These Stocks Have Been Screened for Red Flags

Exchange-traded funds offer a convenient way to invest in sectors or niches that interest you. If you'd like to add to your portfolio some companies that are less likely to be engaging in financial shenanigans but you don't have the time or expertise to hand-pick a few, the Forensic Accounting ETF (NYSEMKT: FLAG  ) could save you a lot of trouble. Instead of trying to figure out which companies will perform best, you can use this ETF to invest in lots of them simultaneously.

The basics
ETFs often sport lower expense ratios than their mutual-fund cousins. The Forensic Accounting ETF's expense ratio -- its annual fee -- is a bit on the steep side at 0.85%, though that's still lower than most managed mutual funds. It's a brand-new ETF with modest assets so far, so fees on the high side aren't unusual as it aims to get up to scale. Given its size, though, if you're thinking of buying, beware of possibly large spreads between its bid and ask prices. Consider using a limit order if you want to buy in.

This ETF has outperformed the S&P 500 over the past three months, but that's not enough time on which to base any conclusions. As with most investments, of course, we can't expect outstanding performances in every quarter or year. Investors with conviction need to wait for their holdings to deliver.

Why forensic accounting?
This ETF is based on an index developed by John Del Vecchio that employs financial statement analysis to look for signs of aggressive accounting practices that some companies use. Such red flags can indicate extra riskiness in a company.

More than a handful of companies that were cleared to reside in the ETF had strong performances over the past year. Xerox (NYSE: XRX  ) and Pitney Bowes (NYSE: PBI  ) each surged about 49%. With a forward P/E near 8.5 and a 2.2% dividend (hiked by 35% earlier this year), Xerox seems a solid value. The woman-led company has been retooling itself in recent years, aiming for higher margins. In its latest quarter, services made up 55% of revenue and grew by 5% on average, versus just 1% for overall revenue. It has inked some long-term government contracts -- including processing Medicaid claims for all of California -- and stands to benefit from Obamacare. The company also has a recent deal worth about $100 million with the Texas Department of Transportation. Xerox is already generating more than $2 billion in free cash flow annually. It recently bought an e-learning company and a pension-administration software business.

Pitney Bowes's legendary postage-meter business has been struggling amid proliferating digital communications. Still, it posted estimate-topping earnings this summer, albeit along with a drop in revenue and lowered guidance. The company sold its management service business, which will help it focus more on core operations and also pay down debt. Pitney Bowes has been attracting income seekers with a double-digit dividend yield, but it slashed that in half earlier this year. Its remaining 4% yield remains generous, though. It sports positive free cash flow and a forward P/E near 10.

U.S. Steel (NYSE: X  ) , in a tough environment, managed to gain 10%. Along with Pitney Bowes, it's among the most heavily shorted stocks in the S&P 500, reflecting many doubters. They have reason to doubt, with the company unprofitable and not making much of a dent in its significant (and growing!) debt. The company has major pension costs, which could be significantly eased by rising interest rates, and its name reflects another challenge – it's very focused on the U.S. steel market, which isn't growing as briskly as elsewhere. The stock yields 0.9%.

Other companies didn't do quite so well over the last year but could see their fortunes change in years to come. Fertilizer concern CF Industries (NYSE: CF  ) shed about 2%, in part due to an oversupply in the market -- though it's worth noting that it has averaged 33% annual gains over the past five years. The company has much to wax bullish about, including hefty returns on equity, solid free cash flow, and an appealing forward P/E ratio of 7.4. Citigroup analyst P. J. Juvekar in September upgraded it from neutral to buy, seeing a bottoming of nitrogen prices and continued low prices for natural gas, which is used in nitrogen fertilizer. High prices for corn can also help the company, and some are hopeful about its incoming new CEO.

The big picture
A well-chosen ETF can grant you instant diversification across any industry or group of companies and make investing in it -- and profiting from it -- that much easier.

Other ETFs Can Be Even More Exciting
Interested in even more compelling ETFs? Check out The Motley Fool's special free report "3 ETFs Set to Soar." Just click here to access it now.


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