incentive to cheat. Not a problem if they don't have much debt.

  2. Avoid companies with high levels of 'goodwill'. A company that has done a lot of acquisitions will undoubtedly have lots of intangibles or 'goodwill' on the books. Goodwill is where the huge write downs come from, and where companies have gotten in trouble by overpaying for assets (i.e. Tyco).

  3. Choose companies that pay dividends. You can't play accounting tricks with dividends. It's real cash that is being paid out to shareholders.

  4. If it sounds to good to be true.... Beware of companies that somehow are performing miracles that their competitors cannot (i.e. Enron). If they are supposedly making big money, yes, maybe it's geniuses running the company, but sometimes it's crooks instead.

Many people are worry that investing in stocks has become something like betting on professional wrestling. They feel like they are involved in a rigged game. There always have been and always will be people who cheat. That's why you diversify, and that's why stocks have been the highest yielding investment over the last 200 years. You are being paid more for taking a risk. But remember that most people running companies are in for the long haul. They know it's earnings, not accounting tricks that will eventually make them rich. Also take comfort in the fact that these things are being found out. It means the system really is working, it's just been slower catching these clowns than we'd like.

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Donald Steinmann and Advanced Financial Management assume no responsibility for any actions taken due to comments made in The Investment Tip of The Week.

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"A good decision is based on knowledge and not on numbers."
-- Plato