Five Things Women Need to Know about Investing in Stocks

There are five basic concepts women new to investing in stocks need to know to be successful. These concepts range from the psychological to the practical and once you accept them, you're ready to begin learning about investing.

The concepts are:

• Investing in stocks is not a "man's" game.
• You already know more than you think.
• You should invest for your retirement.
• You should avoid being too conservative.
• Learn and practice asset allocation.

Some of these concepts, like the last two, clearly apply to every investor, whether you are a man or a woman. I single them out for women so they will pay particular attention to them as they begin the learning process of investing in stocks.

1. Just for Men

Surely, we've moved beyond the notion that woman aren't suited somehow for business or investing. While we "talk the talk," I'm not sure we "walk the walk," when it comes to acknowledging this fact.

The reality that I feel the necessity to write a column about "women and investing" seems to suggest that there is still some concern (and much of it comes from women) about this whole notion.

There is nothing about investing in stocks or investing in general that any woman of reasonable intelligence can't grasp just as readily as a man of reasonable intelligence. So put that notion to rest.

2. You Know a Lot

You already know more than you think. Successful investors understand what they are buying. Women are generally careful consumers, who know what works and what doesn't.

Women make most of the consumer purchases in the U.S. When you get to that point of looking at specific companies, you already have a treasure of hands-on information about their products and services.

There is a great story that is probably an urban legend, but illustrates the point beautifully. When the financial services industry was going through a radical deregulation, banks and other financial institutions had newfound freedoms to go into new areas.

A young stockbroker invested in first this company and then that company looking for the one to make him rich, all with limited success.

One Sunday, he went to visit his elderly mother. He noticed a statement from a stockbroker and picked it up to see how much she had invested.

To his astonishment, his mother's account was in the six figures. He knew that she did not have that much money so he wanted to know how she amassed such a sum. Her answer humbled him.

While he had been chasing after the emerging leaders, his mother had noticed that ATMs (automated teller machines) seemed to be popular, so she invested in the company that made them. It didn't matter which bank was the best, they all wanted more ATMs, so the company profited.

Invest in what you know and observe.

3. Invest for Your Retirement

It's great to save for your kid's education and you probably have several other financial goals.

Here's why you should invest for your retirement. The statistical odds are that you will outlive your partner. That's a reality women must face.

You should plan to have enough money to last you 20 years after you retire. That's a long time.

If your employer offers a retirement plan, participate, especially if they offer some percentage of matching funds.

If you do not work, look into IRA options and even more reason to begin investing now, even if it is not in a retirement plan.

Kids can get college loans, scholarships, and so on. However, when you're 75 and alone (I sincerely hope that's not the case), you will regret not funding your own retirement.

4. Don't be too Conservative

As you get into investing, you will find where your level of risk tolerance is. This is not a suggestion that you should take risks that make you uncomfortable.

However, keeping all your funds in "safe" investments will make it difficult to reach your financial goals. Taxes and inflation will eat your small returns and the best you can do is tread water, if you're lucky.

Stocks, which are riskier than some other investment, also provide the opportunity to beat inflation over a long period and build a solid foundation. Buying and holding good companies for the long term is a way to build a nest egg.

5. Learn and Practice Asset Allocation

Asset allocation is one of those investing terms that you will learn. A good place to start is with this article: Introduction to Asset Allocation.

It's another way of saying spread your money around so it's not all invested in one spot. You'll see the common sense of this immediately.

The important thing to remember is that it is a continual process that you must always have in your mind as you begin investing. If you start out with this mindset, your investments will be in a better position as the years go by.

Conclusion

Don't be afraid to jump in with both feet - investing in stocks knows no gender barriers. There are a number of articles on this site to help you get started and the rest is up to you. Good luck.

Long-Term Investing Becoming Shorter in Global Economy

There is only one reason most investors buy a stock and that is because they expect a return that will be greater than putting the money in some form of savings account.

