The Speculator
Buy the very worst
stocks you can find
We've found a twist in the restatement debacle that
could make you money: The companies doing the worst before they restate are
often the strongest coming back.
If the last three years in the market were made into a
horror film, it might be named “Restatement!” Everything seems fine at the
beginning; companies report record profits quarter after quarter. Shares are
rising nicely, permitting the companies to raise capital. But suddenly, a low
vibrato in the basses foreshadows trouble.
As
shareholders watch in terror, crazed accountants tear the veils off the
companies that had supposedly been doing so well, revealing them as gutted,
bleeding and headed for bankruptcy court. One after another, executives throw
down their genteel masks, revealing fangs dripping with severance payola.
We have a
sequel in mind. It’s called “Revenge of the Shareholders,” and we have
calculated a way that we expect will win many of us parts, or at least help us
turn a profit. (Please follow our directions precisely, and don’t write to complain
if Central Casting turns you down.)
We
noted in our Jan. 9 column that companies that restate earnings do
significantly better than average in subsequent months. But we warned high
variability made trading on our results exceedingly risky (think WorldCom
It
turns out that results significantly improve if you limit your purchases to the
stocks that did the worst in the months leading up to the restatement. We’ll
give chapter and verse below.
Three that bear watching
In
the last two months, 10 companies have either restated earnings or announced
they would do so. Of these, three were rocked by more than 20% in the prior
three months relative to the market. These are Charter Communications
(Note
that two of the three gave variants of the widely used Arthur Andersen excuse:
“Our former CFO was from Andersen…” “Andersen was our accounting firm, so we
reviewed our statements, and…”)
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Three stocks to watch for the next three months |
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A pox on all of us
Only
a decade ago, financial statements were still considered solid and believable.
Back then, only five or six dozen companies a year restated, says Jim Owers, a
Robinson School of Business professor at Georgia State University who has
studied restatements for more than a decade. Last year, the number of
“do-overs” increased to a record 330 -- up 22% from 2001, a Huron Consulting
Group study found. Blame the increase on the atmosphere of the 1990s.
“Investors were demanding ever-more growing profits and revenues,” Owers told
us in an interview on Tuesday. “The consequences of missing a forecast when
other firms were meeting them were so dramatic that in order to meet the
expectations the company had let analysts develop, it appears as though the
ethical framework diminished.”
Earnings
restatements are as terrible for the rest of the market as for the individual companies
involved. They create a sense of fear that all past financial statements are
suspect and could be revised at any time. They raise questions about management
and auditors. At the end of the line, they cast a negative light on the
efficacy of regulation. Uncertainty thus increases for the market as a whole,
driving prices down as investors demand a higher return to compensate them for
the risk of holding shares.
And
that’s not all. A perception that the rules of the game are unfair and shifting
can lead to the breakdown of our market economy. That’s why, after the fall of
the Berlin Wall, so many former Communist countries had problems with markets.
The system of enforcing contracts, the accuracy of accounting system and the
rules regarding insider trading were all in question. Such problems were to be
expected in countries that had suffered through non-market economies for
decades. But here in America, how can numbers, auditors, managers and
regulators all to be suspect? No wonder the market fell so far in this
environment.
Considerable
academic research confirms the negative impact of earnings restatements on
individual companies. Owers co-wrote a paper with Ronald Rogers and Chen-Miao
Lin called “The Informational Content of Different Categories of Earnings
Restatements.” They found that investors reacted most negatively to
restatements when the chief executive left around the same time and accounting
issues were cited as the reason. “They lose about a third of their value in
about three days,” said Owers, who is working on an update. The stocks that
tend to bounce back are those that cited legal or regulatory reasons as the
ultimate settlement may be less onerous than the market feared, according to
Owers. Other commonly cited reasons include acknowledged fraud and changes
related to a restructuring, merger, dividend, joint venture or stock split.
It’s
remarkable how many companies fall significantly before their restatements. The
170 companies in the Owers studies went down an average of 13 percentage points
relative to the market from 10 days before the announcement through one day
after. We found a similar phenomenon in our own study. In 2002, the average
change in the three months before restatement was 20 percentage points worse
than the comparable period’s move in the S&P 500 ($INX).
After the announcement, however, we found that the road
forks in an interesting way.
A strategy -- but no guarantees
We
took all the companies that restated earnings in 2002, and ranked them by their
performance in the three- and six-months periods before the restatement. We
then calculated their performance through year-end. The results are
eye-opening:
The
25 companies that performed worst in the three months before their earnings
restatement produce an average 53% gain through year-end. The 25 best lost an
average 2.8%.
Results
for the best and worst performers six months before their restatements are
similar. The 25 worst produced an average gain of 47%, while the best before
restatement lost an average 4.4%.
Of
course, there’s no way to know if the company will eventually land in the
year’s 25 best or 25 worst. A good rule of thumb is to buy companies that
underperformed the market by at least 20 percentage points in the three months
before the restatement.
We
calculated performance for the three months after restatement (from the first
trading close after the announcement) and found similar results. The 25
companies that did worst relative to the market in the three months before
restatement beat the S&P 500 by 20 percentage points, on average, over the
next three months. The 25 companies that performed the best before their
restatements lagged the S&P 500 by 3 percentage points over the comparable
periods. The table shows some examples of companies that jumped in the three
months after announcing restatements:
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2002 restatements: before and after |
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The
system does not work every time. Some companies just kept falling after the
restatement announcement. Among the basket cases were Peregrine Systems
Two
prime examples of companies that beat the S&P in the three months before
the announcement and went on to post lackluster performance include Transaction
Systems
Under
no circumstances should an investor buy just one restatement stock in hopes of
favorable results. Only by buying a basket of stocks can the inevitable risk of
major losses in individual stocks be mitigated, and then only somewhat.
A
list of companies that restated earnings in 2002 and so far in 2003 is
available on our Web site, along with the regression
equation we use to estimate expected return. We encourage all readers to e-mail us
with comments, criticisms and augmentations. We answer all queries and the
feedback relating thereto will hopefully enable you and us to improve.
Final note
We
often change our views on markets every day, but regrettably our articles are
researched, written and published several days after our original ideas. Right
now, we have the impression once again that the public is being invaded by the
Body Snatchers -- the ones trying to take all hope away. Our thoughts on that
and our updated views on the market are on our Web site.
At the time of publication, neither Victor Niederhoffer nor
Laurel Kenner owned any of the stocks mentioned in this column.