That's exactly why I'm always looking for signs that a company's performance is deteriorating.
Problems began when managers decided to prop up the company's share price during an industry downturn by booking billions of dollars of illusionary earnings.
Shareholders who sold at the first whiff of accounting irregularities lost some money, but those who waited until two years later when the full extent of the accounting fraud was revealed, lost everything.
So in order to avoid being misled, there are a few metrics I use to detect whether a company is in trouble.
Here are three, including specific stocks that fit the bill that you'll want to avoid at all cost...
Warning Sign #1: Heavy Company-Insider Selling
One of the warning signs I look for is unusually high insider selling. Company officers, directors and large shareholders must report their share purchases and sales to the U.S. Securities and Exchange Commission (SEC), which makes these reports public.
Some insider-selling is to be expected, since managers sell stock for many reasons unrelated to the health of the company, such as portfolio diversification or to free up cash for a personal purchase.
But insiders usually know more about their companies' prospects than the rest of us, so when I see too many insiders selling their company shares, I read it as an ominous sign.
Regional financial services firm US Bancorp (NYSE: USB) is a good example of this. Insider selling has been accelerating, which may be a prelude to weaker earnings. Insiders still hold 2.32 million shares (or 0.12%) of the stock, but sold 39,339 shares during the last week of October and 55,191 shares a week earlier.
Compare this with August and September, when insiders sold a total of only 2,140 shares. The inconsistency doesn't end with just that. In the past six months, insiders have sold 808,368 shares, but haven't bought any, even though US Bancorp shares are trading at 11 times earnings, still below the five-year average price-to-earnings (P/E) ratio of 13.
Warning Sign #2:Payouts That Greatly Exceeds Earnings
Another danger sign is a dividend payout that exceeds earnings, which may foreshadow a dividend cut. When I see very high earnings payout, I check the company's cash flow, since certain types of companies (such as utilities, real-state investment trusts (REITs) and master-limited partnerships (MLPs)) generate more cash flow than earnings.
If a company's cash flow doesn't cover its dividend, then it may have to tap its cash reserves to get the job done. But don't be fooled -- cash eventually runs out sooner or later. The only option after that is to cut the dividend.
Diversified REIT Weingarten Realty Partners (NYSE: WRI) isn't covering its $1.10 annual dividend from earnings or cash flow right now. In the first nine months of 2011, Weingarten posted negative earnings per share (EPS) of $0.35.
Funds from operations (FFO) per share -- which is the REIT cash flow metric -- fell 33% compared with the same period last year, to $0.73. In addition, this year's third-quarter FFO per share was extremely weak at only $0.01. This performance casts doubt on Weingarten's ability to deliver on its full-year FFO guidance of $1.72-$1.82 per share.
A stellar fourth-quarter performance is required just to cover the $1.10 dividend, but Weingarten's track record hardly impresses. The company has cut dividends 10% a year in the last five years and, with annual revenue growth forecast at only 1.3%, a turnaround is unlikely anytime soon.
Warning Sign #3: Poor Interest Coverage/Excessive
Here's a huge red flag to watch out for: Companies that are struggling to make scheduled interest and principal payments. If the lender isn't willing to renegotiate borrowing terms, these companies can easily end up going bankrupt.
My Street Authority colleague David Sterman wrote about companies barely covering interest payments last month. A name that didn't make his list but probably should have is hospital-chain operator Tenet Healthcare Corp. (NYSE: THC).
Last year, Tenet generated $472 million in cash flow from operations -- barely enough to cover $402 million in interest payments. Through the first nine months of 2011, Tenet produced $325 million of cash flow to cover $275 million in interest payments, but the current portion of Tenet's long-term debt (debt that must be paid within the next year) has doubled to $129 million from $67 million last year.
In addition, Tenet's balance sheet is stretched to the limit, with $4.1 billion of debt and only $185 million in cash. You can see that even a minor earnings slip could put Tenet over the edge. And that's even without mentioning the company's track record, which in itself isn't comforting. In each of the past five years, for instance, Tenet has only posted 2% in revenue growth and no earnings at all.
The Investing Answer: I re-evaluate a stock every time I see a company's cash shrinking, debt rising or consecutive quarters of declining earnings. The sudden departure of a CEO or CFO is always a major red flag, as is an auditor resignation or a "going concern" opinion.
In case you own the three stocks mentioned in this article: Investors should be especially leery of owning Tenet Healthcare, because of the company's high-risk balance sheet and the current competitive pricing pressures in the health care industry. They should also monitor US Bancorp closely to keep track of the company's insider-selling activity and brace for another dividend cut by Weingarten. Investors should stay away from these three stocks, and perhaps from any others that share the characteristics I outlined above.
Neither Lisa Springer nor Street Authority LLC own shares of these companies.
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