Rule Maker Portfolio
A Reason to Sell

By Phil Weiss (TMF Grape)

TOWACO, NJ (Sept. 24, 1999) -- In August, Matt and I wrote a two-part column on when to sell Rule Makers (Part 1 / Part 2) in which we gave five reasons that we'd sell a stock on the basis of the company's fundamentals. The first of these is that we will not tolerate any deceit on the part of the company's management.

We here in the Rule Maker portfolio are not alone in this sentiment. My favorite financial book is Philip Fisher's Common Stock and Uncommon Profits, which I wrote about in September of last year. In that book, Fisher explains his 15 points to consider when buying a stock. Fisher's final point is that the company must have a management that is of unquestionable integrity.

Fisher only has three reasons for selling a stock. One of these is based on the company no longer qualifying under his 15 points. Arguably, management integrity is Fisher's most important point as he wrote, "Regardless of how high the rating may be in all other matters, if there is a serious question of the lack of a strong management sense of trusteeship for stockholders, the investor should never seriously consider participating in such an enterprise."

Recently, I've come to the conclusion that the management of American Home Products (NYSE: AHP) no longer has the desired integrity. This is actually a painful decision for me to make, as at one time I worked for American Cyanamid, a company that was acquired by American Home Products in 1994. The primary reason that I have continued to hold this stock in my portfolio is my prior association with the company. My analysis told me that there were better places to put the money, but I continued to hold it anyway.

Here's a sampling of some of the recent news that has led me to lose faith in this company's management:

A number of these relate to problems with the company's diet drugs Pondimin and Redux. There have been a number of stories indicating that AHP may have either withheld or suppressed evidence gathered during the drug trials used by the company to garner Food and Drug Administration (FDA) approval for Redux. Similar charges have also been levied with regard to information received after FDA approval. There have even been stories stating that the FBI is investigating AHP for its actions during this process.

The problem with Pondimin and Redux is that when used in combination they have been found to cause heart valve problems. Thus, a number of lawsuits have been filed against AHP by users of these products. While the ultimate cost to the company is unknown at this time, it has been estimated to be as high as $5 billion to $10 billion.

I realize that lawsuits these days are common. It often seems as if many people are just waiting for the opportunity to find someone to sue as it's viewed as an easy way to a financial windfall. I also realize that AHP's settlements of a few lawsuits is not necessarily an admission of guilt. Oftentimes, the legal costs of defending a company against a lawsuit outweigh the costs of simply settling and moving on.

However, I still find all this litigation and the accusations of wrongdoing to be at least a little disturbing. I was able to live though it all until the morning of September 10th when I read in The Wall Street Journal about how 12 of the company's executives had cashed in stock options during the first five months of this year, thereby reaping significant profits. According to the article, these insiders realized profits ranging from $1.4 million to $7.3 million.

I normally don't pay much attention to insider sales of stock, as I know that there are restrictions placed upon insiders regarding the times of the year that they are allowed to sell their stock. I also know that insiders sell stock for financial reasons that have little to do with the company's performance.

In this case, though, I was particularly upset to read the news of insider selling. Back in June of this year, AHP issued a pre-announcement stating that earnings for the second quarter and the year would fall short of expectations. One of the things this shortfall was attributed to was disappointing results from the company's agricultural products business.

Earnings disappointments happen. If you're a long-term holder of a stock, they don't mean all that much -- unless you believe that they're a true indicator of more problems in the future. At the time that I heard of the shortfall, I basically passed it off as no big deal. But after reading about the insider selling, my thinking changed immediately.

You see, I know from when I worked at American Cyanamid that sales of the company's agricultural products are primarily booked during the fourth quarter of the year or, at the latest, during the beginning of the first quarter. The reason for this is that the majority of such products are sold well in advance of the spring/summer growing season. The bulk of AHP's agricultural products business is still composed of that which it acquired from American Cyanamid.

Since the bulk of earnings come late in the fourth quarter or early in the first quarter, and since the earnings shortfall wasn't until the second quarter, I can't help but wonder if the company released some of the reserves found on its balance sheet into income in order to keep its earnings in-line long enough for the insiders to sell their shares (for more on this subject, check out this column). It's also at least a bit disconcerting that the news related to the lawsuits has gotten a lot worse after the shares were sold.

I often laugh at shareholder lawsuits, as only attorneys seem to profit from such lawsuits. But I'm not laughing this time. Though I can't verify my assertions against the company, the facts lead me to believe that I can no longer trust the company's management. So, in accordance with both our Rule Maker thoughts on selling as well as those of Philip Fisher, I'll be selling my shares after this article has been published.

Finally, this coming Monday, our Rule Maker chieftain Tom Gardner will begin a four-week investment seminar via e-mail. Each night, you'll receive an e-mail in which Tom will discuss such topics as how to allocate your portfolio, what to make of bear markets, and when to sell. In addition, there will be a message board dedicated to seminar participants for questions and discussion. For all the details, check out this link:

Tom Gardner's Investment Seminar

Phil Weiss, Fool