They are willing to take the risk that the stock will not do well in exchange for the potential and often future reward that the investment will yield a greater return than a safer investment.

The relationship between risk and reward has a direct bearing on what you should pay for a stock and what you should expect as a return.

How do you find stocks that will reward your investment over the long-term with consistently higher returns?

It would be wonderful if we could count on certain companies being industry leaders for the next 20 years.

Our Job

That would make our job as investors much easier. However, given the rapidly evolving nature of the global economy, it's probably not realistic to count of finding stocks you can buy and count on holding for decades.

We have to buy stocks today and make our best judgement about the companies that have the greatest growth potential and the most defensible market positions.

Using stocks screens, it is possible to find industry leaders with strong financial ratios.

Growth investors will be looking for emerging leaders - companies that are on a fast growth trajectory with products or services that extend their market share.

Value investors look for companies that have been mis-priced by the market, for reasons other than a flawed business concept, and look for a big payoff when the stock is correctly valued by investors.

Investing Strategies

Growth investing strategies create opportunities for wealth as long as the company continues to grow. At some point, many growth companies slow down and the market can be very harsh with the stock.

Some value companies are never truly appreciated by the market and investors are stuck with a stock that has not done much for them for a long time.

The point is you are not marrying a stock when you buy it - there is no, until death do us part.

If you are not earning a return that is significantly better than keeping your money in a relatively safe savings instrument, it's past time to move on.

Long term investing is only for those stocks that keep their end of the relationship, which is to provide you with an above-average return.

Five Reasons to Invest in Stocks

There are at least five good reasons you should continue to invest in stocks. This is the first of a five-part series.

In the middle of the worst financial crisis since the Great Depression may seem like an oddly inappropriate time to suggest stocks are a good investment.

However, I contend the benefits of investing in stocks have not changed.

What has changed (or needs to change) is the investing public's perception of the stock market and its associated risks.

There are five good reasons you should continue to invest in stocks:

1. The stock market doesn't care

The stock market doesn't care about you or your plans. It doesn't have any agenda and could care less about yours.

Why is this a good thing?

Despite what you may have heard on late-night infomercials or read in an unsolicited e-mail, there are no magic formulas for investing success.

There are no secrets of the rich and famous; no secret passwords or handshakes.

In truth, there is nothing standing between you and successful investing, but some hard work and understanding the fundamentals of investing.

While institutional investors have an advantage (more resources, more fulltime professionals), you still have access to all the information you need to be successful.

It may feel at times like the stock market is targeting you for disaster; it is not. If you are caught on the bad side of the risk equation (the higher the risk, the greater potential reward and the higher chance for failure), that's just the reality of investing.

The stock market is most dangerous when investors forget the risk-reward rule and expose their holdings to too much risk, especially when there is not a full understanding of potential losses.

Investing in the stock market should be done with your eyes wide open. When you are blinded by a huge potential payoff or terrified of a loss, you will not make good decisions.

But don't blame the stock market.

Stocks are poised for growth.

Really? How do you know and when is this going to happen?

The truth is no one knows with certainty when the market is going to move up or down.

We can be guided by what has happened in the past and what logic tells us about today's markets.

Historically, stocks have rebounded following a recession or a bear market. The rebound may have been swift or slow, but it has always happened.

The nature of the stock market is that it will rise until investors no longer feel confident of further increases. Then it will fall as investors sell to lock in profits or try to cut losses. Both of these actions drive prices down further.

At some point, investors will regain confidence that stocks are a bargain and return to the market to buy. As more investors move into the market, prices continue to rise and that attracts more investors.

Prices will reach a level that once again becomes uncomfortable and the cycle resumes.

Most investors know that the stock market does not move up or down in a straight line. It will move up then retreat and then resume its rise. The same is true on the way down.

Prices move in a zigzag fashion and it is sometimes difficult to tell when a trend will continue for the long term.

