Look Before You Weep

Most fast-growing companies headed for trouble give investors plenty of warning. The trick is knowing where to find it.

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SOON AFTER IT WENT PUBLIC IN 1981, the common stock of two-time INC. 100 member Vector Graphic Inc. sold as high as $16.50. When last seen in over-the-counter trading this winter, however, the same nicely etched share couldn't even fetch a cup of coffee.

Well, that wouldn't be the first time a stockholder lost real money in a supposedly expanding company -- a fact all too verifiable by the droopy stock market performances of more than half this year's putatively fleet bunch (see box, "Stocking up on Capital Gains," page 84). If ballooning sles, compounded at 132% annually for the composite of the INC. 100, are so inviting on paper, how's an unsuspecting investor to avoid the fall?

To begin with, open the prospective firm's prospectus for the most eye-opening portrait of a company the business world provides (for free, at that). In Vector Graphic's, for instance, attorneys fulfilling their oath of due diligence were obligated to state that "an action seeking dissolution of their marriage has been filed" by the company's founder and chief executive officer, and her spouse, the chairman of the board. For readers who bothered to dig that far, forewarned was forearmed: the couple was divorced shortly thereafter, and the husband started up a competing business, leaving Vector Graphic to the eventual mercy of bankruptcy court.

Alas, stockholders of several high rollers among the current crop -- 70 of which are less than four years old as public companies and surely have prospectuses hanging around -- have met comparable fates. Time Energy Systems Inc. (#37), to pick on the list's worst-performing stock, with a loss of 78% for INC.'s 12-month holding period ending March 3, was ignominiously drummed out of the NASDAQ Over-the-Counter National Market system for failing to file financial statements. The second worst, ComputerCraft Inc. (#60), down 74%, had to restructure its debt, giving away stock-diluting warrants in the process.

Called red herrings in the old days because they threw unsuspecting investors off the trail of maladroit management, now preliminary prospectuses of initial public offerings are required by law to be as guileless as the newborn babes they bring to life. Unlike annual reports, in which footnotes, euphemisms, and the president's pep talk artfully hide financial sins, a prospectus must contain such explicit information as a detailed history of the company's founding, stock and loan transactions in the company by principals, appraisals of the competition, the existence of pending litigation, overhanging stock options, the number of shares being sold, and what the proceeds are being used for. Those aren't headlines from the National Enquirer, to be sure, but you can depend on even innocent-looking prospectuses -- required to be available to the public for at least 90 days after the date of the offering -- to give some hint of where the quicksand lies.

In the cold print of its prospectus this spring, for example, Microsoft Corp. kissed good-bye to $509,850 a departed officer "owed the company." And when the red herring of Vestron Inc. disclosed that a major shareholder was taking advantage of the stock offering to cash in an indiscreetly large portion of his holdings, investors greeted the proposed issue with disdain. So much so that the shareholder had to withdraw his plan to sell the shares, and the underwriter had to redraft the prospectus. The man in the street apparently has wised up since 1983, the year the screens fell out of a wide-open IPO window and all manner of equity-dressed creatures crawled through.

One tip-off to quality comes from scrutinizing a corporation's board of directors, nowadays a key to determining the integrity of an emerging company and the validity of its audits as a private enterprise. Is the board's background financially oriented? Do they have expertise in the business? Do they hold responsible positions elsewhere? More than one dentist has been shanghaied in the past to help steer a neighbor's business. Boards used to be rubber stamps for management, but today outside members play -- or should play -- an educated and actively responsible role, assuring that the business doesn't become too insular.

What's good for the goose ought to be good for the average investor. Most amateur players don't bother to hunt down extraterritorial information, even though they're surrounded by it. Trade publications, for example, discuss corporate developments in their own terms of news or personalities, but to a smart investor they are an inexpensive way to determine market trends, discover clever management, tune in on rumors, and unearth novel companies and products. Beyond that, attending industry conferences and shows in person can pay for itself in investments (and the entrance fee might be tax-deductible). For that matter, what business is your neighbor in? Maybe it's the next Xerox Corp.

Following the lead of compounding revenues alone, as one can tell from certain sectors of the INC. 100, such as the restaurant group, clearly is an adventure. Investors would have gotten mashed in 1 Potato 2 Inc. (#12), the list's third-biggest loser, with a 69% drop. Also an '83 IPO, SPUD has been in the top dozen of the INC. 100 for two straight years, thanks to having squandered the proceeds of its $12-a-share public flotation on no fewer than 93 company-run restaurants, each featuring the culinary delight of a baked potato. Sales were purchased via the influx of public capital onto a balance sheet that otherwise couldn't have supported a lemonade stand. It won't be on the next list, though: despite revenue growth of 66% for fiscal 1985 alone, the eatery ran out of gas early in '86, tacked a "Q" onto its symbol (for an issue in bankruptcy), and passed into Chapter 11 -- a good illustration of how a plunge based solely on soaring revenues can wind up as a bath.

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