3 Stocks to Run From

Articles about great stocks are everywhere. In fact, it's my job to dig for great stocks that pay great dividends, and I'll conclude this article with four stocks you might want to check out yourself. But as anyone who's ever felt betrayed by a stock implosion can tell you, it's also important to focus on the duds, the losers -- the stocks you just might want to run from. Nobody wants a portfolio bomb jeopardizing his or her retirement!

There are a lot of things you don't want to see in a stock, but I'll highlight one particular criterion today. Accrual earnings occur when a company books non-cash inflows and outflows. All companies do so; they're required to by current accounting standards. But consistently booking more accrual earnings than cash earnings can spell trouble. In fact, it does for sure, statistically.

In 1996, an Australian academic named Richard Sloan finally got his paper published. It was in a slightly off-topic journal, but after being rejected for six years, it must have felt good. The paper's premise? That accruals make not just a difference in stock returns, but a huge difference. Academia couldn't believe that investors could have earned 10 percentage points more per year by following Sloan's formula -- in a world where "abnormal" returns are typically confined to the right side of the decimal point.

But it was real. And the once-rejected Sloan has become a top dog of the accounting world. He recently left academia for a plush post at Barclays Global Investors.

Finding the accrual offenders
Let's put a version of Sloan's formula to work to find stocks you might want to run from. I used Capital IQ to screen for the companies with the highest ratio of accrual earnings (net income) to cash earnings (operating cash flow). Although I used three-year averages to smooth out one-time oddities, I want to stress that this is invariably a shotgun-blast approach that doesn't capture everything -- in other words, these stocks aren't guaranteed to be horrible investments, and could well end up in the black. They are simply among the worst offenders on a statistical basis.

Here are three from the screen:

Sloan's formula works in reverse, too. Stocks with cash earnings to spare tend to be stronger investments statistically.

Dividends are dynamite
Speaking of stronger investments, I'll drop another great investment factor on you: dividends. Dividend payers also tend to outperform. And dividends simply pack a wallop. The Fool's own Shannon Zimmerman notes that $10,000 invested in the 1926 stock market would have grown to $1,013,000 without dividends, but a mind-blowing $24,113,000 with dividend reinvestment!

Can we combine cash earnings and dividends? You bet. Here are four stocks with robust cash earnings and dividend yields higher than 2%. They're not official recommendations, but based on the combination of two winning factors, they seem to be on the statistics' good side.

If you like cash earnings and dividends, I invite you to try Motley Fool Income Investor, the Fool's dividend-oriented newsletter service. It's beating the market by 10 percentage points. You can take a 30-day free trial right here.

This article was first published on March 28, 2007. It has been updated.

James Early owns no stocks mentioned in this article. The Motley Fool has a disclosure policy.