The notion that stocks are poised for a growth is also grounded in a belief that the U.S. economy is resilient and can weather even very difficult circumstances.

The real question that remains unanswerable is when the market will move in one direction for a sustained period of time.

That's why long-term investors must be willing to ride out the down markets as well as the up markets.

As we deal with the changes of a very difficult economic period, investors should be aware that out of change comes opportunity.

Some of the companies that were industry and market leaders of the past will not adapt well or as quickly as others.

These are the circumstances when investors can achieve impressive gains by picking the new winners.

Follow the money, especially as federal dollars flow into new industries, such as green energy, and reforms in established industries (health care and financial services).

New regulations will level the playing field for stock investors.

The stock market hates regulation. Many of its participants are hard-line free market advocates and believe regulation stifles innovation and adds extra costs to operations.

Thanks to years of little new in the rules governing the markets, a number of products and services are offered consumers that didn't exist a decade ago.

For many, this has been a revolution and, for the most part, a good thing for the market.

Unfortunately, some took advantage of a laissez faire regulatory environment of the financial services industry and created products, services and partnerships that proved irresponsible.

The financial meltdown of 2007-09 can be directly tied to a financial services industry that was only concerned with generating as much profit as possible without regard to potential risk.

When the illusion of success disappeared, the financial collapse took down the global economy, casting millions out of work and out of their homes.

Yes, some of the consumers who willingly participated in this bogus economy are paying their rightful price, but many more innocents are paying too.

It is clear that our economy, not to mention the global economy, can no longer afford to be caught off guard by a financial crisis of this magnitude.

One of the repercussions of this crisis will be a financial services industry that is more tightly regulated, both in terms of the products it can offer and greater levels of transparency.

How does this benefit the stock investor?

A stronger regulatory environment that demands more transparency will mean investors will have a better picture of what the true risks are for an investment product.

Greater transparency will mean investors can make better decisions based on a more confident picture of the risks and rewards associated with an investment.

Will more regulation add to the cost of investing? Probably, but the benefits will outweigh the costs.

The stock market will not return to its robust former self until investors have confidence they are not going to be suckered into a legal scheme to enrich financial professionals.

Stocks offer the potential for current income and long-term growth.

One of the major benefits of owning stocks is their ability to produce current income (dividends) and long-term growth.

The challenges of the 2007-09 financial crisis put a strain on some companies to reduce or eliminate dividends, but for strong companies, this is just temporary.

When the economy rebounds, some companies will be in better financial condition than others. Mature companies with established markets may be in an enviable financial position.

As is often the case, companies providing products or services to businesses may experience rapid growth. Companies that have curtailed spending during the economic crisis will play catch-up, scrambling to capture market share or protect what they still have.

As we work through a recovery, market-leading companies will become cash cows, throwing off extra income in the form of dividends and stock buybacks.

It is safe to assume that investors are going to be more wary of risk in the future. Companies with a consistent record of dividend payment and growth will command a premium in the market.

Increased regulation (see reason 3) may require companies to return more profits to its owners (shareholders).

It is almost certain that either through regulation or shareholder action, executive compensation and bonuses will come under close scrutiny.

Stocks that return more profits to shareholders may be viewed in a more favorable light by regulators and shareholders. Don't be surprised if regulators encourage dividends through tax policies.

For investors, the combination of current income and long-term growth makes stocks a wise choice for those with a long time frame.

While there is still be much emphasis on quarterly profits, the investing community is likely to take a closer look at companies that have a longer term approach to growing the business.

With the right stocks in your portfolio, it is hard to beat the potential of current income and long-term growth.

You can trade stocks or buy and hold.

Stocks offer traders and investors opportunities for success. This is not unique among securities, but it does make equities a versatile investment.

Long-term investors (buy and hold) have found opportunities for success in picking good companies and riding with them until something changes the investor's opinion of the company or its stocks.

Buy and hold investors are often ridiculed for riding a stock up, and then riding it right back down.

