How to Avoid Massive Blow-Ups in Your Portfolio

Every investor wants to avoid massive portfolio blow-ups, but the unvarnished truth is that it's not that easy. However, careful investors can guard against really bad outcomes in their portfolios, and they can even do better than Wall Street analysts if they're paying attention to the right factors.

My colleagues Tom Jacobs and John Del Vecchio's new book, What's Behind the Numbers: A Guide to Exposing Financial Chicanery and Avoiding Huge Losses In Your Portfolio, helps investors shore up their portfolios against problems hardly anyone sees coming.

Warning: most stocks lose money
I like to joke (half joke, actually) that I dislike far more stocks than I like. As it turns out, as negative as that may sound, it may not be such a bad attitude. Extreme caution about stocks is warranted, and What's Behind the Numbers supports critical thinking as one of the most important tools in the investing toolbox.

Take the ominous first sentence in Chapter One: "Most stocks lose money." Ouch, right? Blackstar Funds looked at data for the 8,054 stocks that would have qualified for the Russell 3000 at some point during the longest bull market in history, 1983 through 2007. That study found that just 25% of the stocks studied represented all the gains.

Even more daunting, 39% of the stocks had a negative total return, and 18.5% of the stocks lost three-quarters of their value. In other words, one out of every five stocks is a really poor investment.

Regardless, investors can still do well by identifying the winning stocks, and selling off any stocks that start to show signs of poor earnings quality or even fraudulent activity in financial statements. That goes a long way in building portfolio outperformance.

The book also touts the value of a hybrid long/short portfolio, outlining how to identify a good short candidate as opposed to a short that could backfire. Believe it or not, such situations are not simply based on valuation -- that's a logical mistake many investors would make, to their peril. However, the authors outline how to analyze the situation in a far safer manner.

High quality: rarer than you think
Following in the footsteps of classics like Thornton O'glove's Quality of Earnings but adding Foolish pizzazz, the authors take investors through the line-up of red flags that could be waving wildly in financial statements -- disasters waiting to happen.

In the first part of What's Behind the Numbers, you can find major keys to ferret out financial hijinks -- actionable identifiers that can be used right away. Aggressive revenue recognition is a huge red flag, and the authors delve into the many more ways numbers can be massaged to make results look better than they are (in the short term, anyway). The book also provides plenty of modern case studies so investors can see how such situations have played out in recent years.

Tons of red flags could be hiding in any company's financial statements, including factors like perilous inventory buildups -- the situation that befell Crocs (NAS: CROX) in 2008 -- and the murky accounting that accompanied Green Mountain Roasters (NAS: GMCR) as it embarked on numerous acquisitions over time.

For an extremely timely example, take Hewlett-Packard's (NYS: HPQ) recent controversy. Could you have seen something like that coming? Well, maybe not the specific incident involving the Autonomy acquisition (which has overstated revenue recognition at its core), but What's Behind the Numbers points out how highly acquisitive companies can be major risks for investors due to confusing and sometimes even squirrely accounting. The authors were wary about Hewlett-Packard to begin with.

Here's a direct quote: "Because there is zero confidence in HP's earnings power, a long investor should simply pass." This is the culmination of observations like this one regarding Hewlett-Packard: "The danger for this company -- and all other serial restructurers and acquirers -- is that they can bundle whatever normal expenses they want into charges, and these numbers will significantly affect operating margins and EPS."

The second part of What's Behind the Numbers lays out the case for setting up a long/short portfolio; after all, bear markets do regularly come around, and possessing the temperament (not to mention the time horizon) to ride out such difficult times isn't necessarily as easy as it sounds. This section illustrates why such a portfolio makes good sense, and outlines exactly what kind of stocks the authors prefer to take long positions in.

Why this book's a great investment
Granted, I didn't agree with everything in What's Behind the Numbers. For example, I know myself as an investor, and while I defend short-sellers -- who are often correct in their bearish assessments -- I also stubbornly believe that shorting stocks is simply too risky for my blood. However, investors should channel some of that short-seller attitude when weighing stock ideas. This book certainly seeks to educate investors how to do that.

The book also poked at lots of the conventional wisdom in investing. I'm a big fan of such irreverence (it's Foolish, after all), but didn't necessarily agree with every opinion (also Foolish, since we often agree to disagree).

For example, the authors pointed out that good companies don't always make good stocks. I agree in principle, although my personal investment philosophy is geared toward identifying truly great companies. Further, I'd counter the book's example of Microsoft (NAS: MSFT) as a "good company" being a matter of definition. Microsoft lost the plot years ago, having dropped the ball on innovation, and it opened itself up to reputational risk with strong-arm tactics over years' time. True, it's stock has done zilch over the last 10 years, as the authors point out, but it's lacked some components that could have made it truly great for the long haul so that "zilch" performance isn't too surprising.

On the other hand, Apple's (NAS: AAPL) a better example of a great, innovative company that (so far) has been a very great stock; the late Steve Jobs had the kind of extraordinary vision that Microsoft management has lacked. I'm sure the authors' intent was to point out that we should never make assumptions on what a "good company" is, of course, nor rest an investing thesis on a flippant definition of one.

That's just a little nitpicking, though, because all serious investors can find a treasure trove of essential information in What's Behind the Numbers, regardless of investment philosophy.

All of us are looking to make money, and the main thrust of the book -- the many ways corporate managements can and do attempt to pull the wool over people's eyes -- is of universal concern to investors. Investors ignore these factors at their own risk.

There is absolutely no argument that Apple is at the center of technology's largest revolution ever, and that longtime shareholders have been handsomely rewarded with over 1,000% gains. However, there is a debate raging as to whether Apple remains a buy. The Motley Fool's senior technology analyst and managing bureau chief, Eric Bleeker, is prepared to fill you in on both reasons to buy and reasons to sell Apple, and what opportunities are left for the company (and more importantly, your portfolio) going forward. To get instant access to his latest thinking on Apple, simply click here now.

The article How to Avoid Massive Blow-Ups in Your Portfolio originally appeared on Fool.com.

Alyce Lomax has no positions in the stocks mentioned above. The Motley Fool owns shares of Apple, Crocs, and Microsoft and has the following options: long DEC 2012 $16.00 puts on Green Mountain Coffee Roasters and short DEC 2012 $21.00 calls on Green Mountain Coffee Roasters. Motley Fool newsletter services recommend Apple, Green Mountain Coffee Roasters, and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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