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In Part One of this series, we looked at the investor's ultimate "frenemy", the Securities and Exchange Commission (SEC). We looked at why this governmental body exists; the various stages of its inquiries and investigations, and looked at the effect of an informal inquiry on several stocks, most notably Linn Energy, LLC (NASDAQ:LINE) and LinnCo, LLC (NASDAQ:LNCO).

The goal of Part Two is to get us beyond the headlines and heated debate surrounding Linn Energy. For many investors, like myself, what's done is done, and the decision to sell or not has likely already been made. If you are still undecided, this article may help you formulate a plan, not just for Linn Energy, but for any future holding that falls under SEC scrutiny.

We can formulate a plan for the future by looking into past inquiries, and seeing the resulting market action. We can then ask some key questions:

1. What happens to a stock when an SEC inquiry is announced?

2. What happens to the stock price if and when the SEC graduates the inquiry to an investigation?

3. Should you buy when an SEC probe is announced?

4. How should I respond if I hold a stock that is the subject of an inquiry?

Be reminded that I am not rendering verdicts on whether or not the stocks profiled are "investible". I am strictly looking at market action as a result of SEC inquiries/investigations.

Because I publish in the Income Investing section, my focus will be on select income-generating stocks.

CHESAPEAKE ENERGY CORPORATION (NYSE:CHK)

One of the more infamous recent SEC probes involves Chesapeake Energy Corporation and its embattled CEO, Aubrey McClendon. Interestingly, this probe was also initiated out of the same Fort Worth SEC office as the Linn Energy probe.

On May 4, 2012, Chesapeake Energy announced that the SEC was initiating a probe into some questionable loans taken out by McClendon (worth $1 billion) against his personal stake in the company's wells.

Even before the announcement of the probe in early May, Reuters had made a similar public report, which no doubt led to the SEC initiating this inquiry. Backing up even earlier, if we look at the share price, it had already been deteriorating since August 2011, when it was above $34.00.

(click to enlarge)

By the time the SEC probe was announced, the stock price had already fallen to 50% from its $34.00 high, down to about $17.00.

On May 4th, when Chesapeake made the announcement of the SEC inquiry, the market barely noticed. In fact, the stock opened at $17.20 and closed up $17.39. It wasn't until over a week later that the news was fully digested, and the stock price slumped to $13.55 on May 17th.

On December 21st, six months later, Chesapeake was notified that the inquiry would continue as an investigation. Interestingly, this did not appear as news until three months later, on March 1, 2013, when the company made its 10-K filing for fiscal year 2012. As of this writing I can find no evidence that the investigation has been concluded.

Let's look at our questions, as they relate to:

Q: What happened when the SEC inquiry was
announced?

A: Initially, the market barely noticed. The market more fully
priced in the inquiry a few weeks later, with a share price
slump to $13.55, a 21% decline.

Q: What happened when the SEC inquiry officially
became an investigation?

A: Although the inquiry became an investigation on
December, details were not released until March 1,
2013. By this time the share price recovered from
the low of $13.55, to a closing price on March 1st of
$19.67. The share price increased substantially during
the timeframe between the inquiry and investigation,
with the lowest price since March 1st at $18.47, only
a 6% differential.

Q: Should I have bought when the inquiry was
announced?

A: Not unless you were willing to suffer through the price
drop to $13.55 in the following weeks. However, if you
bought on May 4th at the closing price of $17.39, and
held through the turbulence, you are money ahead
today, with July 5th closing price of $21.04, a profit
of 21%.

Q: What was the appropriate response as a current
shareholder when the inquiry was announced?

A: Truth be told, if you were of the mind to sell, you
should have done so long before the inquiry. The
share price had already lost 50% of its value from the
high in August 2011. Even so, the trajectory of the
stock price as it stands today shows it would be a
mistake to have sold at the announcement of the
inquiry
, or in the subsequent weeks. The stock price
did recover and did not go back to the lows reached
at the bottom share price of $13.55.

AVON PRODUCTS (NYSE:AVP)

This one is a little harder to figure, as the first time that news was released regarding either an "inquiry" or "investigation" is October 27, 2011 with a regulatory filing. By this time the SEC was issuing subpoenas to Avon; this action in the strictest interpretation of the flow of SEC investigations means Avon was already in "formal investigation" phase.

It appears that investors first heard about SEC involvement at the "investigation" phase, rather than the "inquiry" phase. This is not hard to figure when you understand that the "informal inquiry" process is completely private; neither the SEC, nor the company, are obligated to disclose the matter to the public in the informal inquiry stage.

The market reaction was swift. Shares plunged 18% the day of announcement, from a close on October 26, 2011 of $23.06 to a close on October 27, 2011 of $18.81.

(click to enlarge)

Shares continued to slump through the end of 2011, with a low of $16.09 reached on November 25th. From the low point, the share price continued to recover in 2012, even spiking above $23.00 in April. Even though part of the SEC investigation was concluded in September 2012, share price sank to lows around $13.80 in late 2012. Today, the share price has recovered since both the announcement of the investigation and its partial conclusion, closing July 5th at $21.00.

Let's look at our questions, as they relate to:

Q: What happened when the SEC inquiry was
announced?

A: The first investors seemed to know about any SEC
investigation was at the "formal investigation" phase.
The stock immediately lost 18% in value. The share
price continued to slump through the end of 2011,
not recovering until 2012.

