Tuesday, October 9, 2007

Some Healthy Investor Skepticism

It seems as though Enron is a distant memory. The markets have already discounted the sub-prime meltdown and the demise of New Century Financial (see old post pre-collapse with warning signals). The headlines are now focused on Iran and less importantly, Anna Nicole and abysmally, whether Sanjaya will win American Idol. Although Sarbanes-Oxley was meant to prevent another Enron, all it really did was make the U.S. exchanges less desirable to list on. Note the resurgence of the London exchange and deceleration of U.S. listings. Sarb-Ox didn't really and can't address the true root cause of Enron: unbridled greed and lying. Just because the CFO and CEO now need to validate financial reports, it doesn't preclude them from the same behaviors that led to the demise of Enron. Therefore, continued vigilance and skepticism is required, especially on the part of individual investors. And if put to the right use, it can be quite profitable.

Markets are efficient, but not quite so for the masses, who generally don't have access to program trading and advance warning of impending disasters. What small investors can do though, is be skeptical. Questioning abnormal projections, erratic and abhorrent behavior on the part of company executives can save you money; or make you money if you want to hedge your portfolio with stocks just itching for a crash. Rather than going 100% equities in a portfolio, broad diversification is important. This means a lot of things to a lot of people. To me, it means some commodities, some international, some small cap, large cap, real estate, etc. It also means a component of my portfolio that zigs when the majors zag. A nice way to do that is to buy puts on the major indices (rudimentary and somewhat counterproductive), by owning some funds that employ hedging strategies (more successful, but not always a perfect negative correlation; see earlier posts on hedge funds for the masses) or finally, by shorting (for sophisticated investors only) or buying puts on overpriced stocks (easy to do; options offered for most listed companies with some volume).

What are some warning signs of companies that are about to go down? In hindsight, a lot of these crashes were staring us all in the face and only a few vigilant analysts or hedge fund managers were crying foul. In some cases, there were too far out ahead of the pack and had to cover their positions as the stocks rallied. For those who could hold out or timed it better, they made a killing. Is it coincidental that Dennis Koslowski was buying thousand dollar shower curtains and throwing lavish parties for his wife's birthday with company funds while the stock was poised for a precipitous decline? Did it seem odd that Enron executives were telling their employees to hold their company stock and cursing (for real, in recorded conference calls) at analysts who questioned the sustainability of their earnings from fictitious subsidiaries?

What else to watch for? As Cramer would say, when you hear "accounting irregularities", RUN. By then, it's usually too late for individual investors. That's where some independent research and healthy investor skepticism comes in handy. These two sites are great resources for independent skepticism.

Stocklemon, newly named Citron Research (I guess they're all grown up now): This site is a MUST for any small cap you're thinking about. I was very pleased with the quality and depth of the research completely outing scams and shell companies. They routinely report on the back-office pump and dump schemes, the family members who happen to be the "analysts" reporting favorably on the stocks, and phone numbers listed for companies that are just unused cell numbers. If you're even thinking about investing in a smaller unproven company for that speculative part of your portfolio, check it out here. If you're lucky enough to find a stock that you don't think is all it's cracked up to be AND it lists put options, this may validate your opinion.


Another great resource is Footnoted.org. This site scours 10-K, annual reports and other SEC filings for things that look...strange. For instance, they noted that the CEO of ITWO was alloted 6 times the annual spending compared to last year for being ferried around on the company jet for about a million dollars. The site abounds with information that needs to be reported, but appears in the fine print and requires a seasoned investigator to highlight.


Everydayfinance Blog: http://www.everydayfinance.blogspot.com