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Introduction: Raw Greed and Red Flags > How to Use This Book

How to Use This Book

Altogether, I have talked with more than 50 leading investors, short sellers, former regulators, independent analysts, shareholder rights activists, and leading financial figures to create a road map for investors trying to prevent executives more interested in personal compensation than corporate management from destroying the value of their nest eggs. Among those I have spoken with are former Federal Reserve Chairman Paul Volcker, three former SEC chairmen (David Ruder, Richard Breeden, and Arthur Levitt), and New York Attorney General Eliot Spitzer. I have also spoken with renowned money management figures such as Legg Mason’s Bill Miller, Vanguard founder John Bogle, TIAA-CREF’s just retired head John Biggs, and renowned short sellers such as James Chanos and David Tice. (Short sellers borrow stock and then sell it in the expectation that they will be able to buy it back at a much lower price and take the difference as profit.)

This is a book of warnings, alarm bells, and cautionary tales. It is based around a system of red flags—with three flags next to particular behavior by a company signaling highest risk, two indicating strong risk, and one standing for moderate risk. Also, at the end of many of the sections, I have given notes on how to find the information that I’ve discussed.

Certainly, this is more of a how-not-to book than a how-to book. If you see everything through rose-colored spectacles, believe the Dow Jones industrial average is heading to 36,000 early this century, and don’t hear out the arguments of grizzly bears, this may not be the book for you. To be a good investor, you need to temper optimism with common sense, with proportion, with a large dose of skepticism, and even with occasional cynicism.

I am not telling you to avoid investing in stocks altogether, to hide cash under the mattress, or to sell your house and head for the hills. A red flag on one beach shouldn’t stop you from swimming on the next beach where the waves are less threatening, and if you swim in the water when there is a red flag flying, it doesn’t always mean you will be dragged under or eaten by sharks. For example, one red flag I will cover later is the sale by executives of their own company’s stock. My calling it a red flag doesn’t mean that every time you see such a sale you should ditch the investment. If everything else—the company’s financial condition, board and management quality, and growth prospects—appears fine, then it may pay to stay put. But, when the inside selling is accompanied by shocks, such as the sudden resignation of the CEO, then it is the equivalent of seeing a shark’s fin 50 yards away and heading straight for you.

Readers should take particular note when they see a company that displays five or six of the warnings, especially of the two- or three-flag kind. This was certainly the case with Enron, which had impenetrable accounts, heavy sales of stock by executives, some ominous financial question marks arising from what was disclosed, a compromised board, resignations of senior executives, indications of arrogance at the top, and highly questionable business strategies. All this could have been gleaned from public documents or statements. In Tyco’s case, there was also plenty to worry about. Among the warning signs were an SEC inquiry in 2000, a short seller’s public warning, a serial acquisition policy that made it very difficult to discern how healthy the businesses really were, and a sudden, inexplicable change in strategy.

Sometimes, just one aspect of corporate structure or behavior creates a stench that should deter all but the most foolhardy. An example was the absolute dominance of the Rigas family at cable TV company Adelphia Communications Corp., which was among the companies that imploded as massive levels of alleged fraud began to surface.

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