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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.

For Piezo Electric Products Inc. (#2), the dramatic surge in sales -- from $3.5 million in '83 to $67 million in '84 -- was accomplished mainly through an acquisition for which it paid $11.1 million in cash and stock. Unfortunately, a quick glance at the terms of the deal would have revealed that the substantial additions to assets (from $35.3 million to $51.1 million) were more than offset by substantial additions to liabilities (from $864,000 to $26.7 million). In the face of the impressive 1,787% increase in the year's net sales, hapless stockholders of the merged entity suffered a 29% drop in shareholders' equity. And, worse, a drop in the price of the common from over $2 to two bits. This past March, the money-losing subsidiary was put up for sale and, having no takers, it filed for liquidation. Thanks, guys.

Even if conclusions from rising sales are elusive unless you read between the line items, one professional service that emphasizes revenue growth, Growth Stock Outlook Inc., boasts an enviable record of 11 straight up years and a compound return of nearly 20% a year. Its newsletter's scrutiny of revenues is engendered by editor Charles Allmon's open disdain of competitors that feature earnings growth alone. "Earnings without revenue growth only means companies are increasing margins," says Allmon, who demands that earnings expand along with sales. Because he requires a company history of at least 10 years, with the most recent 3 years showing revenue expansion, the newly emerging technology sector, object of many a fast-growth pitch, is suspect to Allmon. "High tech is high wreck," he sneers. "One bad quarter, and the stock falls out of bed." Large-capitalization stocks, with their millions of shares -- "blue gyps" -- fare little better in Allmon's estimation; due to the stranglehold that such institutions as pension funds have on big-company equities, he sticks mostly to OTC companies, preferably thinly capitalized "so the institutions can's get in."

In theory, institutions eschew the thin markets of such small-cap stocks because when they try to buy them, the price runs smok on the upside, and when it comes time to sell, the bottom falls out. But in practice, several large mutual funds have been willing to put up with illiquidity problems for the chance of a big hit among untapped equities with redoubling potential. And some companies -- such as Ryan's Family Steak Houses Inc. (a 1983 INC. 100 fast-grower), which no fewer than four times in less than four years has wooed institutional interest by splitting its stock -- enhance liquidity by increasing the number of available shares.

You need operating results to support repeated splits, of course, and Ryan's has had them right out of the pan. Starting with its cash-rich, debt-free balance sheet and internally financed working capital, Ryan's 1982 red herring smelled mighty like a red rose. One hint to the stock's blooming was the background of founder Alvin A. McCall Jr., described in the curriculum vitae of officers and directors that every prospectus contains. McCall, the minibiography indicated, had earlier been a principal in a chain of highly profitable steak houses that he later sold. With Ryan's, a careful reader could have concluded, he would be going through the proven process all over again. And the reasoning would have been sound: in less than four years, Ryan's stock gained over 1,500%.

Investors can garner such exceptional returns from many of the smaller-cap stocks of the OTC market, at least one mutual fund believes. Dealing exclusively in that arena, Fidelity OTC Portfolio last year gained 68.9%, the best performance for mutual fund portfolios in domestic equities, and more than double the NASDAQ OTC Composite Index's 31.4% increment. Its manager, Paul Stuka, doesn't attribute the fund's fast growth entirely to fast growth, however. "I'm not sure you want to invest in the fastest-growing companies," Stuka cautions the casual investor. "The names that tend to show up on [INC.-type] lists are often flash-in-the-pan, one-product companies. The danger is you pay a high multiple on earnings for the assumed growth rate, then you find out a few months later that the assumption was erroneous. Revenue growth by itself doesn't interest me. There better be a good reason why earnings didn't follow."

