Muddy Waters Research is an investment research firm that specializes in uncovering companies whose financial statements are inflated by questionable accounting practices. The firm was in the news again when it initiated coverage on NQ Mobile (NYSE: NQ), a company that provides software and services for mobile device users. Although NQ claims to have customers all around the world, the company is headquartered in China, and most of its revenue is generated in that country.
NQ was one of the biggest gainers a week before the negative research report, but the stock price fell by more than 50% within hours of the release.
According to Muddy Waters' analysts, NQ's financial statements are completely fictitious. Their analysis indicates that the company's sales and assets are overstated. They claim at least 72% of the company's security revenue from China is fabricated, and the revenue generated in other countries is even "less real." This means the profits are also overstated.
If Muddy Waters is correct, there is no way to determine what NQ actually earns.
Creating false financials seems like it should be impossible, but if the allegations are true, NQ fooled at least four Wall Street brokerage firms that rate the stock a "buy" or "strong buy." Earnings were expected to grow at about 40% a year, although it is likely those estimates will be lowered now. There are no other "hold" or "sell" ratings on the stock.
Assuming Muddy Waters is right, and they do seem to have a good track record, our question is whether or not our stock selection systems would have been fooled by NQ.
Not surprisingly, our indicators are generally bullish on the stock. A large price gain will lead to high relative strength (RS). Fraudulent financial statements will result in the stock looking attractive on a fundamental basis.
Yet we would not have recommended NQ as a "buy."
From a fundamental perspective, we eliminate stocks that are headquartered in China. This is simply because there are a number of accounting questions associated with companies in that country. Capital controls imposed by China's government make it impossible for international companies to efficiently manage their cash and leave management without the ability to maximize shareholder value.
From a technical perspective, we don't follow a lot of indicators because the few we like work well. One indicator that would have warned us about NQ is the Income Trader Volatility (ITV) indicator.
Below is a weekly chart of NQ that shows the time before the Muddy Waters report was released. ITV is at the bottom. Sell signals are given when ITV (gray line) rises above its 20-week moving average (red line). ITV indicated that NQ was a sell on Oct. 11, almost two weeks before the stock plunged.
ITV is calculated as a stochastic of the recent closing prices. The moving average is used to determine the direction of the trend of ITV. As NQ plunged, ITV rose.
This is not a perfect indicator, because no indicator will ever work 100% of the time. The important point for us is that our screening processes would have helped us to avoid this disaster. We believe that it will work to avoid other big losses in the future.
NQ also demonstrates the importance of diversification. If speculative positions make up only a small part of your portfolio, large drops in price would only result in a small loss of wealth. Every portfolio should hold some conservative positions along with more aggressive stocks.
Action to Take --> Use at least several indicators to determine what to buy and sell, and consider where companies are headquartered before investing.
This article was originally published at ProfitableTrading.com
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