Mellody's Math: Avoiding WorldCom Bomb

July 23, 2002 -- With the market's dismal performance these days, now is not the time to add insult to injury to your portfolio by investing in companies with nonsensical financials, unfound promises of exponential growth and a corporate agenda absent of customer satisfaction — think WorldCom, Enron and Global Crossing.

If your portfolio suffered at the hands of Wall Street's fallen angels, you were not alone in missing the significant signs previewing their falls from grace.

In fact, before executives at WorldCom were raising the perennial white flag to the SEC and Wall Street, multiple red flags were waving rampantly at investors and analysts alike.

The question for investors is how to recognize these red flags and do something before the company is in the headlines of every major newspaper and it is too late to react.

The Tell-Tale Signs of Trouble

Recently, Wall Street has had it shares of mirages with company profits in a state of "not really there."

As a shareholder of a publicly traded company, you are sent annual and quarterly reports disclosing earnings and all related information. In addition, most public companies send their shareholders proxy statements with additional details about business activities often soliciting your approval.

If you have the time to read the manual for your DVD player or shop online for the best airline ticket prices, you probably have time to read the annual reports for your investments.

In these "tell-tale" letters, here is what to look for and avoid:

Put-Together Companies: While acquisitions are often key components of growth and expansion, they should never be the meat and potatoes of a company's growth strategy.

The greatest businesses in America have not been put together through a series of acquisitions, but instead have grown from the bottom up.

For example, some of America's strongest brands, like McDonalds, General Motors, Walgreen, and Wal-Mart rarely acquire companies outside of their core business or use acquisitions to substantially drive growth.

Meanwhile, today's fallen angels are what I call put-together companies. Enron was an oil company that became a trading company and Vivendi was a water company that morphed into a media play. Likewise, Tyco spent about $8 billion in its past three fiscal years on more than 700 acquisitions.

Over the same period, WorldCom made more than 70 acquisitions of their own totaling close to $50 billion in cash, not including millions in stock conversions. In so doing, WorldCom took on $27.5 billion in debt.

This kind of information was widely known and can be traced back to the companies' annual reports. In fact, in Tyco's most recent annual report, they state up-front, "Good acquirers don't build empires. They make money."

And WorldCom's former CEO, Bernie Ebbers recently sold his yacht which he had named Aquasition — a clear reference to his preferred style of business.

Even under the best circumstances, successful acquisitions are very difficult to complete. The greater the frequency and the larger the acquisitions, the more complicated the transaction becomes and the greater likelihood of negative outcomes.

Growth-Lite: It is important to understand the priorities of the company's chief executive. When you read their annual letters, or see them on television, you want to hear about product quality, customer satisfaction and employee loyalty.

Beware of CEOs who seek growth for growth's sake, as they often lack a viable business strategy.

Enron's Chairman Kenneth Lay and CEO Jeffrey Skilling, in their 2000 letter to shareholders wrote, "These markets (retail energy services and broadband) present a $3.9 trillion opportunity for Enron, and we have just scratched the surface. Add to that the other big markets we are pursuing — forest products, metals, steel, coal and air-emissions credits — and the opportunity rises by $830 billion to reach nearly $4.7 trillion."

This statement lacks any mention of customer satisfaction or product quality. The end result of Lay and Skilling's projection was shareholder disaster — not shareholder satisfaction.

Payday: One has to wonder about the fiscal responsibility of a CEO who makes millions of dollars and has to make margin calls to cover his debt.

Consider Kenneth Lay at Enron who realized $123.4 million from exercising stock options in 2000 — a sharp contrast to ordinary shareholders who ended up losing the bulk of their Enron investments.

He also borrowed about $70 million from a line of credit provided by Enron and subsequently repaid it with the sale of stock.

Meanwhile at WorldCom, Ebbers was loaned more than $366.5 million by WorldCom — a towering debt even for an executive making more than $1 million a year.

At Tyco, former CEO Dennis Kozlowski is currently being investigated to determine whether or not he received interest-free loans from the company to purchase artwork.

Again, salaries and loans to executives can be found on the pages of a company's annual report. Keep in mind, as a shareholder or even as a future shareholder, you are paying part of CEO's salary or covering part of their loan, so vote with your feet and sell your stock if you believe the company executives are earning more than they deserve.

A CEO is the ultimate steward of a company and should have the full faith of the board of directors, shareholders and employees. When a CEO faces substantial debt, shareholders should immediately proceed with caution.

Getting Down to the Basics

To review, remember to ask the three basic questions:

1) Is a company growing because of the strength of its brand or because of acquisitions? Think McDonalds versus Tyco.

2) Are company priorities clearly centered on customer satisfaction, product quality and employee loyalty? Think the now deceased founder of Wal-Mart, Sam Walton, versus Kenneth Lay of Enron. The greeters at Wal-Mart are more than friendly faces, but true reflections of the company's commitment to putting customer service first.

3) Is the compensation of the CEO reasonable and are they burdened with substantial personal debt? Think Warren Buffet versus Bernie Ebbers of WorldCom. Buffet's annual salary as Berkshire Hathaway's chairman and CEO is $100,000. In addition, he has never sold a share of his company's stock. Ebbers, on the other hand, made $1 million as CEO, did not hesitate to sell company stock, and borrowed $366.5 million.

E-Mail Mellody with your personal finance questions.

Mellody Hobson, president of Ariel Capital Management in Chicago, is Good Morning America's personal finance expert. Click here to visit her Web site, ArielMutual Funds.com. Ariel associate Matthew Yale contributedto this report.