They say that the worst kind of evil doesn't appear evil at all. Take that lovable little talking doll Chucky from the Child's Play movies -- who would have thought that a cuddly little plaything could wreak so much havoc?

The same can be said for investments. You may be inclined to trust more of your money to a company that seems to be on the path of virtue, only to get taken to the cleaners. Sure, stumbling into an Adelphia or Worldcom could cost a tidy sum, but more can be lost from sinking money into legitimate but poorly managed companies that, on the surface, appear to be high-quality.

In fact, the worst kinds of scams may not rise to the level of scams at all. There's nothing illegal or fraudulent about overpaying for shoddy or broken businesses, but the net effect is the same: You lose money.

Schooled by hard knocks
When I first started investing, I sunk a good chunk of my savings into a risky technology company that was growing rapidly. Initially, the stock shot up 20%. But then cracks in the foundation started to show in an earnings report, and investors began to question the balance sheet. An earnings restatement was announced.

Then all hell broke loose: the senior management bailed, coming under criminal investigation. Stock trades halted, opening days later at a fraction of the earlier price. I had fallen for one of the many corporate scams that year -- and I lost nearly $10,000.

While I've managed to avoid other criminal investments over the years, I've lost much more money investing in reputable, stable companies. There were no illegal acts here, no unethical management practices, no SEC investigations. I simply bought into overvalued companies.

One value scam I signed up for a few years back was Lucent Technologies (NYSE:LU). The company was losing ground to competitors such as Nortel Networks (NYSE:NT) and CiscoSystems (NASDAQ:CSCO) because of several management blunders in the late 1990s. After two straight years watching the stock wither, I figured it might just turn out to be a bargain.

But my great plan backfired. I had overlooked many key signals in the company financials that testified to Lucent's continuing lack of value. Had I paid better attention to the financial signs that tipped many investors to Lucent's collapse in the first place, my portfolio would be far better off today.

Warning flags of a value scam
So what exactly are some of these financial warning signs that can ward investors away from a value scam?

In Lucent's case, one early tip was an alarming inventory buildup on the balance sheet. The company was piling up equipment in warehouses rather than rushing it out the door to customers, with 54% more inventory on hand in 1999 than it had recorded a year earlier. In fact, inventory was piling up much faster than the company's 20% revenue growth, indicating that the company was either losing market to competitors or simply producing products that the market did not want. That's bad news no matter how you slice it.

Another key indicator of decaying company value on the balance sheet is growth in accounts receivable. This is essentially the money that a company is still waiting to receive from customers, even though it has already shipped a product. Sometimes, companies will extend more lenient payment terms (buy now and pay nothing for 18 months!) to lock in product sales and improve top-line revenue. If this is done in desperation to meet short-term revenue targets, as Lucent was doing, it will show up in increased accounts receivable.

A nice tool that captures both of these performance metrics (and more) is the cash conversion cycle. This measures how long it takes a company to convert expenditures back into cash. If there's a hang-up anywhere in a company's basic business process of buying materials and then selling goods -- such as stale inventory piling up -- you'll see it when the cash conversion cycle increases.

Cash conversion secrets
Let's try applying this tool to another industry: retail clothiers. Since teen clothiers live and die by their ability to move inventory, the cash conversion cycle can be a great indicator of company performance.

Cash Conversion Cycle




Pacific Sunwear (NASDAQ:PSUN)




Abercrombie & Fitch (NYSE:ANF)




American Eagle Outfitters (NASDAQ:AEOS)








Source: Company 10-K filings.

By comparison, my painful experience with Lucent's cash conversion cycle started at 75 in fiscal 1997, increased to 113 in fiscal 1998, and jumped to 138 in fiscal 1999 -- all while revenues soared. In the example above, each retailer shows fairly stable operations in the last few years in terms of managing inventory and payments, so no warning signs here.

Putting it to practice
Smart folks like Philip Durell and the Motley Fool Inside Value team use cash conversion and other financial metrics to weed out value scammers. If you'd like to find out just how sophisticated these tools can be at sifting out the real values in today's market, just click here for a free trial of the Inside Value newsletter service.

Basic financial items reported by all companies can determine the intrinsic value of a company, which can then be used to set comfortable entry prices depending upon your risk tolerance. These metrics also blow the horn quickly on those companies that seem to be just peachy on the surface. It's the best surefire way I know of to avoid a value scam.

Fool contributor Dave Mock is not afraid of Chucky and owns shares of Lucent. A longtime Fool, he is also author of The Qualcomm Equation . Gap is a Motley Fool Stock Advisor and Motley Fool Inside Value recommendation. Pacific Sunwear is a Motley Fool Stock Advisor recommendation. The Fool has a strictdisclosure policy.