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Psychology, Scandals and Selling

Adem is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

One of my favorite books is Jason Zweig’s “Your Money and Your Brain.” Most investing books I’ve read were on nuts and bolts, valuations and the like. But what I’ve always struggled with, is the emotional side of investing, not fundamentals.

If you haven’t read Mr. Zweig’s book, I highly recommend it as it focuses on topics you may not have read elsewhere. One of my favorites, is “rules based investing;” in other words, having a plan!

It seems ridiculously obvious that an investor should have a plan prior to investing, but when you see market indices crumbling or sky-rocketing it’s easy to get emotional. Nowadays, I have a rule list, not just for buying but also for selling. I’m not saying to follow my rules (or Zweig’s) verbatim, but rather, I hope you adopt your own set.

Selling is harder than buying, especially after your stock has had a big pop or drop. Rules can make it easier. Here are my two biggest “sell signs.”

Layoffs

If you were a business owner and had to fire thousands of people, would things be going well for you? Of course not! Yet, somehow in the wacky world of investing this news gets spun as positive.  There are two types of layoff scenarios, neither one is good:

The Crowd Roars:

Five short months ago, with the arrival of new CEO Meg Whitman, Hewlett-Packard (NYSE: HPQ) announced the layoffs of over 27,000 employees. How did the street react? Not the way a real business owner would; the stock shot up 10% that day to close at $26/share.

What’s happened since? Well, in just five short months reality has set in. Earnings this year are vastly trailing last years and the stock is trading at just a smidge above $13. That’s correct; less than five months removed from the “great news” the company has lost half its value.

The sad part is, this wasn’t hard to see coming. Even if you were the staunchest Whitman fan and believed in the turnaround story (the jury is still out) the mass layoffs should have been an indicator to just how big a mess she was walking into. The fact that the average investor viewed it positively is just further proof that most people don’t view stocks as partial ownership in real businesses.

The Confirmation:

Career Education Corp. (NASDAQ: CECO) recently announced the layoffs of over 900 workers, the stock did not soar. This however, was further confirmation of trouble. The for-profit education industry has seen declining earnings as it remains in the Federal Government's cross hairs over student loans and graduation rates. If you were hoping for some short term turnaround at CECO without the former two issues being resolved, you should take these layoffs as a negative confirmation—sell.

Layoffs are never a good thing. Nine out of ten times a CEO will spin the news as “cost cutting” to grow earnings, which is not sustainable.

Repeat after me: “The moment a CEO attempts to grow earnings through layoffs, rather than organic sources, I sell.”

Management Issues

Much has been discussed over whether good management should be a reason to buy a stock. Can a good CEO deliver a sustainable competitive advantage?

That conversation is dynamic, when it comes to selling, not so much. When I see red flags with the folks at the top, I want out—quickly. Specifically, I’m selling if:

1). The CEO or (especially) CFO resigns abruptly, with little warning

Remember the HealthSouth scandal? The one where Founder and CEO Richard Scrushy repeatedly forced his CFO's (all 5, in a row) to "fix" negative EPS in order to meet Street expectations? Well, call me jaded, but ever since the HealthSouth scandal I've had one simple rule, if the CFO is out--so am I.

Now, I don't mean this in all scenarios, obviously if the CFO has a succession plan, its one thing, but a blindside? While I'm sure there are some CFO's that wake up one morning and decide that they need to "spend more time with their family" immediately, I'd bet there are at least half that either have a boss like Scrushy pushing them to fudge numbers or simply know the company is in bad financial shape.

Was it any surprise that after CFO Thomas Seifert of AMD (NYSE: AMD) abruptly resigned (two weeks’ notice) two months ago the stock plunged 9% in a day? The stock has continued its rapid slide since ($4.01-1.99 in 2 months). While we can't say anything shady was going on at AMD we have to admit that for a CFO to bail abruptly after a short time on the job, things aren't going so great.

If nothing else, the stigma is hard to shake. Years after the scandal, HealthSouth still has a depressed stock price. With all the struggles at AMD, a CFO resignation doesn’t help.

2). Management is too consumed with the stock price

One of the things I noticed in the brilliant documentary,"Enron, the Smartest Guys in the Room,” was the focus by the filmmakers on managements disturbing obsession with their stock price. Enron Execs’ discussed it endlessly, take a ride in the elevator and there it is on a monitor. That desire ultimately led Mr. Skilling and Lay to cook the books and commit Fraud. Here are two troubling examples of this obsession that have happened just this year.

In July Barrick Gold (NYSE: ABX), despite seeing record gold prices and decent, if not strong, company performance fired its CEO Aaron Regent. The reason? Depressed stock price. The next day, I sold all of my shares. I have great respect for Founder Peter Munk; but he is going down a dangerous road. The market is fickle. Just think of all the recent volatility we've seen with the "flash crash" and "debt ceiling" debacle, anyone who thinks they can control the short term movements of a stock or the market is fooling themselves.

Another example, although not as obvious, in my opinion happened at Netflix (NASDAQ: NFLX). First let me state that I have NEVER been a fan of Netflix; for a long period of time that meant I was dead wrong--and I still may be. But even the most ardent supporter has to admit that the company has turned into Corporate America's version of the "Joe Biden Gaffe-o-Matic" (Qwikster, pricing, etc.).

I digress; my issue goes way back in the summer of 2010 when the stock was at an all time high. At this time concerns first started rising about the cost of streaming content for the company. Investors started to fear that perhaps more costly content would lead to worse streaming options. Then, CEO Reed Hastings made a bold move authorizing a $300 million share buyback, only to see the stock quickly crater to $75/share (a nearly $200 drop).

Shortly thereafter Netflix announced it would have to raise $400 million, diluting shareholders and taking on debt.

How could this happen? Is Reed Hastings an idiot? No. This happened (in my opinion) because Hastings believed that buying the stock at a record price would quiet naysayers, therefore raising the price of the stock further so the capital they needed wouldn't be a concern. Again, that's my theory, but regardless of whether you agree; you can't call Hastings behavior anything other than reckless.

Stick to the Rules

For me, these two red flags are the easy sell signs, not every situation will be so black and white. Other things I look at are financial metrics; are the metrics I value (roic, p/eg, pay-out ratio) going in the wrong direction? Or, if the SEC is doing any kind of accounting investigation (see my CFO point), I'm out.

Finally, when I can't find a simple black or white answer I ask myself this: “has my original investment thesis changed.”

When you buy, write down why. If the stock has shot up 900% but the thesis remains, you’d be a fool to sell; the same is true in reverse.

When it comes to investing real money, it’s too hard to make decisions in the heat of the moment. You need to have rules (buy and sell) that were set up when you were thinking clearly—and stick to them.


 Adem Tahiri has no positions in the stocks mentioned above. The Motley Fool owns shares of Netflix. Motley Fool newsletter services recommend Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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