To amass that kind of record, a jaundiced eye helps. Stuka admits to viewing with skepticism companies whose revenues and earnings are rising precipitously. Like #19 on the 1983 INC. 100 and #58 in 1984, Crime Control Inc., which sold as high as 22 1/4 in the fall of 1983 and was hammered down to 1 1/4 despite a sales jump of 82% that year. "Their earnings were growing very quickly," Stuka recalls, "but if you looked at the statements carefully, they were going extremely cash-flow negative. They were recording long-term leases as sales up front, yet they kept borrowing more and more money." The reason was that revenue from the leases, although posted in its entirety as direct sales, actually was to be paid in over seven years. "A lot can happen in seven years," Stuka observes of the bookkeeping standard, and it did: in November 1984, its earnings growth arrested, Crime Control was barred from NASDAQ trading due to unreliable financial reporting.

If uncommonly swift revenue expansion is suspect, what statistical pace does Stuka feel more comfortable with? "I'm just as excited about a 10% grower, if I can get it at 6 times earnings, as a 30% grower at 18 times earnings. I like earnings, and I like cash flow -- those are my two primary things. I'm probably the world's worst technician," one of the country's hottest fund managers admits, referring to the school of stock-pickers that disdains business fundamentals in favor of analyzing an issue's price movements in the marketplace. "I get advice along those lines, but I don't use it."

One of the country's hottest technicians, on the other hand, claims he doesn't use earnings, so there. "I do alpha and beta and things like that," says OTC Insight author Louis G. Navellier. Though arcane, perhaps, such statistical analysis must have something going for it: the advisory's nine model portfolios, each dealing exclusively in OTC equities, averaged a 66.3% gain last year, best among diversified-stocks selectors.

To title the process "insight," however, may be stretching things, since, to cast his alphas and betas, Navellier merely has to switch on his computer after the market closes. Then, like fish jumping into a net, the stocks do all the work, based mathematically on how their price action compares with the body of equities over a period of time. Why only the OTC? Navellier finds that the freewheeling stocks of small companies there are particularly responsive to his relative-strength formulas. In the end analysis, however, Navellier looses an intuitively roving eye on good-looking bottom lines. "Most of my companies are driven by tremendous earnings growth. More than revenues, I want those earnings to keep flying. That's our caveat -- four quarters of earnings." Even then, Navellier concedes, "You are going to get slapped in the face by one stock or another."

Indeed, it might just be dumb luck that the stock-picking celebrities of '85 stumbled into one of the most vigorous bull markets in history. Not often can investors wait for four quarters of rising earnings to buy a stock, and then enjoy a straight ride to a 300% gain. As one seasoned adviser incredulously noted of a prominent competitor who this spring not only recommended a fully invested position in common stocks, but had his clients fully margined to boot, "He hasn't seen a bear market like 1973 -- yet."

Today's stars have ridden out the debacle of '83, however. And the small investor is the better for it, theorizes Gary Koenig, a veteran stockbroker now out of the public fire at the investment banking firm of Hambrecht & Quist. "The market is your friend," Koenig counsels. "It's a broad aggregate of institutions saying, 'I was burned so bad in '83, I don't want it." Today, he observes, "every deal has the scrutiny of the market going for it, which it didn't in '83."

To sell newly public companies to newly dubious customers, underwriters have been forced to discount the offering prices of even the most promising issues. The modest price-to-earnings ratios seen recently in new issues give investors time to do the necessary homework -- in particular, to study a company's financial statements. If the balance sheet demonstrates staying power -- a solid cash position, no more than 60 days' of inventories, positive cash flow with little borrowing, and no obfuscating footnotes -- investors can pursue the common stock with some confidence. And if that set of managers doesn't know what to do with it, a clean balance sheet will be tempting to someone else who does, as the recent spate of acquisitions attests.

Indeed, clues that someone smarter, more diligent, or better placed than you has discovered rewarding investment opportunities can be found in such activity. When Eastman Kodak Co. acquired a small high-tech company early this year, for example, a bulb should have flashed back home: why is Kodak interested in that industry -- is it going to move out of cameras? No, it is going into data storage. Undoubtedly, an internal merger-and-acquisition team studied possible subsidiary operations and determined that electronic data storage had profit potential -- knowledgeable endorsement of the once-suspect industry. Since the purchase, stocks of several small data-storage companies have tripled.

