I am proud to host the following selection of the best entries to the Festival of Stocks. As always, there are plenty of great articles submitted for this edition. Thanks to all the authors for sharing your articles with everyone. Enjoy!

Memorial Day Parade 2004 San Francisco by Alaskan Dude

Commentary

Steve Alexander presents 10 Red Flags in Financial Statement Filings - MagicDiligence posted at MagicDiligence - Optimizing Joel Greenblatts Value Stock Strategy, saying, “10 red flags to look for when examining a company’s financial statements. Conversely, the lack of these red flags usually indicates a well-run and transparent company.”

VC presents What To Invest In If The Economy Gets Worse posted at The Penny Daily, saying, “What to invest in if you think the economy is going to continue to deteriorate and unemployment will continue to rise.”

Qovax presents Options Backdating, Spring Loading posted at Value Investing and Entrepreneurship by Qovax, a Software Startup, saying, “Options backdating is one of the favorite shenanigans that executives can use to enrich themselves and employees instead of the shareholders. This is because backdating options is usually considered benign and not necessarily illegal as long as everything is disclosed to the shareholders.”

Dr. Barry Burns presents Making a Killing, or Getting Killed in the Markets? posted at Top Dog Trading, saying, “How to protect yourself when the market gaps dramatically against your position.”

Ironman presents Calling a Market Bottom posted at Political Calculations, saying, “When will the stock market hit bottom? Ironman at Political Calculations finds there’s a 36% chance of stock prices hitting bottom in February 2009 and a 24% chance it already happened in January 2009.”

jim presents Basics of Treasury Bonds & Securities Explained posted at Blueprint for Financial Prosperity.

Raymond presents Second Stimulus Check For Obama 2009 Economic Stimulus Package? posted at Money Blue Book.

NetBiz presents Understanding The Stock Market: How To Make Money Even In A Bear Market posted at Money Galaxy - Make Money | Save Money | Invest Money.

Silicon Valley Blogger presents Free Stock Charting Tool To Check Stocks, Chart Market Trends posted at The Digerati Life, saying, “Thank you!”

Sun presents Fibonacci Rule and How to Use it in Trading Gold Explained posted at The Sun’s Financial Diary.

Michael Cintolo presents The Lowdown on Value Investing posted at The Iconoclast Investor.

Insurance Toolbox presents How to Invest in the Stock Market without the Possibility of Losing Any of Your Investment posted at Fine-Tuned Finances.

Super Saver presents Looking for Future Winners instead of Past Performers posted at My Wealth Builder.

Patrick @ Cash Money Life presents Does Zecco’s New Rate Change Make You Want to Change Brokerage Firms? posted at Cash Money Life, saying, “Zecco essentially ended their free trades for many traders - here is how their new pricing structure compares to TradeKing and ShareBuilder.”

ChristianPF presents Zecco no longer free posted at Money in the Bible | Christian Personal Finance Blog, saying, “Apparently, even Zecco can’t keep the good thing going as the economic challenges continue…”

Stock Analysis

Saj Karsan presents Monster Worldwide posted at Barel Karsan.

Jae Jun presents Bill Ackman’s Wendy’s Presentation posted at Old School Value, saying, “Study the rationale for why Bill Ackman invested in Wendy’s”

Stockaholic presents Nova Chemicals (TSE: NCX) – Bankruptcy, Or A Screaming Buy? posted at Traders Corner, saying, “Is Nova Chemicals looking at bankruptcy or a turn around?”

Dividends4Life presents Stock Analysis: Lowe?s Companies, Inc. (LOW) posted at Dividends Value, saying, “Lowe’s Companies, Inc. and its subsidiaries operate as a home improvement retailer in the United States and Canada. The company offers a range of products and services for home decoration, maintenance, repair, remodeling, and property maintenance. Linked here is a detailed analysis commentary.”

One Family presents Our Fannie Mae (FNM) Investment – A Case Of Escaping With Minor Wounds! posted at One Family’s Blog.

Declan Fallon presents Zignals Stock Charts: British Airways posted at Zignals blog.

1. Carefully review investor materials including prospectus before investing.
2. Make sure you are absolutely clear about the fees you have to pay.
3. Do a background check for criminal records or litigations against the fund manager.
4. Find out how often the fund manager will report to you and in what reports will you get.
5. Verify the fund advisor is registered with the proper agencies such as SEC, FINRA or NFA.

