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Can Tainted Stocks Make Good Investments?

In the post-Enron era, scandal doesn't always tarnish a company for life. There can be buying opportunities. Here's what to look for.

Enron and WorldCom are history. Adelphia? Dismembered. Peregrine Systems? Table scraps for Hewlett-Packard. The list of recent corporate deaths from accounting fraud and CEO malfeasance is a long one -- just check out the White Collar Crime Prof blog sometime.

But before you consign all notorious companies to the investors' dust bin, consider the curious duo of Tyco (TYC) and HealthSouth (HLS). Former Tyco CEO Dennis Kozlowski is serving an eight-year prison sentence for misappropriating at least $400 million of company funds. Yet Tyco, a conglomerate, is thriving. From June 3, 2002, when Kozlowski quit, through May 1, 2007, Tyco stock is up 145%, thanks to leadership by respected ex-Motorola honcho Edward Breen and a good mix of core businesses. Longtime Tyco investors are still underwater. But opportunists and bottom-fishers have cleaned up.

HealthSouth is a chain of rehabilitation hospitals and sports-medicine clinics. Ex-boss Richard Scrushy was convicted in 2006 of bribery and conspiracy charges, and ordered to repay HealthSouth $51 million. In April 2007, he agreed to pay a $81 million settlement to the Securities & Exchange Commission. But HeathSouth shares, which fell below $1 in March 2003 when the government first charged Scrushy, are now at $21. They could head higher if Wall Street likes the decision to sell its surgery and diagnostics divisions, invest the proceeds smartly in new operations, and fix its balance sheet by downsizing the huge corporate "campus" Scrushy built.

Two flukes? Maybe not. The rate of CEO dismissals is three times higher now than in the 1990s, and while that's not all because of personal or financial misconduct, boards of directors are less tolerant of shenanigans in the post-Enron era. This means investors can expect more probes and, possibly, more impaired corporate reputations. So can you expect to invest for next to nothing and score a big return? "If you have nerves of steel, sure," says Peter Henning, a law professor at Wayne State University in Detroit and co-editor of the White Collar Crime Prof blog. But be careful.

Henning is a former federal prosecutor and SEC investigator, so he knows of what he speaks. He offers these two key factors to consider when you see a company like HealthSouth trading for 40 cents. First, ask yourself about the fundamentals. If there's still a functioning business with clean management (often the key people are new to the organization), you have a good chance for a turnaround.

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Second, is the company bankrupt? "If they go into bankruptcy, you're dead," says Henning. Don't fight this. In most bankruptcy reorganizations, even if the company survives, the "old" common stock is likely to be canceled with no value while bondholders and other secured creditors get first dibs on new shares. Delta Airlines is a current example. Tyco never ran out of money, so it didn't have to file for Chapter 11. HealthSouth escaped bankruptcy reorganization when a restructuring expert found enough assets to sell to raise cash.


If the company in question can last until it gets new leaders and leaves them something to work with, the stock can recover. Here's a third factor to consider: The more outrageous the misconduct and the harder the stock's crash, the sooner the window for a bounce. The market may be factoring in a bankruptcy filing, and if that doesn't happen, the stock could leap. Then, after a few months, the inconvenient truth sets in that fixing the company is tougher than it looked. The speculative stock buyers happily cash in on the bounce. Then the shares stall or weaken -- another opportunity to consider.

Below, we take a look at ten more cases where the stockholders suffered through one or more ethical or legal problems. Which of these stocks seems to have a future as a high-risk investment? We offer our best estimate for each.

1. Ahold

This Dutch supermarket operator (symbol AHO; share price $13) gets three-quarters of its revenue from U.S. chains and an American wholesale food operation.

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Misdeeds: Charged in 2004 with two inflating profits in U.S. operations by $880 million and falsifying the earnings of some joint ventures. Former CEO and CFO were convicted of fraud in Dutch court and fined but not sent to jail. The company restated several years of financial statements and settled an investor lawsuit for $1.1 billion.

Recent stock performance: Stock fell to $3 from $11 overnight in 2003 when the company announced the fraud. It rebounded to $10 in a few months when bankruptcy fears lifted, was flat for a while, and is up 20% so far this year. It closed at $12.73 on May 1.