One of the most accessible indications of the investment-worthiness of a going concern is stock trading in it by its officers and directors -- insiders -- which is reported to the SEC within four or five weeks and later appears in the financial press. Insider selling has many fathers, but there's only one reason why someone close to a company buys stock in that company in the open market: to make lots of money when the stock goes up. As, apparently, did Barris Industries Inc. insiders, who scoffed up about 1.4 million shares in one month earlier this year and rode them to an all-time high of over $21. But they were nowhere to be seen back in 1980, when Barris had compounded revenue at 75% a year for 1975 to 1979 and placed #32 on the INC. 100. The probable answer: management posted a whopping loss the next year despite continuing revenue growth that put the company on the 1981 INC. 100, and the stock got gonged but good.

Not all stock moves are presaged so starkly, of course. And, too, insiders can be as wrong as the rest of us. So, inevitably, an investor has to learn to detect subtleties and ask questions. Why are inventories up from the previous reporting period, for instance. Isn't the product selling? Are writedowns about to hit the books? Similarly, a sizable increase in cash and securities from the previous year is impressive at first glance, but ought to be suspect. Cash invested at 10% may seem to be contributing to net profit, when actually it is diluting the earnings of a business whose return on investment otherwise is 20%. Why isn't it being put to better use? Is there a big tax liability? Does management anticipate needing that much to fuel the operation because next year's income is in doubt? Has growth been carried as far as management can take it? If the officers really believe in themselves, why isn't the company treasury buying back its own stock?

Even large fund managers probe each opportunity on its own merits, primarily by scouting out management. Investors can ride the coattails of a hot fund simply by studying the fund's quarterly portfolio reports, noting the changes, and executing the same orders. For example, one of the country's most respected managers, obviously betting on a rate decline, could have been seen moving heavily into interest-sensitive equities over several recent quarters -- a well-considered tip for the small investor, who had plenty of time to do likewise.

Individuals can do their own management spadework as well. They can get on the mailing lists of companies, and peruse quarterly and annual reports. Or, merely by checking out earnings comparisons in a daily paper, a small investor can come up with a list of growing situations. Then he or she is entitled to telephone management and make inquiries. Are the pershare earnings pure operating income? Was there nonrecurring revenue? The president himself might not get on the line, but someone will -- or should. "People are frightened of calling up a company," Koenig has found, "yet it's accessible to everybody. That's how you build an edge." Indeed, most small and/or new companies feel that they are underappreciated and are itching to talk, but can't find someone willing to sit still and listen. Further, a would-be investor is entitled not only to phone, but, damn it, to get up and visit the company he or she is considering for investment.

"The individual has a tremendous advantage in the stock market -- if he's willing to spend the time," says Koenig. "It amazes me to see a businessman take a flier on a stock, when he ought to be looking at it like it's his own business." Nor do individuals spend anywhere near the time they should interviewing their brokers. Among other criteria, a broker should at least be able to provide a history of profitable recommendations and should anticipate a customer's interests in matters of news and corporate developments.

However astute, no broker can be expected to be therapist to someone temperamentally unsuited to the rigors of buying and selling. Investing can be as demanding as marriage -- which is exactly the problem. Stockholders often get entangled in disdainfully downtrending stocks whose affection they try to win by waiting it out. Then they can't accept failure, blaming it on the fallen stock rather than themselves. "The guy with the least amount of emotion is going to be the best performer," Koenig agrees. "How many times, instead of talking about their present positions, customers would ask me the price of stocks they already sold!"

A basic discipline of selling is to be able to forget you owned the stock, and not kick yourself if it goes up after you sell it. But if you have enough capital, there are yet more ways to skin the cat. For instance, market apocrypha has it that, recognizing his paranoic tendencies when it came to selling, one investor would always buy twice as much as he really wanted, then would sell half "so the stock would think I was out."

Of course, he could have given it to one of those mutual funds, instead. An increase of 68.9% a year isn't half bad.

Last updated: May 1, 1986




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