Advertisement
Markets

Profit From Scandal

Bad news sometimes makes a stock untouchable -- sometimes it creates opportunities.

A company embroiled in a scandal -- especially an accounting scandal -- can disappear in a heartbeat. WorldCom looked "cheap" at $4. A week later -- poof! -- the company was gone. So heading for the hills at the first whiff of trouble would seem like the smart thing to do.

Advertisement - Article continues below

Once you know a company's numbers can't be trusted, you would have to be a masochist to own the stock, right? Well, not always. Sometimes this logic is flawed precisely because it seems so obvious. Occasionally, scandal creates wonderful opportunities.

In 1963, American Express discovered that $150 million of salad oil that was supposedly in the warehouse of an affiliate wasn't. Amex had been defrauded. The stock tanked. But Warren Buffett stepped in to buy after his research showed that consumers were still using Amex's charge card. He tripled his money in three years. More recently, you could have profited by investing in solid companies such as Apple and Broadcom after they became embroiled in options-backdating scandals.

Room to run. My attempt to benefit from a disgraced company involves ArthroCare, a medical-device stock. I bought the stock in early May at $8.59, and it closed at $14.75 on August 7. I think the stock could climb another 50% over the next 12 months.

Advertisement - Article continues below
Advertisement
Advertisement - Article continues below

ArthroCare makes surgical instruments based on coblation technology, which allows surgeons to operate at lower temperatures than conventional surgery, causing less damage to tissue. The company has a profitable niche in sports medicine and ear, nose and throat procedures. Its surgical "wands" made it a hot stock, and it soared from about $9 in February 2003 to $66 by November 2007.

And then the market took a scalpel to ArthroCare shares. Allegations had surfaced that the company's smallest but fastest-growing division, DiscoCare, which specializes in spinal procedures, had encouraged doctors to buy its equipment by promising to pay them back for any insurance-reimbursement shortfalls. DiscoCare also allegedly paid doctors and lawyers to refer patients for unnecessary spinal procedures.

The Justice Department and Securities and Exchange Commission launched investigations, as did two states. The company said its financial statements, going back to 2000, could no longer be trusted. The chief executive, the chief financial officer and the head of sales resigned. ArthroCare's shares were delisted from Nasdaq and now trade on the pink sheets under the symbol ARTC.PK.

Advertisement - Article continues below

Last March, the stock hit a low of $2.89. In one of those wonderful market paradoxes, that was a crazy price, but it also made perfect sense. William Plovanic, an analyst at Canaccord Adams who rates the stock a speculative buy, explains: "As the level of uncertainty increased, people sold. The bad news created an aura that made the stock untouchable. Its inability to file financials scared investors to death. Finally, its delisting forced selling because most ... funds can't own pink-sheet stocks."

Chaim Davis, who runs Revach Fund, a Miami-based hedge fund, bought the stock near its low, and it's now his largest position. "When looking at ArthroCare, I asked myself four questions," he says. "Is the loss manageable? Is the brand permanently damaged? Are the other units in the business adversely affected? Is the board of directors acting in a way that benefits shareholders?" After talking to doctors, analysts and management, Davis concluded that investors would eventually realize that the legitimate part of ArthroCare was highly profitable.

Analyst Plovanic says that the stock's price will likely rise as the scandal plays in reverse. An upcoming earnings restatement "should be a catalyst, as should relisting on Nasdaq," he says.

Many people know about the ArthroCare scandal. But few of them know it's over.

Columnist Andrew Feinberg writes about the choices and challenges facing individual investors. Accounts he manages own shares of arthrocare.

Advertisement
Advertisement

Most Popular

Medicare Basics: 11 Things You Need to Know
Medicare

Medicare Basics: 11 Things You Need to Know

There's Medicare Part A, Part B, Part D, medigap plans, Medicare Advantage plans and so on. We sort out the confusion about signing up for Medicare --…
September 16, 2020
5 Unfortunate Estate Planning Myths You Probably Believe
estate planning

5 Unfortunate Estate Planning Myths You Probably Believe

These all-too-common misconceptions can steer your estate plans in the wrong direction right from the start. Here’s how to overcome them and tips to b…
September 17, 2020
Election 2020: Joe Biden's Tax Plans
taxes

Election 2020: Joe Biden's Tax Plans

With the economy in trouble, tax policy takes on added importance in the 2020 presidential election. So, let's take a look at what Joe Biden has said …
September 18, 2020

Recommended

Retirees, Create An Emergency Fund for Rental Property
Business Costs & Regulation

Retirees, Create An Emergency Fund for Rental Property

Build a cushion to protect your income from an unforeseen crisis.
September 15, 2020
25 Small Towns With Big Millionaire Populations
investing

25 Small Towns With Big Millionaire Populations

Large concentrations of high-net-worth households are found in surprising locales across the U.S. Check out the latest list of American small towns te…
September 15, 2020
Bankruptcy Filings Chalked Up to COVID-19
investing

Bankruptcy Filings Chalked Up to COVID-19

Bankruptcy filings pile ever higher as the COVID-19 pandemic continues to weigh on the American economy. Here are 24 big-name companies that have soug…
September 11, 2020
What Does the Upcoming Election Mean to Your Investments?
investing

What Does the Upcoming Election Mean to Your Investments?

For smart investors, the surprising answer may be very little. Here’s why, and what you should do (and not do) as election season heats up.
September 11, 2020