This is certainly a risk, but smart buy and hold investors understand that a good deal may not be good forever.

There is a time to hold and a time to take profits and move on to another opportunity.

The financial meltdown of 2007-09 fed the fire of criticism for the buy and hold strategy. Critics pointed to the many investors that saw their net worth plummet.

No one is immune from major market pullbacks, but with proper asset allocation and attention to what is happening in the economy, buy and hold investors have just as good of chance at success as traders.

Traders move in and out of positions based on what the market is doing.

One extreme is the day trader who closes out all positions at the end of each day. Other traders stretch their holding period as long as they are making profits, whether that is hours, days or weeks.

Traders also cut their losses quickly and move on to the next deal.

Are traders more successful than investors? That depends on whether you are comparing smart traders and dumb investors or the other way around.

Traders, also known as active investors, can be very successful if they are clever and work hard. You can say the same thing for buy and hold investors.

The bottom line is success with either strategy takes focus and hard work.

Which you choose (and some do both), is a matter of personal preference. Stocks give you the option to choose.

Can the Stock Market Crash Again?

The Great Stock Market Crash of 1929 marks its 79th anniversary with the usual questions of could it happen again.

Historians continue to study the Crash for answers to questions about what really triggered the loss of 90% of the market's value over the next two and one-half years and what lessons can be learned.

The financial industry has learned some lessons for sure. For example, before the Crash investors could buy stock on the margin with only 10% down. This huge leverage worked against them when stock prices began falling.

Margin Requirements

Margin requirements are much tighter now and not every investor or every stock is eligible for a margin account.

In 1929, volume overwhelmed the market and it could not post trades, and prices fast enough. Consequently, investors often traded blind.

Technology, which admittedly is an Achilles' heel if it ever goes down, does a better job of keeping pace with volume today.

However, the worst day in market history didn't occur in the 1929 crash, but in more modern times on Oct. 19, 1987 when the Dow dropped over 500 points and the trading systems were overwhelmed with volume.

Buying Panic

In this crash, as the buying panic rose, complex computer programs kicked in and began issuing more sell orders. Known as programmed trading, these automated systems added fuel to the fire.

When the dust had settled, over $1 trillion in value had disappeared from the market.

Since then, the markets have put some restrictions in place to make sure the market doesn't run away again. These are designed to let the market catch its breath and cool off if things seem to be getting out of control. For example:

• The market will halt trading for an hour if the Dow drops 10% before 2 pm.
• Trading will halt for two hours if there is a 20% drop in the Dow before 2 pm.
• If the Dow drops 30%, trading is halted for the day.
• Significant events, such as the tragedy of Sept. 11, 2001 may be cause for not opening the markets at all or closing them early to prevent a panic.

Can it Happen Again?

These are only a few of the measures to prevent the type of Crash that occurred in 1929 or in 1987. Will they work? Can there be another crash? No one can say for sure, however it is reasonable to assume that there many people working every day to make sure it doesn't.

Stocks Investment:Think Like Warren Buffett

Back in 1999, Robert G. Hagstrom wrote a book about the legendary investor Warren Buffett, entitled "The Warren Buffett Portfolio". What's so great about the book, and what makes it different from the countless other books and articles written about the "Oracle of Omaha" is that it offers the reader valuable insight into how Buffett actually thinks about investments. In other words, the book delves into the psychological mindset that has made Buffett so fabulously wealthy.

Although investors could benefit from reading the entire book, we've selected a bite-sized sampling of the tips and suggestions regarding the investor mindset and ways that an investor can improve their stock selection that will help you get inside Buffett's head.

1. Think of Stocks as a Business
Many investors think of stocks and the stock market in general as nothing more than little pieces of paper being traded back and forth among investors, which might help prevent investors from becoming too emotional over a given position but it doesn't necessarily allow them to make the best possible investment decisions.

