Our Protectors, Encouraging Malfeasance

Every time I try to do a little investigative work I'm sidetracked by new and more interesting facts. In this case, the new and interesting information that I came across is about the Public Company Accounting Oversight Board (PCAOB). It appears that the PCAOB is the organization or agency that was set up after the Enron and WorldCom fiasco to ensure that someone was watching the accounting and auditing firms. Don't forget that Arthur Andersen (AA) was thrown under the bus as an attempt to assuage an outraged public after Enron.

As part of the Sarbane-Oxley legislation PCAOB was created in 2003 to, "...oversee the auditors of public companies in order to protect the interests of investors..." Now remember, the PCAOB is a private, non-profit organization that requests a bulk of their funding from the SEC. Yeah...I know, the SEC is that other agency that also "...protects investors..." When I take a look at the folks who run this organization I am hopeful that the usual suspects aren't in charge. Ahh, lo and behold, the chairman of the board is none other than a former partner of Ernst & Young LLP (EY), one of the largest accounting and auditing firms in the world. I am irked at the fact that the agency set up to protect me from auditing malfeasance has as their leader a former partner of EY.

Well, maybe these folks are really trying to changes things. So the first thing I do is go to the section on enforcement. I know this has got to be the juiciest section of the website. After all, look at all the drama that has gone on in the last 2 years. As I look down the list of disciplinary proceedings that have taken place since the PCAOB was created I see only one company, Deloitte & Touche LLP, that I recognize out of the 22 cases listed. That doesn't make sense at all.

I decided to take a look at the Deloitte & Touche LLP (D&T) case since I suspect that the other firms were easy prey for the PCAOB. The case against D&T was in regards to the accounting irregularities that were associated with Ligand Pharmaceuticals (LGND). Ligand was forced to restate their financial reports for 2002, 2003 and 2004. In the summary against D&T, it was claimed that D&T knew of the irregularities and failed to comply with PCAOB auditing standards.

The penalty for the offense that D&T committed was a fine of one million dollars ($1,000,000) for not recognizing "...approximately $59 million less in revenue" or a reduction of 52% in revenue for the year 2003. Notice there was no statement of inflating revenue or falsifying the documents. Instead it was simply a matter of recognizing or not recognizing $59 million dollars. Considering that the amount in question is more than half the revenue generated for the year, I think this was more than just a lack of recognition.

Now that you have the quick and dirty of the situation let's craft a little perspective around the enforcement piece. The PCAOB fined D&T $1 million for (not) recognizing $59 million on the balance sheet of LGND. This represents 1.7% of the amount that was "falsified." However, as a result of the restatement of earnings, the market capitalization of LGND fell from $2.6 billion in April of 2004 to $649 million in March of 2005. This equals a loss in market capitalization of $1.9 billion.

The punchline to all of this is that if you add the "falsified" amount to the loss of market capitalization in LGND stock then investors lost a total of $2 billion. This makes the $1 million fine to D&T equal to 0.0005% (5/10,000th) of the amount that was lost by investors. In many respects, this kind of penalty encourages the auditing firms to continue to do what they've been doing all along.

Although I am not surprised by my findings I'm still disgusted at the amount of time and money that is wasted on an agency that draws down $157 million a year to not have any impact on the process of increasing the quality of auditing and the firms that conduct such activities. I find it hard to believe that the PCAOB could only find 22 instances where enforcement action was necessary in the years since its creation. If the wording of the disciplinary action against D&T was about "not recognizing" then the last two years was irrefutable evidence of other auditing firms not recognize problems in companies like Bear Stearns, Fannie Mae, Lehman, etc. Touc.

Please revisit Dividend Inc. for editing and revisions to this post.

When Timing Meets Opportunity

Although the stock market reflects a continuum of time and events, the investment community would much rather focus on the one year performance of investments. With this in mind, I have constructed a timeline of when Dividend Achievers have reached a new one year low.

The 2009 list of Dividend Achievers consists of 284 companies. Many of these companies are in the banking, finance and real estate arena. The above timeline excludes most banking, finance and real estate companies and instead focuses on all other sectors of the economy. I routinely avoid falling industries or sectors of the economy that are breaching new highs (highest relative strength.)

What should be noticed is that the remaining stocks (after excluding banking, finance and real estate) provided us with 166 companies to invest in with 9 months and 35 different days in the year to (theoretically) buy low and sell at whatever price suits our needs. All of this could be done within a one year time frame allowing the investor to get out when and if necessary. Below I have a table with Dividend Achievers performance from their 52-week low (the left column has the best performing and the right the worst performing.)