Our judgment: Avoid. The company is clean now, but it's a sluggard even by the standards of its slow-growth industry. Its plan is to boost profits by cheapening its stores and negotiating lower wages and benefits. In a competitive service industry that's gotten glitzier, downscaling won't work.

2. AIG

AIG (AIG; $70) is one of the world's largest diversified insurance companies and is also a major provider of investments and retirement plans in the U.S. and overseas. AIG is especially big in Asia.

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Misdeeds: Investigations of improper insurance sales practices and a boardroom soap opera surrounding founder Maurice "Hank" Greenberg made AIG front-page news in 2003 through 2005. The process culminated in Greenberg's resignation, the restatement of earnings downward by $4 billion over five years and, some say, fame for then-New York attorney general Eliot Spitzer, now the governor, who led the investigation.

Recent stock performance: The stock has regained respectability because no other legal shoes have dropped since the departure of Greenberg and other ex-honchos. Once $100, AIG fell into the $40s in 2003 and has had several false recoveries. It's now meandering around $70, but with higher dividends than under the old regime. The burst of catastrophes in 2005 hurt. All in all, it's been a fair turnaround.

Our judgment: Buy. The scandal didn't harm AIG's vitals, such as life insurance and investment management in Asia, or its own enormous securities holdings. Its brand name was never a household word, so the scandal didn't hit home like tainted cat food. The price-earnings ratio on forecast 2007 profits is 11, and the current price to book value is 1.7. The former is low and the latter is high enough to tell you the market finds the stock not to be radioactive but also at a level where it could improve. The property-casualty insurance market is currently soft for insurers. It will harden again when there's another round of disasters.


3. Apollo Group

The owner of the University of Phoenix and the College for Financial Planning, Apollo (APOL; $48) is the largest for-profit education provider, with both virtual and actual "campuses." It hopes to expand into online high schools as well as to Brazil, China, India and Mexico.

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Misdeeds: Crowded with what analysts call "headline risk," Apollo has been under threat of delisting by Nasdaq because of tardiness with audited financial statements since spring 2006. Apollo is one of many companies to admit to backdating options for executives, the revelation of which forced its chief financial and accounting officers out of the company in 2006. The former CEO had walked out a few months earlier without warning. There's also tax trouble and a whistle-blower lawsuit now headed for the Supreme Court. (Apollo says the suit should be thrown out.) There are recurring controversies about the quality and marketability of all for-profit degrees, a cloud over this entire industry, though the University of Phoenix is accredited.

Recent stock performance: C's and D's. The stock is down more than half since peaking in 2004 as Apollo reduces its earnings guidance and sows confusion with its late financial reports. (It's been issuing unaudited statements.) The designs on China, India, Brazil and Mexico are in the early and conceptual stages.

Our judgment: Avoid. As a former glory stock, Apollo retains die-hard boosters among analysts and fund managers who think the concept of paid adult education is seductive. But there are other growth industries. If you owned this stock in the 1990s, you did well. But the road from here is a lot rockier.

4. CA

Formerly Computer Associates, CA (CA; $28) is one of the world's largest software companies, with a broad product line for big and small businesses and personal users.

Misdeeds: Former CEO Sanjay Kumar pled guilty to securities fraud and obstruction of justice last year and is serving a 12-year sentence. Seven other former CA execs, who like Kumar were all big holders of stock and options, admitted they conspired to inflate the company's earnings by backdating contracts and other financial lies. CA was actually unprofitable for 2001 to 2004. Today it ekes out narrow profits.

Recent stock performance. CA might have saved itself by settling with the government to compensate wronged investors only $225 million, but the long investigation hurt its competitive position. (Kumar says he'll repay $800 million to investors.) The stock bottomed at $7 in 2003, so it looks like a winner in that it's now in the high $20s. But it's lost about 4% since the government settlement in 2004, underperforming the uptrend in tech and software.

Our judgment: Avoid. The bosses are new hires from the outside. But revenue and orders and measures of profitability, such as return on equity, are all unexciting, both by themselves and compared with competitors. CA shares are also expensive relative to the earnings predictions. BMC, Microsoft, Oracle and SAP are better investments.

