Red Flags: 3 Signs a Stock May Crash

A couple of months ago, while I was cruising in my car, I got pulled over and ticketed, allegedly for speeding. I assure you I did nothing of the kind: My car simply has a 9,000 RPM redline and a sport exhaust, which results in a beautiful exhaust note that makes me a target for law enforcement. I went to court, and while I probably could have gotten off altogether, I accepted an eight-hour detention in traffic school.

I did my time last week: The deadpan humor in the instructional videos they made us watch knocked me out of my seat. But I also picked up some interesting factoids:

1. One in five people is involved in a traffic accident every year.

2. In 37% of all traffic accidents, the victim did nothing to avoid the collision.

3. Half of all fatal traffic accidents involve single vehicles.

Sounds like the stock market to me.

Let me explain. Like traffic accidents, investing accidents occur more frequently than we would like to think. In many of those accidents, the investor is either oblivious to the impending crash or unwilling to take action when the warning signs appeared. And most importantly, when the red flags are present and an investor simply ignores them, he has the equivalent of a single-car accident -- nobody to blame but himself.

Below are three signs that your stock may be ready to take a plunge. These are borrowed from Companies on the Road to Ruin, a special edition of The Motley Fool Select (now called Motley Fool Hidden Gems) I wrote back in 2002.

The SEC investigates, and the CEO suddenly resigns
When a company comes under scrutiny from the Securities and Exchange Commission and its CEO suddenly resigns, that's a pretty good sign that something is wrong.

Back in 2002, we had several prime examples of a company's stock price tanking following a combination of the two occurrences, including Time Warner, Qwest, Tyco (NYSE: TYC  ) , and Irish drugmaker Elan (NYSE: ELN  ) . Another popular example was a Houston-based energy company called Enron. Each of the companies had accounting issues.

A more recent example of this is the ongoing saga at Krispy Kreme Doughnuts (NYSE: KKD  ) , a Motley Fool Stock Advisor recommendation. Former CEO Scott Livengood called it quits in January amid an SEC investigation regarding sweetheart franchise buybacks and an earnings warning in May 2004, ongoing earnings restatements, horrendous operating results, and the company's increasingly poor financial health. The stock -- which closed at $6.63 on Monday -- has lost two-thirds of its value since the SEC investigation was announced in July, and it has lost a quarter of its value since Livengood's resignation -- despite the stock actually going up the day his resignation was announced.

Having said that, I should note that many value investors like to fish for companies following steep declines in their stock prices. This is particularly true when a company has an image problem but an otherwise viable business or brand; in such cases, an investor may bet that new management will come in with a clean slate, or that it can lead a successful restructuring.

In March, Fool contributor Bobby Shethia offered a bull case for Krispy Kreme Doughnuts, while fellow Fool and longtime Krispy Kreme bear Bill Mann countered once again with the dark side of The Force.

Heavy insider selling
It could be something; it could be nothing.

One trait The Motley Fool has long favored is heavy insider ownership. As investors, we like to know that the managers running our companies share the same interest in long-term success. So it's not really too big a coincidence that two of the three biggest holdings in my portfolio -- Ameristar Casinos (Nasdaq: ASCA  ) and Motley Fool Rule Breakers pick Overstock.com (Nasdaq: OSTK  ) (which I also happen to think looks attractive at $37 per share) -- have around 50% insider ownership.

At the same time, companies with minuscule insider ownership tend to miss the cut, while massive insider stock sales are a major red flag.

It's probably ironic that my two favorite examples of heavy insider selling are stocks that have gone through the roof following a massive insider exodus. Symantec (Nasdaq: SYMC  ) , the software company behind the popular Norton Antivirus suite and the example I used in Companies on the Road to Ruin, has a paltry 1.3% insider ownership and an endless string of insider sales. While it's well off its December 2004 highs of around $34 per share, the stock still has more than doubled since Companies on the Road to Ruin was published in September 2002, to its current price of around $20.

Another bizarre example that has turned out to be pretty harmless is Mandalay Resort Group. Back in March 2002, the resort casino operator's top two executives -- CEO and Chairman Michael Ensign and Vice Chairman Bill Richardson -- began selling off their entire stakes. By October 2003, the pair had sold off more than $600 million worth of stock with no public explanation whatsoever -- just an admission to "friends in the gaming industry that they did not want to die owning a casino company." Meanwhile, the business was taking off, and the stock was soaring.

Finally, in June 2004, MGM Mirage agreed to acquire Mandalay at $73 per share, double and triple the prices Ensign and Richardson had sold at. So insider sales are harmless, right?

But then again, if you knew that former ImClone (Nasdaq: IMCL  ) CEO Sam Waksal and pal Martha Stewart were selling ImClone stock based on inside knowledge that key cancer drug Erbitux was going to stumble in its application for Food and Drug Administration approval, you, too, would have sold your ImClone shares back in December 2001. The stock fell from its close at $55.25 the day before the announcement to a low under $14 just six weeks later. Incidentally, in between, the SEC had also announced an investigation into stock sales by top management.

Of course, I should point out that investors never had a chance to use that particular information in this case, because the sales were conducted the day just before the announcement, which is a big reason why such activity is illegal and why Sam and Martha ended up in prison.

That said, as in the previous section, at least one Fool saw value in the fallout of the insider-trading scandal. By September 2002, former Fool Tom Jacobs thought the stock was worth a gamble at under $9, based on the probability that Erbitux would eventually receive FDA approval. The drug did gain approval in February 2004, and ImClone's stock had reached a high at $87 in July before falling back to its current $30-to-$35 range.

Bottom line: Beware
A company under investigation, with a CEO who has suddenly resigned, may end up as a value play, but those are usually a harbinger of bad things. Similarly, massive insider stock sales may ultimately have a harmless outcome, but they also could be a signal that you, too, should be prepared to sell.

The bottom line here: Beware.

I am an advocate of a "tight but aggressive" style of investing; that is, concentrate on a few of your best stock ideas or values and hit them hard. However, I also think it pays to approach certain scenarios by erring on the side of conservatism. As the great poker teacher and theoretician Mike Caro says, "Money you don't lose buys just as many things as money you win." And besides, even if insider sales may not indicate dirty dealing, why would you want to own the stock of a company if the people with the most interest in it don't?

I hope you enjoyed this discussion on red flags as much as I enjoyed my time in traffic school. If you're interested in four other warning signs, Hidden Gems subscribers can access the original special report, Companies on the Road to Ruin, by clicking here.

For more Foolish commentary by Jeff Hwang, check out:

Time Warner was also aMotley Fool Stock Advisorselection. To see the latest picks from Tom and David Gardner, click here.

Fool contributor Jeff Hwang owns shares of Ameristar Casinos and Overstock.com. The Motley Fool is investors writing for investors.


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