Will Today's Hot Stars Turn Cold Tomorrow?

For most of 1991, fast-growing retailer Cascade International Inc. drew raves. Analysts rated it a "strong buy." Small-company mutual-fund portfolio managers loaded up on the stock. Major publications, including BUSINESS WEEK, reported professional investors' praise for the stock. But last November, Cascade's founder disappeared. Allegations of fraud sent the stock plummeting, and in December, the company filed for bankruptcy.

Cascade is one of the more spectacular flameouts of recent years. But while fraud makes for big headlines, many fast-growing young companies go astray in less dramatic ways every year. KnowledgeWare Inc. fell from BUSINESS WEEK's Hot Growth list this year after its track record of double- and triple-digit growth turned to a loss in 1991's third quarter. In the past year, the software company was hit with a lawsuit alleging that it was recording revenue too soon. KnowledgeWare also saw two top executives resign and experienced heavy selling by a large number of insiders. The stock slid from a high of 43 1"/2 in early 1991 to 10 1"/2 in October and now hovers around 12.

COPYCATS. Yet such horror stories don't dissuade many investors from chasing what might be the next Xerox Corp. or Wal-Mart Stores Inc. "I think the benefits of small-stock investing outweigh the risks," insists Tom Maguire, portfolio manager of the $155 million Safeco Growth Fund Inc., which lost $2 million on Cascade.

While small-stock investing can be tempting, investors should keep a sharp eye out for warning signs. The first step in evaluating a small company's potential is to look at top management. "A good top management in a small company can build a very successful business in most any field, and lousy management can screw up the best of businesses," says John H. Laporte, portfolio manager of T. Rowe Price's $1.3 billion New Horizons Fund Inc. Most individual investors can't take the time to get to know management, but they can check for high inside ownership of the stock--a sign that the interests of management are aligned with those of shareholders. A warning signal: heavy selling by insiders when a stock is going public.

It's also a good idea to look at who sits ona company's board ofdirectors. Cascade's board included several members in fields that seemed to have little relevance to the cosmetics and clothing business. It included the CEO's dentist, a casino executive, and a PhD in hypnotherapy, notes Howard M. Shilit, an American University accounting professor and the author of an upcoming book on misleading information in financial reports. Another red flag that can be found in a prospectus: questionable transactions, such as low-interest loans to executives and special business relationships with family members.

The next stop is the company's financial statements. One of the most common maneuvers is to record revenue before it is earned, notes Shilit. For example, a company might receive a large payment up front for services that will extend over months or years--but may still record all the revenue at once. Some companies shift current expenses to a later period, perhaps by depreciating costs too slowly or failing to write off worthless assets. Other strategies to smooth out earnings: deferring current income to a later period or shifting future expenses to an earlier period.

`GONE-GONE.' Investing in small-company mutual funds is a way to spread the risk among a greater universe of companies. Over the past two years, the average small-company fund rose 17.48%, compared with 11.38% for the average equity fund, according to Chicago's Morningstar Inc. For the same period, the S&P 500 was up 15.78%.

This year, however, the picture is rather bleak, with small-company funds down 1.54%--compared with equity funds' 0.97% decline. But performance within the small-company universe can be quite variable. "The more cautious, value-oriented funds that steer clear of expensive stocks are among the market leaders this year," says John Rekenthaler, editor of the Morningstar Mutual Funds guide. "The go-go funds are gone-gone." The top small-company performers this year are Heartland Value Fund and Fidelity Low-Priced Stock Fund, which have risen 18.43% and 12.87%, respectively.

Burrowing into financial statements and prospectuses should turn up clues to a company's future. But as Cascade drove home, even people who invest in small stocks for a living can get fooled. Lists such as BW's Hot Growth rankings provide a good starting point for checking out small companies. But it's up to investors to take precautions to keep from getting burned.

      THE WINNERS...
                                  Two-year total
      Company                    return (percent)
      50-OFF STORES                   650.0%
      MEDSTAT SYSTEMS                 262.1
      DUTY FREE INTERNATIONAL         239.0
      CABLETRON SYSTEMS               238.5
      DIGI INTERNATIONAL              232.6
      HEARTLAND EXPRESS               213.0
      TSENG LABORATORIES              189.6
       Two-year                        total
      Company                         return (percent)
      FINANCIAL NEWS NETWORK          86.8
      WEITEK                          79.3
      QUIKSILVER                      72.6
      STEVENS GRAPHICS                71.1
      GEODYNE RESOURCES               70.0
      TOP AIR MANUFACTURING           68.2
      CODE-ALARM                      62.7
      OREGON METALLURGICAL            62.2
      Calculated on basis of stock price as of Apr. 30; excludes companies no longer