5. DHB Industries

This small Florida-based company (DHBT.PK; $6) makes body armor and bulletproof vests for the military and police.

Misdeeds: They're colorful. Here's a complaint from the SEC in August 2006: The former chief financial officer and chief operating officer "routinely overstated the value of DHB's inventory by tens of millions of dollars" (this in a company with annual sales of $300 million) and performed other accounting tricks. The SEC says the two officers got more than $8 million together from bonuses and by selling stock at inflated prices. DHB himself, David H. Brooks, the former chief executive officer and founder and chief stockholder, is being investigated by the SEC after he collected tens of millions of dollars. He's on "indefinite leave" while his fate is sorted out.

Recent stock performance: Improved. A new CEO, retired Army general Larry Ellis, owns up to the ugly past and has brought in turnaround specialists. Production continues, with new products -- which is good because the military rejected some of the old vests when Brooks was running the place. There's a new credit line. The stock, which went from $1.50 to $21 during the pump-and-dump era, is back from $1 again to $6, though it's trading on the pink sheets. The American Stock Exchange evicted DHB in 2006.

Our judgment: Buy -- with play money. If you believe a stained company can redeem itself and that you can trust its financial statements -- and in the Sarbanes-Oxley era the CEO has to attest to their accuracy or could go to jail-- DHB has a real business.


6. Doral Financial

Doral (DRL; $1) firm owns of a bank in Puerto Rico and a mortgage company. It recently sold its New York City bank branches.

Misdeeds: Restated earnings from 2000 through 2004 and issued several embarrassing statements about how it booked undeserved profits from misclassified mortgage sales. The New York Stock Exchange is threatening to delist Doral for late filings of financial statements.

Recent stock performance: Way down. The stock, around $50 when the negative stories broke, is below $1.50 despite the recruitment of a new CEO from General Electric (it was $4.50 when he was hired in August 2006). Doral is having investment bankers see about restructuring or selling the company and refinancing its long-term debt. The debt comes due this summer, so unless it gets new capital, the company will be in a real pickle. It might not survive.

Our judgment: Buy only with poker chips. If you think a $1 stock is worth a shot, especially when it could be delisted (which would put it off-limits for many funds and institutional investors), you're brave. In late April, Doral issued an update that wasn't encouraging and warned of dilution if there is a restructuring. The shares dropped another 20%. It does have a book value of $4 a share, and bank stocks, even sick ones, generally sell for more than book value. Outfits with more egregious histories have managed to survive. But the odds are long on this one making it back to real prosperity.

7. Jackson Hewitt

Jackson Hewitt (JTX, $28) is a franchiser of tax-preparation offices, with an emphasis on loans to the lower-income customers secured by their tax refunds. "Financial services," as that's called, is a key source of Jackson Hewitt's profits. On April 10, Jackson said it would stop marketing early-stage loans made in the advance of refund anticipation loans.

Misdeeds: Franchisees were nailed in April by the Justice Department and IRS for falsifying tax returns and accepting kickbacks of what the government says are undeserved refunds. Lawsuits allege many audacious schemes, costing the Treasury $70 million.

Recent stock performance: Down. This scandal is so new the company hasn't reported any earnings since it broke, but Jackson Hewitt shares weren't doing much anyway for more than a year. The stock could plunge more than the 20% it's already lost if there's lasting damage to the brand's reputation or the top management gets sucked into the scandal that's been described as wayward franchisees. Either way, this can't be good for the ability to sell franchises.

Our judgment: Avoid. There's nothing tangible about the tax business, which depends on trust. The government is not accusing the vast majority of Jackson's tax preparers of wrongdoing, but the episode has to raise doubts about the organization's supervision, training and quality control. This is a prime example of the cockroach theory. It's best to stay away from such stocks until it's clear the pests are all gone.


8. Marsh & McLennan

Marsh & McLennan is (MMC, $32) a giant worldwide insurance broker and benefits-consulting firm. It owned the Putnam mutual funds until February, when it sold Putnam to a Canadian insurance company.

