Do You Trust the Market?

Who can we trust anymore? Anyone? Anyone? Bueller? If you're going to invest in stocks, you need to trust your companies. How? By understanding your companies to a fault, by avoiding companies with confusing accounting, manic acquisitions, and evasive management -- but that's not all.

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By Jeff Fischer (TMF Jeff)
July 1, 2002

When you look at your brokerage statement, do you feel as if someone you never met swindled you? Do you feel somehow betrayed?

Let's be frank: Do you feel as if you've been robbed by fat cats in flashy suits who have defrauded investors for personal gain?

You should. Because even if you haven't owned shares of Enron, Tyco (NYSE: TYC), WorldCom (Nasdaq: WCOME), ImClone (Nasdaq: IMCL) and who knows what else, you've suffered. We've all suffered. We've suffered because a few high-ranking liars have stunk up the entire business joint.

Confidence in the U.S. stock market is near an all-time low, one not seen since the 1930s. Although the U.S. stock market and many of its businesses remain the best in the world, we're now skeptical of it all. We don't have confidence. Not much. How could we?

Enron: Deceit, faked numbers, insider trading, environmental destruction, leaving the average employee out to dry -- in short, scam artists running a $60 billion lie.

ImClone: Insider trading and everything that comes with it (sneakiness).

WorldCom: Bogus accounting from an officer. Hiding $3.8 billion from shareholders. Possible fraud and bankruptcy for the country's second-largest long-distance company.

These high-profile scandals have helped bring down the entire market, every index, and most stocks. They've played a role in the dollar's swift decline, too. The U.S. stock market looks like a publicly funded crime spree to the rest of the world.

Because a crime spree is partly what happened in the 1990s, and now it comes to light. The same sort of corruption took place in the 1920s. Wherever there appears to be easy money, corruption is not far behind. And financial bankruptcy follows moral bankruptcy.

But I'm still investing
I recently invested more money in four companies that I own. I did so right after the WorldCom fraud emerged. I felt almost stupid doing it. How could I trust anything on this market? How could I trust that one of my companies wouldn't be next to go belly-up, admitting some hoax?

I've never been to the headquarters of my investments. Maybe they're all inflated rubber buildings and wood cutouts made to look real from the air. We pulled that trick on the Germans before D-Day. Maybe my companies' numbers are just pulled from thin air, too. "Five billion in sales would be nice." "Let's say we did it." "Great. I'll tell the auditors."

Maybe this was happening at my companies. Maybe....

That night after I invested, before falling asleep, doubt echoed in my mind again and again: "Maybe, maybe, maybe...." Until I fell asleep and dreamt of being penniless, all nine of my investments turning out to be frauds:

Johnson & Johnson (NYSE: JNJ): It never existed. All made up. It even made up the Tylenol tragedy for publicity. Mellon Financial (NYSE: MEL): Only client is itself. It just trades fake money back and forth with itself, and has since the 1800s. eBay (Nasdaq: EBAY): Has zero registered users. All its website activity is simply computer generated.

When I woke, I checked online. My stocks were still there. Still trading. Still had value. Had I done something right? For a change? Maybe, maybe, maybe....

What I've avoided
I have problems. I don't like dishes to sit in the sink. I don't like clutter. I don't want anything extra in the car. I like neatness. To a fault. See, I have problems.

But this helps me when I invest. I don't invest in companies that have confusing accounting statements -- or statements littered with footnotes and oddities. I avoid companies that make large acquisitions frequently, ending up with all kinds of pro-forma clauses and one-time-only charges and gains. I need to be able to look at a company's accounting statements and see a neat, clean picture. Period.

I don't buy companies that focus on EBITDA over free cash flow and earnings. Or companies that carry too much debt. How much is too much? I don't want to own a company that has more long-term debt than it has cash and equivalents. There are too many strong companies to consider buying ones with debt burdens. Especially now.

We live in such an uncertain world. I wouldn't buy stock on margin, and I won't invest in companies that margin themselves with more debt than cash. I especially avoid companies with debt in strange off-book ventures that you only read about vaguely in SEC documents.

Along with avoiding confusing companies, investing should go something like this, which isn't different from what the Fool's said for years:

  • Understand what your companies do and how they make money -- understand this to a fault.
  • If you're going to own individual stocks, you need to read at least each one's annual SEC 10-K statement and make certain nothing in it confuses or surprises you.
  • You need to fully understand every financial statement that your company releases. Do you need to learn how to read financial statements? (Enrollment for an easy, good class ends today.)

Finally, I also -- ironically -- am now skeptical of companies that put up consistently improving financials, quarter after quarter, year after year, the way Enron did.

So, I like that Johnson & Johnson suffered -- and admitted -- very slow years in the late '90s. I like that Paychex (Nasdaq: PAYX) is suffering them right now, as is Mellon Financial. I like that Mellon is conservative. Cautious. These are all human companies. Companies that seem honest and humble. They aren't flawless.

Don't prove me wrong, companies. Don't prove me wrong. Show me your honest flaws.

In closing, outright fraud is like being robbed when you're not home. Without warning, there isn't much you can do about it. But having an alarm system in your head, especially now that many others have been robbed, will certainly help. Now is the time to start investing confidently, if you haven't been. It's time to rebuild.

(Join us on the Fool on the Hill board to discuss topics in this column.)

Jeff Fischer owns nine stocks, all shown in his profile. Most he's owned several years. The King invariably has a full belly, while the Fool has a full disclosure policy.