Anyone can access company reports and analyze numbers with software, but Bill Gates or Larry Ellison isn't likely to sit a spell with a little guy anytime soon. (Not that face time guarantees anything. Wall Street analysts used to tour Enron's headquarters and its phony trading floor, for all the good that it did them. Heck, Salomon Smith Barney analyst Jack Grubman used to attend WorldCom board meetings, but, like a fat-and-happy hobbit in the Shire, was oblivious to the shadows of impending doom. At least that's his story.)
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Knowing that with the computer models they consult, it's "garbage in, garbage out," quants are ever vigilant for symptoms of fuzzy accounting. What kind of red flags do they look for? Von Pentz likes to compare cash flows with earnings in quarterly and annual reports. (A handy place to check company data: www.morn ingstar.com.) The numbers should be moving in the same direction at more or less the same pace. If cash flows are falling and earnings are rising, "you know something is being done to create reported earnings," he says.
But beware of lagging earnings as well. For Robert Arnott, managing partner at First Quadrant in Pasadena, Calif., one worrisome sign is if revenue and receivables are outpacing earnings. "That means they are getting into lower and lower profit-margin businesses" while trying to keep the bottom line pumped up.
Legwork. Overly aggressive accounting is one thing, though. Flat-out deception is quite another. What then? "When they are lying to you, they're lying to you," says von Pentz resignedly. Just to be safe, von Pentz has been meeting more with corporate management. While the Enron and WorldCom examples show it's tough to tell if someone is conning you just by looking at them, von Pentz recalls going to a conference several years ago and meeting with the suits at Rite Aid. Call it an uncanny observation or a lucky guess, but "something just didn't smell right," he says in describing his decision not to invest in the firm. Indeed, several Rite Aid executives were later charged with crimes stemming from accounting irregularities in the 1990s.
Albers still steers clear of the executive suite. As a check on the numbers, he keeps a close eye on a stock's relative strength--how well it performs vs. the overall market and its sector--for signs of weakness. (Investors can do this for themselves at http:// finance.yahoo.com.) Since a stock price supposedly reflects all available information, a sagging stock just might be reflecting whispers of trouble by insiders and their pals on the Street. And like many managers, Albers tends to avoid firms buying lots of other firms--so-called serial acquirers--which creates myriad opportunities to finagle.
Of course, if you don't have the time or inclination to dig through balance sheets or track comparative stock performance--and that's most of you out there--it's better to go with a mutual fund. Not only do you get the benefit of a professional's expertise, but you also get diversification so that a few bad apples won't mean postponing retirement until you hit 80. Just take a pass on funds that charge sales loads or other fees that can exceed 5 percent, advises Michael Cooper, finance professor at Purdue University. He notes that funds with higher fees do not, on average, outperform low-fee, similar risk index funds or even actively managed no-load funds.
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