How to profit from companies involved in a scandal

While any company involved in a major scandal - whether it be a financial scandal, directors involved in stock fraud, offering illegal stock options, or other shenanigans - might be bad news for existing shareholders because of the risk of downside pressure on the stock, in some cases this can represent a good buying opportunity for others, or even for existing shareholders to top up their holding in the company.

However, it is not as plain sailing as it may seem. It might be difficult to discern how bad the situation is and how long the negative effects of the scandal will weigh on the stock.

To profit from such scandals, it requires diligence on your part to examine and find out how bad the problem is and whether the company has a viable future. Remember, the last few years have witnessed some spectacular collapses of companies that were once riding high and household names.

There is no doubt that many people bought into companies like WorldCom, hoping that fortunes would turn, but the underlying problems were so serious that resulted in many shareholder losing a fortune.

• What we have learned from Enron, WorldCom is that every company is vulnerable if there are major, major problems.

How to determine whether the scandal has led to fall in share price

You can do this several ways.

• You should follow stories from the financial press. Problems with big companies in particular will be all over the financial press.

• Use charts to find out how much the company is under performing other stocks in the sector or against the market as a whole. Of course, some financial data providers have charts that allow you to superimpose the graphs of several companies at the same time, so you can compare price performance of similar and competing companies.

Avoid companies with serious financial problems or stock manipulation

If its serious manipulation of financial data to enhance profitability and thus stock price of the company like in the case of companies like Enron and WorldCom, there might not be way back. These companies lose faith in investors, lending institutions and therefore are unable to reverse the stock slide and eventually filing bankruptcy. Do not be tempted to buy the stock thinking the worst is over.

• If the problem affects the company's business model and impacts negatively on sales and profitability then it might better to stay away from the stock.

Other problems

An example of a less serious problem facing a company is Hewlett Packard. The company is currently embroiled in a scandal involving the tapping of journalists to find out the person or persons (within the company) responsible for leaking confidential information about the company to journalists. This has led to the resignation of its Chairwoman, who was thought to be at the centre of the spying scandal.

Wait for the problems to die down

Wait for the dust to settle on the problem, this will allow you to better analyse the situation from the standpoint of seeing whether the problem might more deep rooted or whether the end is near as far as the problem is concerned.

Financial strength

Provided the problems are not very serious and the company is financially very sound and has competitive advantage over rival companies, it should be able to withstand less serious problems like that facing Hewlett Packard, even if there is substantial near term downward pricing pressure on the stock. This is because the company is not likely to be affected by sales of its products and service and the problems are not likely to have much bearing on the consumers, who will still go out to buy its products.

For example, pressure on Hewlett Packard's stock, albeit rather small, can represent a good time to buy into the company because the company has a very strong business selling PC's and other technology products with worldwide sales topping that of any other PC manufacturers in terms of revenue. Also, the company has a stable and increasing dividend payout.