Avoid My Mistake

By James J. Cramer

We have a rule at the hedge fund that I run: sell a stock at the first whiff of accounting irregularities. This rule has kept us from losing fortunes, including those we had made in Oxford Health, Sunbeam and Waste Management, to name three recent situations where the stench of overcooked books, and a dramatic decline in stock price, followed closely behind that early whiff. When a stock gets hit because of a product glitch, or a short-term execution problem, I will consider holding on, or even buying more.

But when a company gets caught misstating its financial performance, I try to be interested at no price--and so should you. You simply can't tell if the whole enterprise is worthless.

My hedge fund recently violated that rule, and last week we paid the price. We believed the management of Cendant when it told us three months ago that it had an accounting glitch but that it would not be major. We looked the other way because Henry F. Silverman, president of Cendant, had made so much money for us in the past. We even bought more when the stock got clocked from $36 to $18 in one day.

We weren't alone. Cendant, the result of last year's merger of HFS, a franchise company whose brands included Howard Johnson and Avis, and CUC, a kind of discount-shopping club, dazzled many a portfolio manager. After downplaying its accounting "irregularities" last April, the company last week revealed that the CUC side of the business had actually fabricated nearly $300 million in revenues over three years. The stock, which had rebounded to $25, quickly retreated to the high teens. It has since gone lower. And why shouldn't it? Most of the "earnings" that had jacked up the stock were simply fraudulent, as Silverman now admits (while denying any blame).

To add insult to injury, the day before last Wednesday's new negative prognosis, a couple of giant institutions apparently somehow got the word ahead of the rest of us and bailed out at much higher prices.

Both Silverman and Cendant chairman Walter Forbes, (the former president of CUC) say they saw no hint of the fraud until very recently. Whether I believe them is less important than this: I had a chance to get out after the stock rallied on the first assurances, and I didn't. I wanted to be made whole--a costly impulse in these situations.

Oddly, my partner and I had just done the right thing a few weeks before, dumping Sunbeam when it first declined to talk about its sales numbers. We feared there might be a secret warehouse somewhere stuffed with unsold barbecue grills. Good worry; the stock now sits 40 points lower, and the board has pulled the plug on Chainsaw Al Dunlop. Why? A massive overstatement of sales and earnings.

Despite the huge, multiyear nature of the fraud at Cendant, there were no criminal investigations through week's end. A number of class-action suits have been filed, but I doubt we will see much after the lawyers take their cuts. Looks as though the only winners here were the two top executives, who together sold more than $100 million worth of stock before we even smelled that first hint of trouble. The losers: those of us who believed that someone who once misled us wouldn't do it again.

Jim writes for thestreet.com website. He maintains some of his long position in Cendant. Nothing in this column should be construed as advice to buy or sell stocks.