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Red flags to look for when buying securities


YOU DIDN'T have to be an Enron Corp. stockholder to be burned by the company's collapse.

Enron's questionable accounting practices and precipitous fall have undermined the confidence of investors who didn't own a share of the energy trader, experts say.

"It calls into question some of the underlying foundations of how the market operates ... the fairness and accuracy of the information used by investors to make their investment decisions," said Dan Stoll, a Silver Spring investor who doesn't own Enron. "You think the game is fair, and the game is rigged."

The 44-year-old systems analyst said Enron won't change the way he invests, but it may alter the way he votes. Stoll said he likely will back candidates who support eliminating the conflict of interest that occurs when accounting firms consult for the companies they audit, which was the case with Enron's auditor, Arthur Andersen.

"I'm concerned myself," said Marvin Burt, a Rockville financial planner, who said Enron has made him a disbeliever in self-regulation of accounting firms. "If you can't trust financial statements, your information is not dependable."

Saxon Birdsong, a money manager with Baltimore-Washington Financial Advisors in Ellicott City, said he never purchased Enron for his clients, but about a dozen have called anyway asking: "How do we protect ourselves when something this bad is allowed to happen?"

How can investors protect themselves?

Many experts agree it would have been difficult, if not impossible, for the average investor to have spotted Enron's troubles before they made headlines. But there are some red flags to look for when buying stock. A single flag may not mean serious problems, but more than one may signal that it's a stock to avoid.

Among the signs:

A confusing business. Birdsong said he considered buying Enron, but decided against it. "It's a simple test before buying anything for a client: I have to understand it. I couldn't understand how they were supposed to make money," he said.

Investors should use the same test. "If you can't understand it, then you have no business owning it," Birdsong said.

Executive hype. Be wary of companies where top executives seem more interested in talking up the company's stock price than running the business, said Pat Dorsey, director of stock analysis for Morningstar Inc., a financial research firm in Chicago.

"What it says to me is they are focused on pleasing Wall Street and saying what Wall Street wants to hear," Dorsey said. They also may be too focused on their stock options, he said.

"Over the long run, if you are running the company properly, the stock price should take care of itself," Dorsey said.

Enron's management early last year told analysts the stock was worth $126 a share, according to Dorsey. By late November, it traded for 26 cents.

Analysts' hype. This doesn't signal corporate financial problems, but stocks that are heavily touted by analysts already have had their price pushed up, so latecomers end up buying high, experts said.

Analysts are often reluctant to criticize a company for fear of losing its lucrative investment banking business or losing access to executives, experts said. And a thumbs-up by analysts doesn't necessarily mean a company is sound.

Less than two weeks before the Securities and Exchange Commission launched its Enron investigation, 13 brokerages rated the company's stock a "strong buy," three rated it a "buy," while none recommended "hold" or "sell," according to Thomson Financial/First Call.

A sudden change at the top. Enron's chief executive officer made a surprise departure last summer after only six months on the job. While CEOs come and go, they usually give plenty of warning.

"Most companies, especially high-profile ones, don't like doing things that are unexpected. The thing that Wall Street hates more than bad news is surprising news," Dorsey said.

A change in auditors. "That's very suspect," said Peter Ricchiuti, assistant dean at Tulane University's business school. Companies rarely switch auditors, and a shift should raise eyebrows and questions. "You don't know if the reason is that they came to a conflict or there was a disagreement over how something should be accounted for," he said.

Enron didn't switch auditors; it fired Arthur Andersen only last month, saying it did so because of the auditor's advice and destruction of documents.

Excessive insider selling. "Senior managers should generally be selling holdings in a company to diversify," Birdsong said. But heavy selling could signal that insiders know something negative about the company that investors don't, experts said.

One shareholder lawsuit accuses Enron insiders of selling $1.1 billion in company stock over three years while misleading others about Enron's finances.

Be aware that technology companies often compensate top management with options, so investors need to gauge the size of the stock sale relative to what the person owns, Dorsey said.

Restatement of earnings. Sometimes companies restate their earnings on their own and sometimes they're prodded by regulators to do so because of accounting, either intentional or unintentional, that could be unclear or misleading, said Bill Lauer, chief investment officer with Chevy Chase Trust in Bethesda.

Frequent restatements of earnings could be a sign of financial problems or that management "may not have grasp of what they are doing," he said.

Other than looking out for potential signs of trouble, investors should take other steps to safeguard their portfolio, experts said.

They should be diversified, so if one stock tanks, it won't wipe out their savings, experts said.

Investors should take time to research companies before buying stock, rather than relying on tips. For instance, they should read the footnotes in annual reports, which can detail litigation or other significant issues. Convoluted footnotes, too, may be proof enough that the company is too confusing to invest in, Birdsong said.

And, if you're going to invest in individual stocks, brush up on accounting basics, Dorsey suggests.

"This stuff is not as complicated as it looks. Accounting is not Greek. You can understand it with just a little bit of work," Dorsey said. "Three hours with a basic Accounting for Dummies book will do you more good than watching three hours of CNBC."

To suggest a column idea, contact Eileen Ambrose at 410-332-6984 or by e-mail at eileen.ambrose@baltsun.com.

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