Following the onset of the Great Depression, our country was forced to re-evaluate the way the stock market operated. Realizing the need for an arm of the government to oversee our capital markets, the Securities and Exchange Commission was created in 1934. In its role, the federal body's goal is to ensure a competitive yet fair marketplace that's run in a smooth fashion. To help achieve this goal over the years, the SEC has launched myriad investigations into companies and their business and reporting practices.
These investigations are launched for all sorts of reasons, but one thing seems to have held true, at least in the fairly recent past: that SEC investigations, whether informal or formal, tend to have some seriously gravitational affects on stock prices in the near and potentially long term.
Evidence of near-term underperformance
A study in 2005 by The Leonard N. Stern School of Business showed that a company's market share declined, on average, by 6.18% and 6.23%, respectively, following the announcement of an informal or formal investigation. It also displayed that the stocks typically underperformed the market for the following three months as uncertainty surrounding emerging information maintained its grasp. However, following those initial three months, the stocks tended to regress toward the mean, leading them to outperform the market. Data was compiled from more than 240 informal and formal investigations from 1998 to 2003.
The latest victim
For a while now, talk has surrounded LINN Energy's (NASDAQ: LINE ) hedging strategy and the way it was handled from an accounting point of view. While a select group warned of potential misrepresentation, others seemed to overlook this fact in favor of a distribution that ranked near the top of its industry. These hedging strategies and their representation are now directly under the SEC's microscope, with LINN's distribution payments and acquisition of Berry Petroleum hanging in the balance. As a result, the past two days have been especially hard on investors, with the stock down over 31%.
Like LINN, many others have come under SEC investigation in the past, and their subsequent performance has been more than lackluster:
Better watch your book
Ebix (NASDAQ: EBIX ) , an insurance software company, has been under investigation since last November but had denied these allegations initially. Just 13 days ago, an acquisition deal was called off by an arm of Goldman Sachs after further investigations were announced by the U.S. Attorney for the Northern District of Georgia. The stock reacted to the announcement by dropping 44% and 13% in the two days following as investors sold off. This reaction is justified in the fact that the probe surrounds alleged accounting misconduct.
Improperly hunting for tax havens
While in the midst of reconciling tax-accounting issues, Weatherford International (NYSE: WFT ) came under SEC investigation for potentially selling goods to sanctioned Iran and Syria back in March 2012. The stock has yet to recover and has traded down 20.6% since March 16, 2012, while the S&P 500 is up 15% and rival Halliburton is up 23.9% over the same time frame.
Accounting issues have continued to plague Weatherford, along with potential improprieties surrounding Iraqi contracts, resulting in the delay of its latest annual report. All of this follows restatements of its 2010 and 2011 annual reports. Over the past three years, Weatherford has underperformed the S&P 500 and Halliburton by 52.2% and 56.9%, respectively.
Once the veil is lifted
Molycorp (NYSE: MCP ) presents a fine example of what can transpire after the SEC's investigation is complete and shows little in the way of further enforcement. Just last week, the company's shares spiked 10.5% after the SEC completed its investigation into Molycorp's policy of changing its public disclosures and levied no burdensome actions or fines. Unfortunately, this most recent price spike has done little to rejuvenate the rare-earth miner's volatile stock, which stands at just 27% of its year ago price.
Foolish final note
While it may be a bit more difficult for average investors to unearth accounting malpractice within their portfolios, the SEC has a fairly good track record. Even though some investigations might not warrant as much awareness, those surrounding accounting issues can clearly affect a company's market value in a substantial way. Being able to sell shares before or immediately following an announcement might not always be possible (or legal), but investors should certainly consider whether a company deemed suitable for an investigation is worth any space at all in their investment accounts.
The best investing approach is to choose great companies and stick with them for the long term. The Motley Fool's free report "3 Stocks That Will Help You Retire Rich" names stocks that could help you build long-term wealth and retire well, along with some winning wealth-building strategies that every investor should be aware of. Click here now to keep reading.
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