Street Sense: The fundamentals of stock market investing
Look for "Red Flags" on Stocks
If you know what to look for, you can tell when things are beginning to go badly for a company. That's the time to sell.

BY JERRY HELZNER

Wall Street pros like to say that "the first piece of bad news isn't the worst piece of bad news." In other words, once the first little black cloud appears over a company, you can expect stormy weather ahead. Savvy investors know the warning signals -- or "red flags" -- that indicate a company's in trouble. These investors don't wait around for the company's stock to collapse. They get out at the first sign of bad news.

WATCH FOR THESE SIGNS

Here, you'll learn to identify the following red flags early enough, so you can do the same.

ILLUSTRATION: AARON MCCLELLAN

Insiders begin to sell their company stock. Individuals who manage or are otherwise closely associated with a company can sell company stock under certain conditions, but they must report their sales to the Securities and Exchange Commission. These filings are available to the public on the Internet through Yahoo Finance.

And while it's true that insiders sell stock for a variety of reasons, such as buying a house or paying college tuition for their kids, multiple insider sales of a single company's stock is one of the clearest warnings that things aren't going right. If the insiders are selling a stock, you should be getting out too.

Key executives leave the company. News of senior managers packing their bags is one of the most serious red flags and an excellent indicator that a company is facing lean times. Oh sure, the company will issue statements saying that the CEO is leaving to spend more time with his family or to "pursue other opportunities." Those explanations are often just smokescreens.

Top executives usually don't leave unless the business is going bad. Remember when Jeffrey Skillings, the brand new CEO of Enron, suddenly quit for vague personal reasons? How many people now believe that this young, up-and-coming executive didn't know that Enron was in deep trouble when he quit his "dream job?"

It's an especially bad sign when a company's Chief Financial Officer (CFO) leaves suddenly. No one knows more about a company's financial condition than the CFO.

Lawsuits begin to pile up against a company. All big companies get sued from time to time; it's part of the price of being big and having deep pockets. But when you see a number of similar lawsuits being filed against a company, it's a good time to exit that stock.

It took years, but asbestos-related claims have driven several major companies into bankruptcy and their stock prices to near zero. The tobacco companies are another example of litigation taking its toll. Philip Morris stock tends to rise or fall with the outcomes of the numerous lawsuits that have been brought against the company and the tobacco industry.

SOME COMPANIES DON'T DELIVER

Finally, let's not forget shareholder lawsuits. Shareholders, prodded by aggressive law firms, are now quick to file suit against companies for issuing so-called "false and misleading" statements.

For example, if XYZ Company says in July that it anticipates good business results for the rest of the year -- and then doesn't deliver those results -- expect to see shareholder lawsuits, which can sap a company of time and money. You don't want to own stock in a company that's constantly defending itself against lawsuits.

EYECARE STOCK NOTES

Things have gone downhill for the stock of Lumenis (LUME), which has an ophthalmic laser business it bought from Coherent. Lumenis, which last year traded above $30 a share, slipped below $5 in June after the Securities and Exchange Commission launched an investigation of the company, focusing on distributor relationships and writeoffs. In the post-Enron era, investors don't tolerate companies with accounting issues.

Ophthalmology Management Associate Editor Jerry Helzner has written more than 50 articles on stock investing for Barron's. He has been a regular stock market columnist for other business publications and was a member of the equity research department of a major regional brokerage firm.