Blue chip stocks: Sell if you doubt the integrity of insiders

We’ve always believed that investors should sell a stock if they have any doubts about the integrity of the people who are in charge of the company. In other words, if you think a company is run by crooks, you should sell the stock right away, no matter how attractive it seems as an investment. As the Madoff scandal so clearly shows, there are no limits to the ways in which unscrupulous operators can abuse and cheat you if they are inclined to do so.

Over the years, we’ve refrained from recommending, or advised selling, a number of stocks, including blue chip stocks because we felt their capital structure or promotional materials were designed to make it easy for insiders to mislead or take advantage of the investing public. We didn’t miss much as a result; in fact, we sidestepped some ugly situations.

To profit from this rule — that is, to use it to enhance your long-term returns, not just avoid losses — you need to apply it in a moderate fashion. That is, you need to distinguish between lack of integrity on one hand and naiveté, or poor judgment, on the other.

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For example, many public companies, and even some blue chip stocks, eventually run afoul of tax rules or regulatory decisions. But if you take that as a sign of low integrity, you can wind up selling solid investments at market lows.

One good example of this type of situation recently occurred with Manulife Financial, one of the blue chip stocks we cover in our Canadian Wealth Advisor newsletter. Shares of Manulife Financial dropped 14% after the Ontario Securities Commission began looking into whether the company fully informed its shareholders of the business risks of a market downturn late last year.

Manulife Financial sells life and other forms of insurance, as well as mutual funds and investment-management services. It operates in 19 countries and territories worldwide, including the U.S. and Asia.

The company reported a loss of $1.1 billion, or $0.67 a share, in the three months ended March 31, 2009. However, if you exclude one-time charges, it would have actually earned $803 million, or $0.50 a share.

A big part of the loss came when Manulife Financial devoted $1.1 billion to strengthening its reserve for segregated-fund guarantees. This is the main focus of the OSC’s investigation. The OSC may find that Manulife Financial should have anticipated that the big drop in stock markets late last year would hurt its ability to meet those guarantees.

In light of these developments, we’ve updated our view of Manulife Financial in the current issue of Canadian Wealth Advisor. Click here to see how you can get your copy today.

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