Comfort Zone Investing: When Stocks Wave Red Flags

Some industries are built on dividend payments, ones like Real Estate Investment Trusts (REIT). But even here, investors need to look at the average for all REIT's (in the category such as apartments, office, etc.) and see whether the stock under investigation is well above.

Many times, a high dividend is paid just one more quarter, then it's slashed to a much lower level or eliminated. Investors are better served to stay on the conservative side when it comes to yield. There's always a reason for much higher yields, and it's never good.

Management Changes. As mentioned a few columns ago, management is what makes it all happen. They make decisions that turn into profits or losses. When executive offices continually have new faces, that's a problem. Good managers are hard to find and if a company consistently has its top officers leaving, it means there's something basically wrong, either from a human perspective such as the CEO is too difficult or a large shareholder is too involved or something else. But there is a reason. It doesn't matter the cause, when you see a company's executives constantly changing in a short period of time because they leave voluntarily, beware. Something's rotten in the state of the company. Eventually that shows up in the bottom line.

Accounting Restatements. Accounting tells a lot about a company. It's when management starts changing the accounting that you have to worry. Not something like a shift between First In, First Out to Last In, First Out. That's a business decision. It's when they start restating past statements, you need to pay attention. It often means something was reported incorrectly initially and is now required to be stated according to certain accounting rules. Sometimes management will try to manipulate the accounting in illegal ways to make the bottom line look better. Watch out for too many restatements and closely examine each one as to why it's being done.

Another accounting concern: switching accounting firms often. Usually that means management isn't getting the answers it wants because the accounting rules don't allow for it, and their accountants won't go along with management. Changing accountants too often is definitely a red flag.

Sales Slow Down. Investors focus on the bottom line. Earnings are what make a stock go higher. But the top line is just as important. If sales aren't growing, it's hard for earnings to increase after cost cutting reaches its limits of effectiveness. There's no way around this one. Sales have to keep going higher if a company is to sustain growing profits. The best companies improve revenues with internal growth, the kind that comes from selling more of the product or service the company offers. Some companies grow sales by buying other companies, called external growth. Sometimes that works. Many times it doesn't because the new acquisition has to acclimate itself to a different way of doing business. Often there are culture clashes, and things don't work out. Watch the top line as well as the bottom one. It's best when the top line is growing and the bottom line is growing faster.

There are other reasons for concern, but these flags are large and warrant attention. If you own a stock that fits into one of these categories, more research is required as to whether to keep it or sell. And if you don't already have a stock with these problems, try to keep it that way.

Ted Allrich is the founder of The Online Investor, chairman of the board of Bank of Internet USA, as well as the author of the book Comfort Zone Investing: Build Wealth and Sleep Well at Night. In this weekly column, he offers advice to investors who are just getting started.