I found it interesting that the months of March and October are where the most companies reach their new lows. This seems to confirm the stories that we've all heard about October being the worst month to be holding stocks, yet it seems that it might be the best month to be buying stocks. As we are in a real bear market (as opposed to the fake bear markets touted by the folks on CNBC just because the market declined 20%) the distribution of new lows is much less than in "normal" or range bound markets.

Conversely, during the roaring bull markets of the past, stocks hitting a new 52 week low were few and far between. I was definitely put to the test when I did my fundamental due diligence. The thinking at the time was, "if the company was so great then why is everyone else selling it?" Because I developed my investing approach with the worst case scenario in mind I now realize that it is most ideal for bear markets. During bull markets I was forced to hold companies much longer than I have done recently.

It should be noted that the basis of my investment philosophy hinges on the belief that if I can buy quality stocks at a new low then I can avoid much of the buyers remorse associated with individual stock selecting. I never intended for this approach to be a "trading" strategy. I have sailed through the nautical graveyard of other sunken ships that have fallen prey to the siren song of easy money in trading. However, the reality of Charles H. Dow's principle of "seeking fair profits" has demonstrated to be a reality to reckon with in today's fast paced, gee-whiz technology society.

I have continually examined the stock market data every which way to see the benefits of "buy and hold" only to come to the conclusion that such an approach is inconclusive and unreasonable. It just isn't fair to tell someone that if they look at the stock market over the last 100 years it has outperformed all other asset classes. Nobody has an investment timeline of 100 years, so why sell such a ridiculous idea to an uninitiated person who works so hard for their money.

Believing that somehow I'm right on this matter, I still need to emphasis that anyone hoping to follow my approach should first limit their efforts to their retirement accounts (IRA, Roth IRA, 401k etc.) Some may feel that it is hard to think rationally when a stock is down and the news is so negative. My answer to this is that it doesn't hurt to prove that the company is really going to disappear off the planet. After all, the timeline above takes place every year with varying quantities and distribution no matter what. Touc.

Dividend Inc. in Crawford Perspectives

In the September 2008 issue of Arch Crawford's newsletter the Crawford Perspectives (CP), the Dividend Inc. posting from August 29, 2008 was featured with commendation. This is an honor of particular importance to me because I remember reading the Crawford Perspectives when I was a teenager working at the San Francisco Public Library's Business Department.

Although Mr. Crawford might not approve, Mr. Mike would hand me his copy of CP with a note on the front saying something like, "check this out" or "another wow wee for ya!!!" While I never understood the material at the time, I would read through every pages as if there would be an exam the next day. Mr. Mike never did give an exam, instead he'd say, "10% is all I ask." Well, that 10% has grown awfully big since those early days.

The Crawford Perspectives has been published for over 30 years. In my opinion, anyone who can remain focused and dedicated for so long in a profession as unforgiving as the investment advisory business must have earned their keep. According to the Hulbert Financial Digest and CNBC (video link), the Crawford Perspectives closed out 2008 with a 42% gain.

To see the context of my work in the Crawford Perspectives, go to the website at www.crawfordperspectives.com and then click on the September CP Letter which is on the home page or click here for the pdf. On the 2nd page you'll find my article.

Thank you for the mention Mr. Crawford.

Touc.

AIG Tells Us a Story, The Drama isn't Over

In the chart below, you will see the stock price movement of AIG (AIG). I have marked two points that are of significant importance. Point A indicates the closing price low during the peak of panic for the company and the stock market in general. Point A, on September 17th at the closing price of $41, represents the height of panic and a lot of unknown about the future. Point B, on May 8th at the closing price of $40.20, represents a time when recovery was hoped for and expected after the March 9 low in the stock market.

This chart tells me everything I need to know. If point A represents the unknown future of the world's largest insurance company and point B represents our most optimistic signs of recovery then I am afraid of what it would take to get us back to a similar crisis situation that would represent point C. Ideally, the stock price should have gone above point A if a recovery was truly in the cards. Unfortunately, the resistance to going above point A is a warning sign.

At the risk of being way off the mark, what I see coming down the road is a situation similar to Japan's after the 1989 crash. First went the stocks, then real estate collapsed, then the banks failed (became zombies) and then the insurance companies got crushed. I arrive at this conclusion based on the ridiculously close Dow Theory non-confirmation in the Transports on June 11th.

