Restatement of Earnings a Bad Sign
When a company restates earnings, its stock often plummets 20% to 50% in a single day. Investors are disgusted, not only because they have just been told that results were worse than initially reported but also because they no longer know if they can trust management.
That’s a natural reaction. But John Dorfman, a columnist for Bloomberg News and a money manager, wondered whether there might be an opportunity amid the chaos. Could companies that restate their earnings possibly be buy candidates once the dust settles?
To test the idea, he identified 10 companies that restated earnings in 1994 and studied what happened in the following years.
The short answer: Stay far away from stocks of companies that restate their earnings. Four of the 10 ended up going bankrupt and wiping out shareholders. Only two showed a higher stock price at the end of 1998 than at the end of 1993. Only two of the 10 stocks rose during the five-year period and only one beat the Standard & Poor’s 500.
OK, you say, these stocks weren’t a good long-term bet. But perhaps you could make big gains over a shorter period if you caught the company as it began to rebound? Well, based on Dorfman’s review, such timing would have required great luck and great dexterity.
In the year after the restatements were announced, three of the 10 stocks rose and seven declined. The average performance was a gain of 16.5%, which sounds pretty good until you realize that the S&P; 500 added 34.1% that year.
The tarred companies did outperform the S&P; 500 in 1997, the third year after the restatements, but Dorfman says that’s a statistical fluke because one of the 10 companies, Pace American Group, rose in price that year to a tenth of a penny a share, from one-hundredth of a penny the year before. That was a 900% return, and it pulled up the average return dramatically.
And in 1998, four years after the restatement, only six of the stocks were still trading. Their average return? A loss of 11.5% while the S&P; was rising 26.6%.
