Buy a 'Backdating' Stock?
Why Shares Don't React Like Regulators
By JOANNA L. OSSINGER
February 2, 2007; Page C2
For the scores of companies swept up in the options-backdating scandal, repercussions have included financial restatements, regulatory investigations and executive resignations.
In what would ordinarily seem like bearish news, however, there may be some buying opportunities. A number of bets have paid off as many stocks have dipped on adverse disclosures about possible backdating, only to bounce back within weeks, days -- or even hours.
Gartmore Small Cap Fund had nearly a 30% return last year partly because it purchased stocks when they fell on backdating news, says Charles Purcell, senior portfolio manager of the $937 million fund. "The underlying businesses were the same, and we were going to get past this eventually," he says. "It's taking advantage of the 'groupthink.' "
One of Gartmore's buys was Foundry Networks Inc., a manufacturer of telecommunications-network gear. In late June, Foundry announced a federal inquiry into its options practices, sending its shares down about 10% to near $9 in the subsequent weeks. But Foundry's stock bounced back to more than $14 while the investigation continued, thanks to a strong third quarter. The share price fell only 2.1% Jan. 22, the day Foundry announced the results of the inquiry and stripped its chief financial officer of financial-reporting responsibilities and unseated its chief executive from the chairmanship. The stock is once again trading on the Nasdaq Stock Market above $14 a share.
"In hindsight, it looked like free money," Mr. Purcell says.
The rise in shares of Foundry and other companies with potential options-backdating issues highlights a big difference between the current rash of investigations and accounting scandals on Wall Street of the past decade. Stocks of companies such as WorldCom and Enron never recovered from their accounting improprieties because they had large effects on the companies' bottom lines. The options scandals fall into the realm of executive compensation, which historically has had less impact on stock prices. While the additional payouts are technically coming out of investors' pockets, the amounts make a relatively small dent in companies' financial health.
Brian Barish, president and director of research at Cambiar Investors, a Denver investment-management firm with more than $8 billion in assets, says he doesn't want to trivialize the backdating issue because "it is still cheating" if done in violation of securities rules. But, he says, even in cases involving wrongdoing, "it didn't bespeak other ethical violations in the business."
Helping embolden investors have been the high-profile cases of stock prices that have overcome downward pressure from the backdating scandal. Apple Inc., for instance, reported on June 29 irregularities in the granting of options, including a grant given to Chief Executive Steve Jobs. The next day, the stock price declined 2.9% to $57.27 on the Nasdaq. But by the end of July, the shares were back over $60 amid strong earnings. Shares are now trading in the $85 range thanks in part to the results of the company's internal investigation, which absolved Mr. Jobs of misconduct as well as the buzz generated by Apple's new iPhone. A government inquiry is continuing.
To be sure, investors have good reason to be wary when a company falls under an options-investigation cloud. It is illegal to date options earlier than the time they were awarded, which can make them more valuable, if it isn't properly disclosed to shareholders.
Shares of some affected companies have gone down after initial announcements and stayed down. Vitesse Semiconductor Corp. was trading on the Nasdaq in the mid-$3 range before a March 18 page-one Wall Street Journal article highlighted an unusual pattern of options grants to the then-CEO. The company launched an investigation which uncovered numerous accounting irregularities and led to the termination of three executives, one of whom remains on the board. Vitesse's stock price is currently at less than $1 a share in over-the-counter trading.
A Wall Street Journal analysis aided by Birinyi Associates of the stock prices of more than 120 companies whose names have surfaced in options-backdating investigations shows that nearly 60% of those firms underperformed the Nasdaq Composite Index last year. The Dow Jones Industrial Average outperformed 70% of those stocks last year. The DJ Wilshire 5000 index, a broad market, beat about two-thirds of the companies' stocks. But many of these stocks probably underperformed the market averages for reasons other than the options scandals and there are enough exceptions to attract contrarian investors. The companies became caught up in options investigations at different points in the year, and were at different points in resolving the investigations at year's end, so this is simply a rough comparison of performance.
Also, as the options-backdating discussion evolves, investors are recognizing that the degree of wrongdoing -- if there is any -- covers a wide spectrum. Three former Comverse Technology Inc. executives have been charged with criminal fraud; two have pleaded guilty. There also have been a number of high-profile executive departures, including CEOs at companies such as UnitedHealth Group Inc., CNET Networks Inc. and McAfee Inc.
But some of the inquiries have resulted so far in little more than financial restatements. Some companies have conducted internal investigations that exonerated key executives, which has generally seemed to satisfy Wall Street even if federal examinations are continuing.
Last month, for instance, Take-Two Interactive Software Inc. said in an SEC filing that a former chief executive "engaged in a pattern and practice of backdating options." Shares dipped slightly on the Nasdaq, but rebounded later in the day. "People started to think maybe they were cleaning up their act," says Arvind Bhatia, an analyst with Sterne, Agee & Leach in Dallas. Mr. Bhatia rates the stock a "sell" and Sterne trades in Take-Two's shares. It hasn't provided any investment-banking services to the company. |