I am now considering closing out my remaining 25% position in the stock market and going 100% cash. I don't mind missing upside action when the signals are pointing unanimously down. My guess is that we're going back to the 6440.08 level on the Dow Industrials in the best case scenario. I hope that I'm wrong. Touc.

Market Barometer Update

The downside target for the Dow Jones Industrial Average in my Market Barometer in the right hand column has been updated from what is found below.

Industrial Average (DJI):
7/4/2009 and falling
upside target: 8774
downside target: 8280

Research Recommendation: Weyco Group (WEYS) at $22.26

Today's research recommendation is Weyco Group (WEYS) because the stock price fell within 10% of the 52 week low during intraday trading. According to Standard and Poor's, Weyco Group, "...distributes, wholesale & retail, men's branded footwear in the U.S., Canada, Europe; offers casual footwear, dress shoes and accessories under Florsheim, other brands."

WEYS has increased its dividend for 28 years in a row which gives us ample information about the quality of the company's management. Essentially, WEYS has survived 4 recessions of varying degrees since 1980 (current recession excluded.) As recently as May 28, 2009, WEYS has increased the dividend by a little over 7% from $0.14 per quarter to $0.15. This indicates that management believes that although the current recession could get worse the company will survive.

On the balance sheet we find that WEYS has little or no long-term debt, return on assets were 8.9% in 2008 which seems to be fitting since we've been in a recession since December 2007. Normal return on assets seem to be around 11% on the low end. Return on equity for 2008 was at 10.7%. Prior to 2008, return on equity was around 13% on the low end. A major concern regarding this company is the fact that it has such low trading volume. If there were to be a mass exodus then getting out at a reasonable price would not be possible.

From a technical standpoint, I like to look at WEYS from the worse case scenario. In this regard there is no better vantage point than the decline from the top in 1972 to the bottom in 1974. This is a period when the stock went from a high of $0.75 to a low of $0.20, a decline of 73%. If such a price decline were to take place from the most recent high of $41.99 then the assumed bottom would be at $11.34.

Applying Dow Theory to WEYS gives us the following upside and downside targets:

• Upside
• $23.95 (fair value)
• $29.95
• $41.99

• Downside (focus on the downside risk)
  
• $17.93
• $11.34
• $5.91
  

If we were to invest in stocks the way that Charles H. Dow would then we would buy half of the intended amount now and purchase the second half if the price declines. For example, let's say that you wanted to invest $4452 in this company. What you would do is buy $2226 worth of stock now (approximately 100 shares) and hold the stock if the price goes up. If the stock goes down then you would invest the remaining $2226 at the next level that you felt was ideal. This approach works well regardless of the market that you're in as long as you set aside the amount that you intend to invest before making the first purchase. Also, after making the first investment never invest the second half somewhere else.

The purpose of my research recommendations is to point out quality Dividend Achievers that are near a new 52-week low. From this point begins the research to verify the quality of the stock for both short and long-term investing. It is hoped that the stock price declines further so that the valuation meterics are in favor of the buyer. These recommendations are within the context of the 2nd year of an 18-year bear market. A bear market that I expect to trade in a range between 16,000 and 5,000. Touc.

Please Take My Survey

At the top of the right hand column on my blog I am conducting a survey about who should create arbitrage opportunities (definition of arbitrage) in financial markets. The results will be included as part of an upcoming posting. Your participation is greatly appreciated. Touc.

ETF: Mediocrity with No Pretense of Value

We're really in for it when this finally devolves. The following paragraph is the introduction to the Operation of Exchange-Traded Funds in the Federal Register:

"All ETFs trading today operate in a similar way. Unlike traditional mutual funds, ETFs do not sell or redeem their individual shares (‘‘ETF shares’’) at net asset value (‘‘NAV’’). Instead, financial institutions purchase and redeem ETF shares directly from the ETF, but only in large blocks called ‘creation units.’ A financial institution that purchases a creation unit of ETF shares first deposits with the ETF a ‘‘purchase basket’’ of certain securities and other assets identified by the ETF that day, and then receives the creation unit in return for those assets. The basket generally reflects the contents of the ETF’s portfolio and is equal in value to the aggregate NAV of the ETF shares in the creation unit. After purchasing a creation unit, the financial institution may hold the ETF shares, or sell some or all in secondary market transactions."

Securities and Exchange Commission Exchange-Traded Funds; Proposed Rules. Federal Register. March 18, 2008. Vol. 73, No. 53. page 14620.

