Seven Resolutions for the New Bull Market

2. Beware the Paradigm Shift

A "paradigm shift" usually hits companies when their outlook is the brightest. When the personal PC shifted IT spending from mainframes to desktops, IBM (IBM - commentary - Cramer's Take) was the dominant maker of mainframes, seizing dominant market share over seven competitors and achieving a record market cap in 1988 (a new high wasn't achieved until 1997, by which time IBM had shifted most revenues to services rather than hardware). Companies like Digital Equipment Corp., which built mini-computers with proprietary operating systems, disappeared. Meanwhile, beneficiaries of the new paradigm like Microsoft and Compaq (CPQ - commentary - Cramer's Take) took off. Compaq was later the victim of another paradigm shift, from "build for inventory" to "build to order" -- Dell (DELL - commentary - Cramer's Take) was the primary beneficiary of that shift.

I recently sold my positions in Sun Microsystems (SUNW - commentary - Cramer's Take) and EMC (EMC - commentary - Cramer's Take). I believe both are terrific companies, but sales of Sun's proprietary servers/operating systems are being pressured by cheaper Wintel- and Linux-based servers. My analysis is that the Sun servers are still the performance leaders, but not the price/performance leaders. EMC is in the same bind -- losing price/performance leadership to NetWork Appliances (NTAP - commentary - Cramer's Take) even though the EMC storage systems offer higher overall performance.

3. Nonsense Business Plans Make Nonsense Investments

Kozmo.com was an Internet era business which married one lousy business (bicycle delivery) with another lousy business (convenience stores), wrapped up in an Internet-based interface. The business strategy boiled down to "We're losing money on every sale, but we're making it up in volume." Briefly, Kozmo.com was valued at billions of dollars on the way to eventual bankruptcy.

When the next investment fad comes along, let your common sense prevail. If the business plan seems laughable, don't invest -- no matter how hot the stock is trading.

4. Accounting Problems? Goodbye

When a company restates its earnings, management is essentially saying that they have no idea how the company is doing. It also means that any quantitative screens that you use to select companies for further research are useless. Finally, it's rare that one restatement isn't followed by another -- and another. So, on the first announcement of accounting concerns, sell the stock automatically. This strategy would have protected you against some, if not all, of your losses in Enron, WorldCom, Global Crossing and Tyco (TYC - commentary - Cramer's Take).

How can you predict when a company might have accounting problems? An imbalance in the Statement of Cash Flow, as described above, is one way. Another flag is when a company shows large increases in revenues and earnings on its Income Statement, but Accounts Receivable (from Balance Sheet) soars while Cash (from Balance Sheet) is declining year over year. Sunbeam achieved big revenue gains by "channel stuffing" -- filling distributors' warehouses with products that were ultimately unsold and returned, but recording the shipments as realized sales (thus, an increase in accounts receivable even though no cash was received). Subsequently, Sunbeam went bankrupt.

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David Edwards is a portfolio manager and president of Heron Capital Management, a New York management firm. Edwards was a contributor to Harry Domash's Fire Your Stock Analyst: Analyzing Stocks On Your Own available at Amazon. At the time of publication, his firm was held positions in Dell and Amazon.com, though positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Edwards appreciates your feedback and invites you to send it to David Edwards.