How to Avoid the Next Stock Bomb

By Jason Zweig

When WorldCom became the latest big stock to blow up, I called my most trusted sources among money managers to ask how an individual investor can avoid buying such a bomb. The most common answer I got startled even an old cynic like me: We can't talk right now; we're too busy trying to unload our WorldCom shares. So don't feel foolish if you have been whacked. A lot of "smart money" has too. And there's plenty you can do to minimize your odds of owning the next disaster. Here are my dos and don'ts:

--DON'T BUY "SERIAL ACQUIRERS" Great companies grow mainly from within, while those that gobble up lots of other companies almost always end up with a nasty bout of nausea. Tyco is only the latest case; earlier came Conseco and others all the way back to the notorious LTV in the 1960s. Cisco, which has eaten dozens of other tech firms in recent years, hasn't quite gagged yet, but I'll be surprised if it doesn't.

--DO READ THE FINE PRINT I invariably read a company's report from back to front. The stuff they don't want us to find is buried in the back--starting with the footnotes. Read about the company's pension plan; if its projected annual rate of return is more than 7.5%, a shortfall could bite into future earnings, and "you should be concerned," says Lehman Bros. accounting expert Robert Willens. Watch for off-balance-sheet liabilities, a fancy term for financial risks that the company hopes will never come home to roost, and for development costs that are capitalized instead of expensed. These factors don't mean you should shun a stock; they mean you should check its teeth. Firms with aggressive pension assumptions include IBM and SBC Communications. Among the off-balance-sheet biggies are General Electric and Fannie Mae. And outfits in the cable and telecom industries seem to capitalize everything short of the potted plants.

--DON'T FEED YOUR MONEY TO PIGS Read the proxy statement at sec.gov (click on "SEC Filings & Forms," then on "Search for Company Filings"; then enter the name of the stock). I would shun any company that pays a manager more than $100 million a year in cash and stock. Make sure that none of the top managers used to work for the firm's "independent" auditor--and that the firm isn't lending millions to its bosses, as WorldCom did. (Check the "Related Parties" section of the financial reports.)

--DO FOLLOW THE MONEY Howard Schilit, head of the Center for Financial Research and Analysis in Rockville, Md., suggests looking at the statement of cash flow in a company's annual and quarterly reports. Over time, net income and cash flow from operations "should move in the same direction and at similar rates," he says. Cash flow is hard to finagle, so if net income rises faster than cash flow, that can be a sign of accounting tricks--as it was at Enron in 2001.

--DON'T BET ON DEBTORS Companies that binge on borrowed money, like WorldCom and Adelphia, end up with no margin for error. Robert Olstein, manager of the Olstein Financial Alert Fund, avoids firms whose debt is greater than half of total capital or more than five times their free cash flow. (Get these ratios at morningstar.com Enter the company name under "Quicktake Reports"; scroll to "Financials.")

--DO SPREAD YOUR BETS Even if you want to pick individual stocks, placing most of your equity investments in a broad index fund, like Vanguard Total Stock Market, remains the best way to keep a corporate crook from blowing the bulk of your wealth to bits. And remember: it's at frightening times just like these that stocks offer the highest future returns. So cover yourself but don't bail out of the market entirely. --By Jason Zweig. With reporting by Cybele Weisser

With reporting by Cybele Weisser