7 Stocks Raising Another Red Flag

While high-frequency trades spat out by computers may appear to drive today's market, there is still room for investors to earn fat returns through old-fashioned fundamental analysis.

Beginning in 2002, activist value investor Bill Ackman became convinced that the bond insurers were much riskier than their triple-A rating suggested. When the extent of their exposure to structured mortgage securities came to light during the credit crisis, the stocks imploded, and Ackman's short positions turned into huge winners.

A showman and a serious analyst
Although he is primarily known for his brash tactics, Ackman is first and foremost a deeply inquisitive security analyst. On MBIA alone, he amassed 140,000 pages in documentation in the course of his research. One of Ackman's favorite investing books is Thornton O'Glove's Quality of Earnings, a primer on a rigorous, skeptical approach to financial analysis that enables investors to identify "time bomb" stocks for protection -- and profit.

All serious investors should put Quality of Earnings on their reading list. In the meantime, let me give you a taste of what O'Glove calls "the best method I have ever discovered of predicting future downwards earnings revisions of Wall Street security analysts." This method covers two balance sheet accounts: accounts receivable and inventory.

In this article, I'll focus on the former.

• What are accounts receivable?

When a company has delivered goods and services for which it has not yet been paid, the sums it is owed go onto the balance sheet under accounts receivable.

• What can accounts receivable tell you?

As O'Glove points out, if accounts receivable are growing faster than sales, this could indicate the company is granting its customers more favorable payment terms or that it is having a hard time collecting what it is owed -- neither of which is a positive sign for the business. Another possible explanation is that the company is offering aggressive incentives to goose sales, which hurts profits while providing only a temporary boost to the top line.

Say it ain't DSO
An easy way to track the growth of accounts receivable relative to sales is a metric called days sales outstanding (DSO), which is the amount in accounts receivable expressed as a multiple of the company's daily revenue. By definition, when the DSO increases from one period to another, accounts receivable growth is outpacing sales growth. The following table contains seven stocks from the Russell 1000 index that exhibited a high increase in their DSO over the most recent four quarters:

Source: Capital IQ, a division of Standard & Poor's.

Now, let me be very explicit that these are not short recommendations. Statistical screens are powerful tools for sifting through large amounts of data; however, they are blunt instruments when it comes to analyzing individual stocks. Screens highlight "high-probability" pockets in the market, but you need to conduct detailed company-specific analysis in order to confirm that a specific result isn't a false positive.

Good businesses, bad surprises?
Cisco Systems, for example, is a terrific business that I have highlighted as a potential buy recently for its low multiple and expanding business.

Nonetheless, even great companies aren't immune to negative earnings surprises that are predictable with a careful analysis of earnings quality. One must perform adequate follow-up research to determine for each specific company whether the DSO is truly a harbinger of an imminent problem or not.

Your next step
If you'd like to learn more about ways to spot potential ticking time bombs to protect your portfolio or profit on short ideas, enter your email in the box below to receive John Del Vecchio's free report "5 Red Flags -- How to Find the Big Short." Del Vecchio has an impeccable record as an analyst and a money manager; most recently, he managed the Ranger Short Only portfolio from 2007 to 2010, where he outperformed the S&P 500 by 40 percentage points. John's report is free, and it's the first step toward putting powerful analytical tools to work for your portfolio.