Misdeeds: Caught in a complicated insurance scandal called "bid rigging," which also involved AIG. In layman's terms, think of it as price-fixing. Marsh agreed to set aside $850 million in restitution back in 2005. Putnam was also one of the biggest fund sponsors nabbed in the mutual fund industry's scandal for letting favored short-term traders get better prices than the mass of shareholders. That and poor investment performance drained money from Putnam's funds, costing Marsh stockholders because Marsh didn't get a top price for the fund company.

Recent stock performance: The pattern is similar to AIG: a stock that used to trade richly struggles several years later. Marsh used to be well over $50 and, despite a stronger stock market, it now fights to stay above $30. But there's not much risk at this level. Putnam won't be missed, and a survey of insurance buyers by Lehman Brothers says Marsh has stopped losing market share from when it was under investigation.

Our judgment: Give it three months. Marsh could recover if the hurricane season gets active and insurance rates go up. MMC is a broker and gets commissions from insurance premiums but doesn't take the claims risk itself. Higher rates help.

9. Qwest

Quest (Q; $9) is a merger product and successor to an old Bell spinoff, US West. It's not as diversified as other Bell descendants because it never bought a wireless company. More than half the revenue is from plain old telephone service, a declining business.

Misdeeds: Former CEO Joe Nacchio, who ran things his way from 1997 to 2002, was convicted in April on 19 of 42 counts of securities fraud and insider trading for lying to investors. The stock, over $50 during the high-tech mania of 2000, fell to $1 in June 2002, about the time Nacchio was forced out of the company. Subsequently, Qwest restated its financial statements to the tune of billions.

Recent stock performance: Up. There's been a post-Nacchio bounce because, honestly, who wouldn't take a chance on a big Bell System property trading for $1 a share, even if the whole company is a consistent money-loser? Those lottery tickets have cashed in, as Qwest is trading at more than $9, a five-year high. That's still a gigantic loss if you worked there or trace shareownership to the days of US West and the old AT&T. But it validates the point about buying businesses with real fundamentals and that are not in bankruptcy at blown-up prices. Qwest just got a share of the U.S. government's largest-ever telecom contract, in partnership with Verizon and AT&T. It's even profitable again -- 30 cents a share over the past four quarters.

Our judgment: Buy. There's always the chance someone bigger will buy the company or the earnings will recover faster than the forecasts. At $9, you are paying 30 times those past 12 months' earnings as compared with a P/E of 18 for Verizon and 20 for AT&T, which also have good dividends. But those are blue chips. Qwest is a speculative gamble -- and one worth taking.

10. Tenet Healthcare

The firm (THC; $7) operates 57 full-service hospitals, mostly in large cities and suburbs, such as Atlanta, Dallas, Los Angeles, South Florida and Philadelphia.

Misdeeds: The government could have used a federal building across the street from Tenet's headquarters in Dallas. In June 2006, Tenet settled with the Justice Department, coughing up $725 million plus interest in a case about Medicare overbilling. In January 2006, Tenet and Justice settled shareholder lawsuits and claims for $140 million. The SEC weighed in with charges that four former executives and the company covered up that earnings growth from 1999 to 2002 was because of those inflated Medicare receipts. Tenet settled this for $10 million and a black eye. The IRS found $207 million plus interest in back taxes.

Recent stock performance: Awful even compared with other hospital stocks, which aren't great shakes. Tenet stock's pattern tracks the financial misstatements. From 2000 until 2002, it soared from $10 to $50. When the problems came to light, it did a round trip and has been below $10 since the fall of 2005. The settlements with the government didn't produce even a small relief bounce.

Our judgment: Avoid. Remember that comment about fundamentals? Let's assume the feds are through with Tenet. Jeb Bush, the President's brother and former governor of Florida, just joined the board of directors, which presumably he wouldn't have done unless he saw the company as clean. However, Tenet still has plenty of business and financial problems and is short on cash. With no earnings and a book value of only 56 cents a share, $7 is steep, and the balance is frightful. Some 35% of revenues are Medicare and Medicaid billings, which never seem to be enough for what investors wish, nevermind what doctors and hospitals need. Tenet also says it is hit hard by bad debts and uninsured patients, which is a challenge because it is largely an inner-city operation. If California and Florida enact plans to insure everyone, Tenet would be a beneficiary. Then you might look at the stock.