Not a bad list at all. Some of the things mentioned in the list coincides with my 5 Red Flags of Fraudulent Hedge Funds. I talked about a few more red flags that are easier to spot.

Scam Trucks by jepoirrier

But, Harry Markopolos, in his testimony, said it took him just five minutes to identify Madoff’s scam. The biggest tip-off is the 45 degree graph depicting the consistent returns that Madoff claimed his funds were achieving. It’s just plain impossible. In fact, had SEC listened to any of Markopolos’ complaints back in 2000, 2001, 2005, 2007 and 2008, Madoff could’ve been caught earlier.

If you haven’t been following Madoff’s story, read What Madoff Can Teach Us. One thing is for certain — investors can not rely on any agency to protect them. As I’ve said before, the SEC can only stop the fraud after investors have lost their money. It is up to us to be able to tell the wolves from the sheeps. Read more on how to detect investment fraud.

Tasked to duplicate Madoff’s success, Harry Markopolos, a former CIO of Rampart Investment Management, started his own investigation into Madoff beginning in 1996. After years of failed attempts to reproduce Madoff’s results, Markopolos was convinced that Madoff’s record of consistently outperforming the market 72 times in a row, to be precise, was simply impossible.

In May 2000, Markopolos sent the SEC evidence that would’ve implicated fraud at Madoff’s funds. But the SEC official who received the documents, Maeghan Cheung, had basically pooh-poohed the claims. Now that Madoff is exposed, Markopolos stepped up to identify shortcomings in the SEC that could’ve saved investors billions of dollars. Markopolos didn’t do so earlier out of fear for his family’s safety. This was well founded.

In his past life, before Madoff turned his focus onto his Ponzi scheme, he was the Chairman of NASDAQ. As Chairman, he championed the idea of greater transparency. To this extent, he worked very closely with the regulators. How close he was with the regulators was uncertain. The old adage “keep your friends close, but keep your enemies closer” seems to be in play here. Perhaps it was his reputation and public stand on greater transparency and accountability that had the regulators turn a blind eye.

What’s disturbing is it wasn’t just Markopolos who raised the alarm. Other rival money managers also attempted to duplicate Madoff’s returns to no avail. Complaints were filed with the SEC, but the investigations conducted were “inconclusive”.

The moral here is not to rely on the SEC to keep investors safe. The SEC can only react, not prevent. By the time the SEC can prosecute, the damage is already done. Prevention is better than cure, no? Learn how to identify the 5 Red Flags of Fraudulent Hedge Funds. Find out What Madoff Can Teach Us.

According to Mr. Joseph, 98% of the victims of investment frauds are senior citizens because they have accumulated sufficient wealth over a lifetime. And the problem is, as we begin to see during this recession, these Ponzi scam artists are legion.

Mr. Joseph thinks more Ponzi schemes and frauds are uncovered during tough times because more and more people are seeking guaranteed high returns. And that’s easy to sell despite the fact that “guaranteed high returns” is really an oxymoron.

But, let me offer another theory on why there’re more frauds reported during tough times. The reason is the fraud schemes are not sustainable. A Ponzi scheme that guarantees consistently high return is guaranteed to fail. In fact, the higher the return, the faster it falls. If you observe these fraud cases, they were started way before the recession. So people didn’t flee to the guaranteed high returns during recession. They were chasing guaranteed high returns when the economy was booming. In other words, we were greedy when we should have been afraid. The recession certainly helped make the fraud schemes fail faster.

Both articles chimed in on steps investors can take to protect themselves from fraud. The advice doled out echoes what I wrote in 5 Red Flags of Fraudulent Hedge Funds. Although, I don’t quite agree with DeCharles’ advice on diversifying. What if you are diversifying across all “guaranteed high return” funds? If you read 150 Stocks - The Secret to Proper Diversification?, you’d know why I agree with Warren Buffett when he said “Diversification is a protection against ignorance.”

Former Merrill Lynch CEO, John Thain spent $1.2 million fixing up his office last year which included a $1,405 trash bin. I don’t even know where to begin to find such a luxurious trash bin. Just before Bank of America took over Merrill, he paid out $4 billion in bonuses to associates and then quit. Thain himself initially asked for a $10 million bonus, but decided to forego the bonus later. Thain did promise to repay the renovation cost of his office… after the news came out in public. Bank of America received $25 billion in aid via TARP.