That's why Buffett has stated he believes stockholders should think of themselves as "part owners" of the business in which they are investing. By thinking that way, both Hagstrom and Buffett argue that investors will tend to avoid making off-the-cuff investment decisions, and become more focused on the longer term. Furthermore, longer-term "owners" also tend to analyze situations in greater detail and then put a great eal of thought into buy and sell decisions. Hagstrom says this increased thought and analysis tends to lead to improved investment returns.

2. Increase the Size of Your Investment
While it rarely - if ever - makes sense for investors to "put all of their eggs in one basket," putting all your eggs in too many baskets may not be a good thing either. Buffett contends that over-diversification can hamper returns as much as a lack of diversification. That's why he doesn't invest in mutual funds. It's also why he prefers to make significant investments in just a handful of companies.

Buffett is a firm believer that an investor must first do his or her homework before investing in any security. But after that due diligence process is completed, an investor should feel comfortable enough to dedicate a sizable portion of assets to that stock. They should also feel comfortable in winnowing down their overall investment portfolio to a handful of good companies with excellent growth prospects.

Buffett's stance on taking time to properly allocate your funds is furthered with his comment that it's not just about the best company, but how you feel about the company. If the best business you own presents the least financial risk and has the most favorable long-term prospects, why would you put money into your 20th favorite business rather than add money to the top choices?

3. Reduce Portfolio Turnover
Rapidly trading in and out of stocks can potentially make an individual a lot of money, but according to Buffett this trader is actually hampering his or her investment returns. That's because portfolio turnover increases the amount of taxes that must be paid on capital gains and boosts the total amount of commission dollars that must be paid in a given year.

The "Oracle" contends that what makes sense in business also makes sense in stocks: An investor should ordinarily hold a small piece of an outstanding business with the same tenacity that an owner would exhibit if he owned all of that business.

Investors must think long term. By having that mindset, they can avoid paying huge commission fees and lofty short-term capital gains taxes. They'll also be more apt to ride out any short-term fluctuations in the business, and to ultimately reap the rewards of increased earnings and/or dividends over time.

4. Develop Alternative Benchmarks
While stock prices may be the ultimate barometer of the success or failure of a given investment choice, Buffett does not focus on this metric. Instead, he analyzes and pores over the underlying economics of a given business or group of businesses. If a company is doing what it takes to grow itself on a profitable basis, then the share price will ultimately take care of itself.

Successful investors must look at the companies they own and study their true earnings potential. If the fundamentals are solid and the company is enhancing shareholder value by generating consistent bottom-line growth, the share price, in the long term, should reflect that.

5. Learn to Think in Probabilities
Bridge is a card game in which the most successful players are able to judge mathematical probabilities to beat their opponents. Perhaps not surprisingly, Buffett loves and actively plays the game, and he takes the strategies beyond the game into the investing world.

Buffett suggests that investors focus on the economics of the companies they own (in other words the underlying businesses), and then try to weigh the probability that certain events will or will not transpire, much like a Bridge player checking the probabilities of his opponents' hands. He adds that by focusing on the economic aspect of the equation and not the stock price, an investor will be more accurate in his or her ability to judge probability.

Thinking in probabilities has its advantages. For example, an investor that ponders the probability that a company will report a certain rate of earnings growth over a period of five or 10 years is much more apt to ride out short-term fluctuations in the share price. By extension, this means that his investment returns are likely to be superior and that he will also realize fewer transaction and/or capital gains costs.

6. Recognize the Psychological Aspects of Investing
Very simply, this means that individuals must understand that there is a psychological mindset that the successful investor tends to have. More specifically, the successful investor will focus on probabilities and economic issues and let decisions be ruled by rational, as opposed to emotional, thinking.

More than anything, investors' own emotions can be their worst enemy. Buffett contends that the key to overcoming emotions is being able to "retain your belief in the real fundamentals of the business and to not get too concerned about the stock market."

Investors should realize that there is a certain psychological mindset that they should have if they want to be successful and try to implement that mindset.

