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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.

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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.

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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.

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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.

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