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'Black Swan' Stocks Could Lose 50% or More Due to Accounting Practices


These are companies that investors should run away from screaming as loudly as the victims in horror movies.

Some of the names on the Black Swan list are clearly there for a reason; others may or may not prove to have similarly acute accounting problems. Still, the list is a reminder that even at venerable blue-chip companies, things can go very wrong. The causes of the debacles vary, but there are some familiar factors across the 40 companies.

Half of them offer incentives that may lead chairmen, CEOs, and CFOs to disregard warning signs; nearly two-thirds have a chairman who also serves as a CEO. (The latter has long been a major source of contention between governance activists and corporate boards.) By far the largest reason why a company may end up on the list, however, is because of its track record of mergers and acquisitions.
As for the accounting issues that pop up as reasons for GMI waving a red flag, well, investors may do well to devote some extra scrutiny to factors such as asset turnover, the ratio of cost of goods sold to the company's revenue, the valuation of intangible assets and accounting policies on such items as goodwill and depreciation expenses.

Only about 5% of the companies that GMI monitors end up earning a failing grade, the rating agency says. They just happen to be the ones that GMI makes the most noise about, because investors really care – and rightly so. To be a successful investor, first and foremost you have to figure out how to avoid losses; to lose 10% in a year is bad enough, but in order to get back to where you started you have to earn more than 11%. It's simple math. If a company earns good grades on the transparency of its accounting and the more intangible measures of good governance, the odds that it is hiding something nasty in the woodshed are going to be lower; then you simply need to worry about the more obvious issues of business risk.

GMI may not be correct in predicting gargantuan losses for all 40 names on its Black Swan Risk List, but the company is right to remind us that these issues matter, however difficult they may be to understand. Over and over again, investors have shown that they don't really internalize the messages of past crises. The events of 2001-2002 may have sparked a brief surge in interest in forensic accounting, but it hasn't stuck around. Hewlett-Packard and the other Black Swans should serve as a wake-up call for us all.

Editor's Note: This article by Suzanne McGee originally appeared on The Fiscal Times.

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