Citigroup, who also received $25 billion via TARP, planned on purchasing a $50 million executive jet. After hearing Obama’s comment that using private jets is not “the best use of money”, they canceled the plan.

As I have mentioned before in Executive Compensation - What to Watch For, executive compensation in the financial industry tend to be substantially higher. Investors need to understand how executives are compensated, whether or not the compensation is fair and, most importantly, whether or not executives are incented to enrich shareholders instead of themselves. There’s a reason why Warren Buffett would rather own preferred stock in Goldman Sachs.

Yesterday, I wrote How to Spot An Arthur Nadel dishing out some tips on how prudent investors could have saved themselves from scam artists like Nadel. About a week ago, I talked about the 5 Red Flags of Fraudulent Hedge Funds. Incidentally, one of the red flags mentioned in the NY Times article (i.e. marketing to unqualified investors) also appeared in my list of 5 red flags. Leaving my bias out of the equation, I can honestly say my list is better.

More and more investment frauds will be unraveled in the next few weeks. Just yesterday, police nabbed six suspects involved in a pump-and-dump scheme ran in the guise of a Langbar company which traded on the Alternative Investment Market (AIM) of London Stock Exchange (LSE). Langbar, the biggest share fraud on the LSE, reportedly took in more than $600 million from investors and invested in… nothing. Trading of Langbar shares have been suspended. The new CEO, Stuart Pearson, who is also a chartered accountant, issued an audited statement that €280 million were deposited into Langbar bank account at Banco do Brasil. After reassuring investors that the company had millions in assets, Pearson suddenly reported that investigation by Kroll indicated that the company had no such assets ever in the history of the company. He added that the company may have been defrauded. Pearson himself is now under investigation.

Nadel has been transferring funds into secret bank accounts controlled by him and his wife, Peg Nadel. Investigations also revealed that he owns homes in Sarasota and North Carolina, a 500-acre development in North Carolina, a Learjet 35A (worth about $1 million) and two Cessna Citation IIs (worth about $1 million a pop).

In a recovered letter to his wife that was meant to be shredded, he advised his wife to withdraw as much cash as possible from the bank account because the account might be blocked soon. He also directed her to documents that should give Peg ownership of “what’s left”. And, “sell the Subaru if you need money”, he says.

What’s interesting is there were several giveaways that should have raised suspicion for the prudent investors:

1) According to court records, Arthur Nadel was a former attorney who lost his license to practice for taking client escrow funds back in 1978. He took $50,000. He ended up repaying the full amount.

2) Nadel promised investors an average of more than 20 percent per year. In his sales materials, the funds were represented as earning 11 - 12 percent a month last year! That’s more than double your money in a year.

3) The funds’ reports were never audited. Despite the insistence by Nadel’s two partners to hire an independent auditor after Bernard Madoff’s arrest, Nadel resisted and decided to flea instead.

4) Neither Scoop Capital nor Scoop Management are registered with SEC despite having more than $200 million in assets under management and over 500 investors combined.

To learn more about how to spot a fraudulent hedge fund or a Ponzi scheme, read 5 Red Flags of Fraudulent Hedge Funds.

So if Raju didn’t benefit from the inflated cash nor did he trade his shares for profit, why would he cook the books to begin with? Satyam employs about 53,000 people. 13,000 of which investigators claim are non-existent. It appears Raju might have been siphoning crores (1 crore is approximately $205,000) every year to benami bank accounts (i.e. held in the name of Raju).

We’ve heard of inflated earnings. But inflating cash is almost impossible to pull off without auditors cooperation. And that is exactly what Satyam had going to cheat its investors for years. Two senior auditors of PricewaterhouseCoopers admitted to receiving substantial compensation in return for deliberately overlooking the fudging. The auditors further disclosed that the CFO and other directors were in it as well. With management and the board of directors working in concert to cook the books, investors don’t stand a chance. To be able to value a business based on public financial statements alone, an investor must be able to assume that the statements fairly represent the business.

Watch for more institutions reporting major losses in upcoming months as the Satyam scandal unfolds. Satyam lost more than 80% of its “value” when the news broke. India’s largest bank, State Bank, already reports a possible loss of $100 million from its exposure to Maytas (Satyam spelled backwards). Maytas, a real estate company, also owned by Raju was about to be acquired by Satyam. Raju engineered $1.6 billion deal that fell through. Not a single rupee, huh?