Q: What happened when the SEC inquiry officially
became an investigation?

A: See answer to question above.

Q: Should I have bought when the investigation
was announced?

A: Not unless you were willing to suffer through the price
drop to $16.09 in the following several months. If you
held long enough, the price would fluctuate wildly in
2012, reaching highs of $23.03 in April, and lows of
late 2012 of $13.08.

The share price today, with part of the investigation
closed, is $21.00. With a closing price of $18.81 on
October 27, 2011, had you bought on the announce-
ment of the investigation, you would be money ahead
by 11%. You would have done better selling in early
2012; if you could have sold on the closing high of
$23.03, you would have doubled the profit at 22%.

Q: What was the appropriate response as a current
shareholder when the inquiry was announced?

A: Like before, if you were of the mind to sell, you should
have done so before the investigation. The high for
the stock in 2011 was in July, with a share price of
$29.00. The share price had already lost 20% of its
value the day before the announcement.

The trajectory of the stock price shows a mixed
picture. Given that the stock slumped even lower in
late 2012, a case could be made for a sell. However,
if you did sell at the announcement of the investigation,
you would have missed out on the current price
appreciation of 11%.

WYNN RESORTS (NASDAQ:WYNN)

On February 8, 2012, Wynn Resorts received a letter from the SEC asking that it preserve documents in relation to an informal inquiry it was making into a dispute between Wynn Resorts and its largest shareholder. A filing regarding the inquiry was made by Wynn Resorts on February 13, 2012, at which point the story hit the media.

The market hardly noticed. The share price closed February 13th at $110.56, and closed higher the next day at $111.16. Even after an investor lawsuit was filed, the price seemed impervious to decline.

It wasn't until the SEC made filings in a Nevada state court on May 3rd that the market factored in a potential investigation. The stock price closed on May 2nd at $133.65; within a week (May 9th) the stock price was down to $115.37, a decline of almost 14%. The stock continued to slump through the summer, closing at a low for 2012 of $92.79, a decline from the date of the May 3rd filing of over 30%. As to the outcome, the suit appears to be ongoing.

(click to enlarge)

Since the low of $92.79, the share price has steadily increased in value. It never again touched that price point, and closed on July 5th at a share price of $127.01.

Let's look at our questions, as they relate to:

Q: What happened when the SEC inquiry was
announced?

A: Not much. The share price actually increased.

Q: What happened when the SEC inquiry officially
became an investigation?

A: It wasn't until filings were made in court that the SEC
inquiry appeared to hit a more "formal" investigative
mode. The market took notice. When it was all said
and done, the stock price depreciated just over 30%
from the date of filing, through the next four months.

Q: Should I have bought when the investigation
was announced?

A: Not unless you were willing to suffer through the price
drop of over 30% over the next four months. The share
price the day after the filing (May 4th) was $127.40.
The current share price $127.01. This makes buying on
the date after the filing a break-even proposition. The
good news is that if you bought literally on any day
after May 5th, you are now money ahead. If you were
lucky enough to buy towards the August bottom, your
investment would now be in the green by 30%.

Q: What was the appropriate response as a current
shareholder when the inquiry was announced?

A: As with Chesapeake and Avon, if you were of the mind
to sell, you should have done so before the investigation.
The stock had been as high as $165.25 in July 2011;
the share price had already lost 23% of its value the day
before the announcement.

However, if you bought well, the best approach would
have been to buy into the weakness. Since the share
price at investigation is virtually identical to today, there
would have been only upside to buying shares during the
four months after the court filing was made.

Conclusion

The three SEC inquiries I pose are just a sample of many I discovered in my research: Goldman Sachs (NYSE:GS), Wells Fargo (NYSE:WFC), CBOE Holdings, Inc. (NASDAQ:CBOE), Netflix (NASDAQ:NFLX), Zillow (NASDAQ:Z), JPMorgan Chase (NYSE:JPM), OCZ Technology (NASDAQ:OCZ), among many others, have been subject to SEC scrutiny.

While the intensity of scrutiny and the outcomes of the probes varied from one company to the next, I did find a consistent theme: all companies' share prices - at some future point in time - recovered from the lowest points of market reaction to the news of the SEC inquiry / investigation.

In addition, not a single company I looked at went out of business as a result of the investigation. All the companies I looked at that are publicly traded are still just that…publicly traded, in business companies. If there is a governmental body for which companies should more fear scrutiny, it may well be the Federal Trade Commission (FTC), which retains power to refer companies for criminal penalties to the Department of Justice.

While this author cannot give you custom-tailored advice on how you should react to the latest SEC crisis, I will say this: odds favor those who will not sell during the hysteria.

Instead it pays to look for opportunities in the crisis. Your opportunity may be to avoid the stock and look elsewhere. That is a valid choice. Those with strong stomachs and money to risk may choose to bottom-fish as the price goes lower. Others who already hold the stock may wish to continue holding. If you choose this route, take the opportunity to dollar-cost-average. Doing so at least puts you in a better average price point, should you decide to sell as the share price appreciates.

Whatever you do, refuse to be shaken out at a significant loss. History shows that the share price will recover at some point to a more favorable position. When it comes to dealing with SEC actions, selling a bottom is the only real catastrophe.

Source: SEC Inquiries: Opportunities, Wrapped In Hysteria, Inside A Catastrophe - Part II