[PennyPlayer]

1. Trust Management? Credibility of the management can only be judged over time by watching how they disclose the inevitable ebb and flow of their business. Do they come right out and say: "We had a rotten year and here's why?" Or do you have to wade through a lot of public relations claptrap to get to the paragraph that states earnings were rotten? If there is bull in the text, there is liable to be bull in the financial presentation.

2. Fundamentals. You actually have to read the financials -- all the way through. Dull as it may be, an awful lot is there if you bother to look. You have no one to blame but yourself if you get blown up by a stock when it was all there in the footnotes while you were too busy insulting someone in the chat rooms.

3. Everything's Relative. Compare a company's growth and margins with those of its competitors and industry statistics. If these are so much better than everyone else's, are they a) geniuses, or b) padding the numbers? In more technical industries, there are clearly better widget propositions that make one company perform better than another. And economies of scale clearly help market-share giants like Budweiser and Frito-Lay. But what were people thinking when Sunbeam announced double-digit growth in gas grills, which had been a single-digit growth market since forever? That global warming was really here and the entire Midwest and New England had decided en masse to upgrade their grills in anticipation of year-round barbecues?

4. The Fewer the Restructurings, the Better. This has been the black hole of earnings management, as there are so many contra-accounts set up that can whip dollars back and forth that no one can possibly pretend to understand what is really going on. A number of companies begin to restructure the minute growth starts slowing, thus obscuring the fact. When in doubt, discount the earnings of a chronic restructurer.

5. Pooling and Fooling. It is understandable why a company with a price-to-sales ratio of 25 would want to use high-priced stock to make acquisitions. It would be stupid not to, since the money is almost free. But pooling has enormous scope for abuse, and it is difficult to get a handle on things like internal growth rates for a company that has pooled itself a half-dozen times. It destroys the ability of the investor to understand what management is buying, at what price and with what returns. This puts you in the position of buying the "trust me" story -- which does not always have a happy ending.

6. Follow the Cash. The checkout folks at the supermarket do not take reported earnings -- they take cash. Even something as simple as looking at the base line in the cash flow statement -- cash flow from operations -- can sometimes keep you out of disaster. Pay attention to what is being added and subtracted from reported earnings that are non-cash. Cash flow growth that is consistently lower than earnings growth can be a major red flag.

7. Timing Is Everything. Look particularly close at earnings when a company announces an acquisition in an earnings release. It's sometimes coincidental -- but often a distraction from the fact that the core business is soft.

8. The Old Reliable. Comparing inventory and receivables growth with sales growth is the oldest and most readily apparent warning flag of a problem.

9. Material Accounting Changes. Please read the footnotes: Are asset depreciation schedules getting pushed out, thus boosting earnings? Have pension accounting changes swung the company from reporting a cost to reporting a benefit, a la GE (GE:NYSE) and Lucent (LU:NYSE)? Are they capitalizing where they used to expense? You won't know it unless you look.

10. Use the Proxy Statement. The accounting treatment of stock options is highly contentious, and frankly we are still sorting out how to best account for the extent of expense avoidance and real share dilution from option giveaways. But regardless of your technical competence, if options outstanding are a material percentage of shares outstanding, it is safe to say that "net to the shareholder" will be less than you think, that compensation expenses are probably understated and therefore that earnings are overstated.

11. Keep It Simple. If you don't understand it, and don't have complete confidence in management, move on. I'll steal the line from Warren Buffett: It is far easier to avoid the dragon than to slay it.

12. Beware the Serial Rollup. Has there been a huge spate of acquisitions in a short period of time? Do you wonder how a management team can process so much in such a short period of time? Often, they can't, and as the fortune in the cookie says, "Fast-moving water obscures sharp rocks underneath." As a result, roll-up strategies invariably become a short-sellers dream. If Tyco managers can make something out of what they have absorbed in the last five years, then they are truly an exception.

PennyPlayer.