Ironically, just three months ago, Satyam received an award for excellence in corporate governance. Satyam resembles Enron more and more. A Singapore money manager says it best, “In a bear market chickens are coming home to roost, so it gets highlighted at a time like this.”

Base Salary

The base salary is guaranteed pay for the executive no matter how the company performs. The pay for top level executives varies depending on the size of the company and the industry. Needless to say, the financial industry executives tend to get the biggest slice of the pie that ranges in tens of millions of dollars.

However, there is a handful of CEOs who opted for $1 salary. You might think these guys are shareholder angels. On the contrary, these CEOs may make their millions in stock options or other forms of compensation. Despite his $1 salary, over the last decade Steve Jobs has accumulated over 5.6 million shares of stock options worth about $500 million. In addition, Apple pays Jobs about $800,000 for the use of a Gulfstream V given to him by the company for $90 million.

Stock Options

Stock options are a great way to align executives’ interests with that of shareholders. If the exercise price of an option is significantly above the current market price, then management is incented to push the current market price higher. Because of this, stock options usually make up the biggest component of executive pay.

Unfortunately, there are several problems with options. The first being how options are expensed. Granting stock options to executives is not free. When stock options are exercised, they have the effect of diluting existing shareholders. As long as the cost of granting the stock options are expensed properly, shareholders can decide whether the compensation is reasonable. The second problem arises when stock options are backdated. In the past, companies were only required to report the granting of stock options within two months of the grant date. This rule allowed companies to grant stock options during an opportune two-month period where the stock price was low at the beginning and high at the end. The grant date will then be recorded as the beginning of the two-month period thus locking in an instantaneous gain! The SEC has caught on to this shenanigan and enforced a two business day reporting rule instead. Be sure to check out Options Backdating, Spring Loading for the low-down on options backdating.

Bonuses

The third component in an executive pay package is bonus. Executives are typically awarded pay-for-performance monetary rewards to encourage them to increase the company value. Again, the theory behind bonuses is that it motivates executives to enrich the shareholders by meeting certain targets such as earnings per share.

But the problem with bonuses often lies in the target set for the executives. If the target set is short term and easy to manipulate accounting wise, the executives will end up being incented to lie to earn their bonuses. This is most evident in Countrywide’s Chairman and CEO Angelo Mozilo. During the real estate boom between 2004 and 2007, Mozilo cashed in over $400 million worth of stock options by lowering lending standards in order to meet short term performance targets.

Perks

In addition to the three main components of pay above, top level executives are also entitled to perks like relocation expenses, company-owned transportation, corporate jets, health insurance and personal security. Perks such as corporate jets are not all bad. Corporate jets allow executives to travel efficiently and therefore saves the company money. But when the perks can no longer be justified, investors should consider a different investment.

General Electric CEO, Jack Welch, received a luxury apartment, sports tickets and fresh flowers from the company. Barry Munitz, former CEO of The J. Paul Getty Trust, demanded a $72,000 Porsche Cayenne SUV for his company car. Macy’s CEO, Terry Lundgren, drives around New York City in his armored Hummer H1 that costs sharedholders $87,000… per year! As an investor who demands safety of his investment, you ought to ask youself if elaborate parties for family members, interest free loans and $6,000 shower curtains are justifiable?

Severance Packages

A component of executive compensation that receives less scrutiny from investors is severance package. Most executives have severance packages. Severance packages are compensation received after the employment of an executive has been terminated. Severance packages can include cash, stock options, health insurance and retirement benefits. Understandably, severance packages are necessary to some extent to protect the executives. But when it gets out of hand, the severance pay can motivate executives to do more harm.

HP’s former CEO, Carly Fiona, received $21.4 million in cash and other benefits after termination. AIG’s former Chief, Martin Sullivan was paid $47 million in total in severance packages when he resigned after two quarters of record losses. You can’t help but wonder if the CEO is already executing his exit strategy from the day he came on board after negotiating a sweet severance package.

Conclusion

The first rule of investing is to invest safely. Getting in bed with wolves is not the best way to preserve capital. Investors must understand how their money is used by management. If management is spending money to enrich themselves, it’s time to jump ship. You can learn find out how management is compensated by reading the proxy statements and footnotes of 10-Ks and 10-Qs. To learn more about how to evaluate management, be sure to read Evaluating Management.