My translation to the above is:

A financial institution can buy "creation units" or IOUs of questionable value from an Exchange-Traded Fund (ETF.) The acquiring institution can use a basket of stock of equally questionable value to pay for the IOUs. If for some reason the acquiring institution can find someone else to unload the IOU on then it can be sold in part or in whole on the secondary market.

I admit that I'm unfairly maligning the meaning and/or intent behind the language in the SEC's proposed rules for the way an ETF operates. However, there can't be no denying (double neg intentional) that this arrangement sounds a lot like the old collateralization of mortgage debt. Additionally, this is awfully similar to the way unit investment trusts operated from 1926 to 1929. The structure of a scheme like this only works when the market continues higher or new money floods in.

Exactly what do I see wrong with the SEC language? The above text allows firms that have stock of negligible value (or a value far less than what was originally paid) exchanged to another firm that gives "creation units" which are put into the accounts of retail clients who are not interested in dealing with the failure of actively managed mutual funds. At some point after the creation units have been designated to retail clients the financial institution can then sell the creation units to willing buyers on a secondary market.

Who would be willing to buy these creation units? Well, if enough interest is drummed up through advertising and buttressed by positive press then other financial firms can justify buying these units with the hopes of selling to a new wave of retail buyers.

The blowback from something like this is on par with the unwinding of a derivative contract gone bad. I hope that my skewed interpretation of this is due to the fact that it is now 3:30am. Touc.

related article:

• December 16, 2008
  

Dow Theory

Because it is worth emphasizing, I will reiterate comments that I made on this blog on Sunday June 14, 2009 regarding Dow Theory (excluding the charts.)

"...the declining trend of volume since March 9th does not support a further rise in the index unless new money comes in. The chart below also shows the Industrials drawing out a flat or sideways movement on the approach to the important technical level of 9034.69. According to Dow's Theory, the Industrials could retrace back to the 8048.52 level before stabilizing or going higher.

the Transports fell 4.23 points short of exceeding the prior high after falling to the 2999.45 level. Exceeding the high of 3404.11, despite the declining volume, would have given hope to the idea that the market could move higher.

...the prospects for the market moving higher don't look too exciting. This means that unless we see a great company get severely underpriced by the markets we'll be holding off purchases..."

Dow Theory has truly pointed the way for this market. On the chart below you can clearly see that since June 12th the Dow has broken down.

Based on Dow Theory indications, I knew it was important for me to get my article published before the open of the market on Monday June 15th. My June 14th posting also indicated that I was at 75% cash (my highest cash position since December 2008) as a reflection of my concerns about the market going forward. While I wish the market could go higher, the indications have been resoundingly against my desires. I hope that I have transmitted my stance on the market with both of these indications (Dow Theory and cash.) Touc.

H&R Block Comes Through

Yesterday H&R Block (HRB) exploded to the upside by gaining 9.96%. The reason for the increase in the price was due to "better than expected" earnings (no surprise here.) At the time that I made the recommendation, there were naysayers on Seeking Alpha who thought that I had to be crazy to consider HRB worth investing in. Some of the points made by the critics seemed pretty convincing. However, my main concern was the viability of the company and the ability of other investors to recognize the upside potential.

Since the stock was recommended on my blog on May 19, 2009, we have seen the price increase by 19%. Again, my ideal is to acquire the stock as close to the low as possible and then sell the stock as investors start to realize the qualitative elements.

Initially, the qualitative elements of every stock seems like a subjective matter. However, according to Geraldine Weiss, author of Dividends Don't Lie, the dividend is the one thing that cannot be manipulated. Using the extended dividend payment history (Dividend Achievers only) results in a fair assessment of the overall quality of the stock and in turn the company as well. While I could provide a data dump showing all the ratios and regression analysis I can do on a stock, the reality is that we as investors need something that is reliable, proven and simple. Demonstrating that I'm a smarty-pants with corporate financial numbers will only serve to further confuse the uninitiated. For those that have an interest, they can run the numbers on their own.

After I recommended selling HRB on Friday June 5th, the stock has gone up by 7%. This is great as far as I'm concerned. I have accomplish my goal of "seeking fair profits." Besides, I don't wish to hold a stock when others are willing buy at a higher price. My long-term goal is to get some of the gains all of the time rather than try to get all of the gain once in a while. Touc.

related articles:

• June 5, 2009
  
• May 31, 2009
  
• May 30, 2009
  
• May 19, 2009