7. Ignore Market Forecasts
There is an old saying that the Dow "climbs a wall of worry". In other words, in spite of the negativity in the marketplace, and those who perpetually contend that a recession is "just around the corner", the markets have fared quite well over time. Therefore, doomsayers should be ignored.

On the other side of the coin, there are just as many eternal optimists who argue that the stock market is headed perpetually higher. These should be ignored as well.

In all this confusion, Buffett suggests that investors should focus their efforts of isolating and investing in shares that are not currently being accurately valued by the market. The logic here is that as the stock market begins to realize the company's intrinsic value (through higher prices and greater demand), the investor will stand to make a lot of money.

8. Wait for the Fat Pitch
Hagstrom's book uses the model of legendary baseball player Ted Williams as an example of a wise investor. Williams would wait for a specific pitch (in an area of the plate where he knew he had a high probability of making contact with the ball) before swinging. It is said that this discipline enabled Williams to have a higher lifetime batting average than the average player.

Buffett, in the same way, suggests that all investors act as if they owned a lifetime decision card with only 20 investment choice punches in it. The logic is that this should prevent them from making mediocre investment choices and hopefully, by extension, enhance the overall returns of their respective portfolios.

Bottom Line
"The Warren Buffett Portfolio" is a timeless book that offers valuable insight into the psychological mindset of the legendary investor Warren Buffett. Of course, if learning how to invest like Warren Buffett were as easy as reading a book, everyone would be rich! But if you take that time and effort to implement some of Buffett's proven strategies, you could be on your way to better stock selection and greater returns.

Real World Investing

When I was a child, I grew up in a small farm town and used to walk to the local public library just off the town square during the weekends to pour through the Value Line Investment Survey. When I found a stock that interested me, I'd pay to have copied on a black and white machine for $0.01 to $0.03 per sheet, take it home, study it, and then open a small safe that I had purchased from an acquaintance of the family. Inside, there were dollar bills (that I had ironed), coins from around the world, and stock tables.

Today, my life is remarkably the same. The difference is, the copy of Value Line is my own, sitting on a mahogany desk, the walls are covered in framed stock certificates and fine art, I'm writing with a fine fountain pen, and the coffee is served to me in a gold-rimmed cup. Yet, the nature of what I do is identical � in fact, I have such a passion for studying companies, that it brings me the same joy now as it did back when I had no net worth of which to speak and was trying to figure out how to make my way in the world.

That is the very essence of what is great about the American dream. My family wasn't wealthy or powerful, and yet because the knowledge was available, upward mobility existed and allowed me to pour my time, efforts, and talents into something that brought me joy (and profits). This was underscored earlier in the week when I was reviewing the Fortune 500 rankings. Charlie Munger has pointed out in the past that it only takes two or three great investments in a lifetime to get very rich (and you only have to get rich once). That means thinking through the problem of what could go wrong and working to make as certain as possible that you are getting full value for your money.

Let me illustrate the point by taking you through some of the stats. My hope is that seeing real-world examples can help you in constructing your own portfolio:

Wal-Mart Stores vs. Chico's

In 1999, shares of Wal-Mart traded at $70.30 and the average annual p/e ratio was 39.1 according to Value Line. That means that it had an earnings yield of only 2.56% - less than the historical rate of inflation! Any fool should have been able to see that it was perfectly asinine to buy shares at that price. True enough, nine years later, the stock traded in the mid-to-low 40's and only recently recovered into the 50's.

In fact, had it not been for the talents of Wal-Mart's brilliant CEO, Lee Scott, and his management team, the value destruction could have been far worse for those who overpaid during the bubble. Why? They have taken net income from $3.5 billion to $12.7 billion in that time, earnings per share have increased from $0.77 to $3.13, and cash dividends have skyrocketed from $0.14 to $0.88 per share. In fact, according to the company's annual report, Wal-Mart's growth alone would have created a Fortune 75 company. It's disappointing to hear market pundits complaining about this type of performance when they are focusing on the ticker and not the underlying business. Results like these at a behemoth that is bigger than some countries are monumentally difficult and deserve praise. Instead, all you hear is people complaining the stock has gone down for almost a decade, not realizing that they were idiots for paying the prices they did.

