Playing The Sleuth In A Scandal Stock

By Glenn Curtis AAA

The pervasiveness of business-related scandals has changed the way that many analysts and investors think about corporate governance. For example, no longer do senior executives get a free pass when they botch an acquisition or their company misses earnings - they can be sued, along with their company, insurance carrier and anyone else even remotely involved in event.

The good news is that an investor's willingness to hold management's feet to the fire will probably lead to fewer corporate scandals going forward. But there will always be rotten apples that will continue to manage recklessly and/or just plain steal from their shareholders.

In any case, the possibility that a corporate scandal could emerge in the future means that investors should be prepared, not only to investigate the scandal on their own, but also to make their own assumptions based on the potential damage to shareholder value and the underlying stock price. In this article, we'll show you what to look for and how to keep a scandal from tainting the value of your portfolio.

Take Matters into Your Own Hands
Some will suggest that an investor would be better off leaving the investigation (and the resulting valuation) up to the press and the analysts that cover the company. In fact, there are a few reasons why an investor would be wise to play the role of detective. The first, and probably the most important, reason would be to preserve capital and to avoid "opportunity lost".

It could easily take weeks or even months for a journalist or analyst to fully uncover the depths of a given scandal. By completing your own analysis on a timely basis, you'll be able to get out of the stock in question before the herd tries to sell. Furthermore, an investor's own analysis might find that the scandal is not be as bad as the media has implied, providing investors with an opportunity to get involved in the stock at a very low cost.

Clues to Look For
There are several facets an investor should look at when analyzing a potential scandal stock. First, the investor should try to determine exactly who is involved and to what degree. Logic should dictate that if the chief executive officer is involved, there may be others under that person that may have acted as accomplices. If this is the case, the scandal (and the lies) will probably multiply until the dust settles. Also, as a rule of thumb, the more elaborate the deception and the more accomplices, the larger the dollar value of the fraud. A great example of this was Enron, where the scandal spread from Ken Lay and Jeff Skilling, to subordinates such as Andrew Fastow and a number of other "C-suite" execs.

Conversely, if a lower level manager looking to advance his or her career was caught fudging the numbers, one might assume that this person may have been acting alone or with only a few other minor accomplices. In other words, the fraud is more likely to be contained, and less damaging to the overall organization. For example, Raymond Stevenson, a former vice president of taxation at Tyco, pleaded guilty in 2006 to failing to report more than $170 million in income on a 1999 Tyco International tax return. However, because the shenanigans were essentially limited to one man and because Tyco is such a huge company, most analysts agree that the company will survive.

Stock scandal sleuths should also pay attention to the portion of the company the scandal encompasses. If it is the company's primary revenue source, one could assume that the scandal could take an enormous toll on its financial statements, and by proxy, its stock. On the flip side, as mentioned above, if the scandal is limited to a smaller or discontinued operation, the likelihood that the damage will be contained goes up significantly.

Check Out the Financials
Balance Sheet
After the major players and the divisions they represent are identified, the next step is to analyze the company's financials. Specifically, an investor should review the last balance sheet for several items. First, take a look at how much cash the company has, because this will be its lifeline. Can the company afford to weather inquiries from the major regulatory bodies and a shareholder suit if one should emerge? If not, consider selling out the position! For example, a large company with $9 billion in cash and cash equivalents on its balance sheet would be in a much better position to weather a scandal than a company with fewer assets and a smaller number, such as $309 million, on its balance sheet.

Liquidity
Next, calculate the company's liquidity situation by examining its current ratio. The current ratio is calculated by dividing current assets by current liabilities. This ratio will help you to determine what kind of breathing room the company will have if things get real hairy. Depending on how conservative you want the estimate to be, you can change the composition of the current assets value. Keep in mind that not all short-term assets (such as inventory) can be easily liquidated to pay off liabilities. For the most conservative estimate, you can just use cash and cash equivalents as assets.

In a current ratio, current assets should outnumber current liabilities by a ratio of at least 2:1. If a company has a lower ratio, it will have an awfully difficult time juggling its debts - not to mention a pile of legal bills - if it is involved in a scandal.

Footprints in the Footnotes
Next, look at the accompanying footnotes to the financials in the company's latest filings with the SEC. In those footnotes, the company may reveal whether it holds an insurance policy that could offset some of the legal costs that might arise in a scandal. Incidentally, these same footnotes may also reveal whether the company has set aside any money in a reserve account for the same purpose. An insurance policy and/or a reserve account would signal that at least some sort of cushion exists that could protect the common shareholder.

Assessing the Damage
The next goal for the investor should be to determine what the ultimate financial impact of a scandal might be on a particular company. How many quarters of earnings will need to be restated if any? Will the numbers being restated be significantly askew from the new numbers?

Obviously, some guessing will be involved. By listening to the facts of the case and doing one's own homework, the investor should be able to come up with an educated guess. For example, when news broke that Enron's officers had been masking debt by conducting a sizable number of off-balance sheet transactions and booking revenues improperly, it could be assumed that multiple quarters would be affected, and that the dollar amounts of fraud (while not precisely quantifiable) would render previous earnings reports meaningless.

In some cases, it may be impossible to comprehend the potential future financial impact of a scandal. In these instances, entire years of previously filed financial statements may have to be restated.

Reaction to the Scandal
What should investor's do if they find themselves holding a scandal stock?

The only logical answer is to sell the stock and to avoid becoming involved again unless and until the outlook for the company and the common shareholder clears.

The Bottom Line
Corporate scandals have and will continue to make headlines, but rather than wait for the media to cover the event, investors should conduct their own investigations in an effort to either preserve their capital and/or to isolate an appropriate entry point into the stock before it rebounds.

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