How to Cash in On a Stock Scandal
Tuesday, March 6, 2007 | Dylan JovineRating:
For the scores of companies swept up in the options-backdating scandal, repercussions have included financial restatements, regulatory investigations and executive resignations.And though Wall Street hates a scandal of any kind, the current rash of investigations and accounting scandals on Wall Street is far different than those of prior years. Stocks of companies such as WorldCom and Enron never recovered from their accounting improprieties because they had large effects on the companies' bottom lines.
In contrast, the options scandals fall into the realm of executive compensation, which historically has had less of an impact on stock prices.
And while nobody disputes that investors will ultimately pay the final tab for the scandal, the reality is that the amounts largely make a relatively small dent in companies' financial health.
As such, there are still several great buying opportunities for investors who, like me, have been waiting for the dust to clear more fully before plunging back into the water.
Indeed, there already has been fast money made in buying stocks like Foundry Networks (SYM: FDRY), a manufacturer of telecommunications-network gear.
In late June, Foundry announced a federal inquiry into its options practices, sending its shares down about 10% to roughly $9 in the following weeks. But thanks to a strong third quarter, Foundry’s stock bounced back to more than $14 as the investigation continued, even as it ended with the ouster of its C.E.O. and C.F.O.
But some of the companies that have gone down after the initial announcements have stayed down.
One example is Vitesse Semiconductor Corp (SYM: VTSS) which was trading on the Nasdaq in the mid-$3 range before a March 18 page-one Wall Street Journal article highlighted an unusual pattern of options grants to the then-CEO.
The company launched an investigation which uncovered numerous accounting
irregularities and led to the termination of three executives, one of whom
remains on the board.
As of this writing on Monday, Vitesse's stock was selling for .92 a share on the pink sheets (OUCH!)
So, how do you tell the difference between a buying opportunity and a “value trap” in this context? One way to do so is to separate the behavior of the stock price with the strength of the underlying business.
For example, if a company has a strong underlying business that continues to grow (even as its stock price shrinks under the light of scandal,) the inverse action of the stock going down while the business “goes up” tends to lead to a buying opportunity.
One great example of this was last month's Fallen Angel Stocks recommendation (which I cannot share out of respect for paying members.)
Under the taint of scandal, Wall Street punished the stock by sending its shares down close to 30%, shaving off close to $20 BILLION in stock market value for a scandal that is expected to cost the company less then $1 Billion in restatements.
But with this company, you have a dominant $78 Bil (sales) franchise that is increasing revenue while at the same time lowering costs, thus increasing its ratio of profitability.
When the scandal first hit, the stock was selling in the $70 range…it’s now selling in the low $50 range.
What’s the difference?
Getting rid of a bad CEO means that the business is now better than it was, as it is under better leadership. In addition, the company has reported double digit sales and earnings growth.
Most importantly, though, the stock price is lower than it was before.
Hmmm....Better business Higher Sales Higher Earnings = Higher Stock Price most of the time.
But in this case it equals a lower stock price which, as somebody who hunts for and invests in fallen angel stocks for a living, I take advantage of because it happens so rarely.
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Dylan Jovine
Contributing Editor
The Tycoon Report