Yet, at the same time in 1998, a small retail store chain known as Chico's was experiencing tremendous success and traded at only 14x earnings. The stock went from (adjusted for splits) $0.40 per share to the more recent price of $7.15, turning the same $100,000 investment into $1,787,500. Basic elementary logic should have told people that it would be far easier to grow a company that generated $9.1 million in profit at a very fast rate than it would be to grow one earning $3.5 billion. That means that if investors thought Chico's had a bright future, they should have been more than happy to pay 14x earnings for it with its smaller sales and profit base (and thus, higher potential growth) than paying nearly 40x earnings for a giant company. The problem is, how many people took out a calculator and asked themselves what their assumptions in future growth implied and required to accomplish?

You may wonder why I've chosen the figure $100,000 for each investment. Obviously, most people don't have that kind of cash sitting around available for their portfolios. Yet, it's probably an average person working at a factory for a decade or two is going to be able to amass at least that in his or her 401k with decent planning. I wanted a number that therefore was possible and illustrated Ben Graham's idea of thinking of a stock as a piece of a business.

If you were going to start your own metal working firm or retail store, you would probably have to come up with six figures to get it off the ground � fixtures, computers, hiring employees, working capital, etc. Yet, most people don't realize that choosing to buy, say, $100,000 worth of a relatively small mall-based retailer, Hot Topic for instance, you are buying 0.044% of the company. The choice then would become, "would I rather own 100% of my own small business or buy 0.044% of this one?" Those who think like that might very well have a better chance of enjoying satisfactory investment results if they did. Buffett has consistently said he would rather own a small piece of the hope diamond that the entirety of a rhinestone.

Are Your Stocks Doomed?

Few people seem to spot the early signs of a company in distress. Remember WorldCom and Enron? Not long ago, these companies were worth hundreds of billions of dollars. Today, they no longer exist. Their collapses came as a surprise to most of the world, including their investors. Even large shareholders, many of them with an inside track, were caught off guard.

This doesn't mean it's impossible to see a corporate train wreck before it happens. Sure, it involves some work, but by digging into a company's activities and financial statements, even the average investor can identify potential problems. Here are some general guidelines for spotting companies that may be headed for trouble.

Cash Flows
Keeping a close eye on cash flow, which is a company's life line, can guard against holding a worthless share certificate. When a company's cash payments exceed its cash receipts, the company's cash flow is negative. If this occurs over a sustained period, it's a sign that cash in the bank may become dangerously low. Without fresh injections of capital from shareholders or lenders, a company in this situation can quickly find itself insolvent.

Bear in mind that even profitable companies can have negative cash flows and find themselves in trouble. This can happen, for example, when a rapidly growing business with strong sales makes large investments in stock, staff and manufacturing plants. At best, there will be a delay between when the company forks out cash for these business costs and when it collects cash from resulting sales. But this delay can severely stretch cash flow. At worst, the sales growth is not be sustained, and large quantities of stock (and staff) end up idly sitting in warehouses, causing a devastating impact on cash flow. Either way, you should steer clear of companies that report both profits and negative operating cash flows period after period.

Examine the company's cash burn rate. If a company burns cash too fast, it runs the risk of going out of business. Enron's cash flow fell from negative $90 million in Q1 2000 to a very troubling negative $457 million a year later.

Debt Levels
Interest repayments place pressure on cash flow, and this pressure is likely to be exacerbated for distressed companies. Because they a higher risk of default to banks, struggling companies must pay a higher interest rate. Debt therefore tends to shrink their returns.

Total debt-to-equity (D/E) ratio is a useful measure of bankruptcy risk. It compares a company's combined long- and short-term debt to shareholders' equity or book value. High-debt companies have higher D/E ratios than companies with low debt. According to debt specialists, companies with D/E ratios below 0.5 carry low debt. And that means that conservative investors will give companies with D/E ratios of 0.5 and above a closer look.

Let's consider Enron's debt-to-equity levels before it declared bankruptcy in Dec 2001. At year-end Dec 2000, its D/E ratio stood at 0.9. At June 2001, it grew to 1.1. Finally, its Sept 2001 quarterly report showed a D/E ratio of 1.4. Enron would have qualified as a risky debt prospect each time.

At the same time, the D/E ratio doesn't always say much on its own. It should be accompanied by an examination of the debt interest coverage ratio. For example, say a company had a D/E ratio of 0.75, which signals a low bankruptcy risk, but it had an interest coverage ratio of 0.5. An interest coverage ratio below 1 means that the company is not able to meet all of its debt obligations with the period's earnings before interest and tax (operating income), and it's a sign that a company is having difficulty meeting its debt obligations.

Share Price Decline
The savvy investor should also watch out for unusual share price declines. Almost all corporate collapses are preceded by a sustained share price decline. Enron's share price started falling two years before it went bust. The same holds true for WorldCom.

A big share price decline might signal trouble ahead, but it may also signal a valuable opportunity to buy an out-of-favor business with solid fundamentals. Knowing the difference between a company on the verge of collapse and one that's undervalued isn't always straightforward. Looking at the other factors we discuss below can help you tell them apart.

Profit Warnings
Investors should take profit warnings very, very seriously. While market reaction to a profit warning may appear swift and brutal, there is growing academic evidence to suggest the market systematically under-reacts to bad news. As a result, a profit warning is often followed by a gradual share price decline. See this article on market under-reaction by Harvard finance professor Jeremy Stein.

Insider Trading
Companies are required to report, by way of company announcement, purchases and sales of shares by substantial shareholders and company directors. Executives and directors have the most up-to-date information on their company's prospects, so heavy selling by one or both groups can be a sign of trouble ahead. While recommending that investors buy his company's stock, Enron Chairman Kenneth Lay sold $123 million in shares in 2000. That was nearly three times his gains in 1999, and nearly 10 times what he made in 1998. Admittedly, insiders don't always sell simply because they think their shares are about to sink in value, but insider selling should give investors pause.

Resignations
The sudden departure of key executives (or directors) can also signal bad news. While these resignations may be completely innocent, they demand closer inspection. Warning bells should ring the loudest when the individual concerned has a reputation as a successful manager or a strong, independent director.

You should also be wary of the resignation or replacement of auditors. Naturally, auditors tend to jump ship at the first sign of corporate distress or impropriety. Auditor replacement can also mean a deteriorating relationship between the auditor and the client company, and perhaps more fundamental difficulties within the client's business.

SEC Investigations
Formal investigations by the Securities and Exchange Commission (SEC) normally precede corporate collapses. That's not surprising since, many companies guilty of breaking SEC and accounting rules do so because they are facing financial difficulties. Unfortunately for most Enron and WorldCom investors, the SEC didn't spot problems in these companies before it was too late. However, the SEC has a pretty good nose for detecting corporate and financial misdeeds. While many SEC investigations turn out to be unfounded, they still give investors good reason to pay closer attention to the financial situations of companies that are targeted by the SEC.

Conclusion
Just as a seriously ill person can make a full recovery and go on to lead a fulfilling life while a seemingly healthy person can drop dead without warning, some very sick companies can make miraculous recoveries while apparently thriving ones can collapse overnight. But the probability of this is very low. Typically, when a company is struggling, the warning signs are there. Your best line of defense as an investor is to be informed - ask questions, do your research, be alert to unusual activities. Make it your business to know a company's business and you'll minimize your chances of getting caught in a corporate train wreck.