Martha Settling Down, Along With Company's Stock Price

Absence makes the heart grow fonder, and in the case of Martha Stewart, her five-month exile tucked away at "Camp Cupcake" in West Virginia made investors grow fonder of Martha Stewart Living Omnimedia (search) shares (NYSE: MSO).

The day before she got out of jail last week, the stock hit $37.45, its highest level in a year. On Friday, the day she got out, it started dropping and kept dropping-- to 28 the next Monday, 26 on Tuesday, 25 on Wednesday, and it's still dropping.… So, what lessons can we learn from the travails of Stewart and her company's stock?

Lesson No. 1: It pays to be a contrarian investor. Buying the stock when Stewart was accused was a good bet. Let's see why.

Stewart took her company public in October 1999, and MSO's market capitalization rose to $1.7 billion on sales of just $14 million. Just a tad overvalued, you might think.

Over the next few months, MSO shares did fall almost 74 percent, then hit a high of $35 in the summer of 2000. The stock was trading near $20 in the middle of 2002, just before Stewart was accused of obstructing justice and lying to the government over her sale of ImClone (search) shares. Then MSO dropped to its low at $5.

However, from the moment she decided to go to jail and serve her sentence rather than try to get a new trial, MSO's share price started rising. From about $18 per share in October 2004-- when she checked into Alderson Federal Prison (search)-- it zoomed to $37.45, more than doubling in value during the five months she cleaned the administration building as her work duty.

Since Stewart owns about 60 percent of MSO shares, let's hope she was able to reach her stockbroker to sell. Because now that she's back in sight, the stock has started to tumble.

Lesson No. 2: Instead of "buy the rumor, sell the news," substitute this rule: "Buy the indictment, sell the release from prison."

Buying when the CEO is down and out and the stock is too is a perfect example of a good contrarian play. In contrast, buying a stock when the CEO is back on the scene (as in, Martha out of jail) is investing by going along with the herd – not a good move for the pocket book.

Some of the best press Stewart ever received came while she was prisoner number 55170-054. The Wall Street Journal wrote a story about how she had gotten along with other inmates by counseling them on sentencing guidelines and serving as a pipeline to the outside world on the need for prison reform.

Clearly, she made a good decision to stop dragging out her requests for a new trial and to head straight to prison. She did it the American way: She bit the bullet, she took her medicine. She hit rock bottom, and now we're ready to let her try to redeem herself.

But while Stewart may now be marketing herself as the new softer-edged version of Martha the decorating diva, what really matters to the other 40 percent of MSO investors is what happens to her company's stock price.

Legally, she's not off the hook yet. Besides the nominal home confinement (even though she can be on the job more than eight hours a day, which sounds like the same degree of home confinement most of us face), she must deal with some difficult legal problems.

One is an insider trading investigation by the Securities and Exchange Commission, which could lead to her being barred from serving as an executive or director fora public company, including her own. Another has to do with a shareholder suit, claiming that Stewart did not properly disclose her legal situation, which eventually affected the price of MSO shares.

In the meantime, MSO has its own internal financial problems, having lost $60 million for the year. Its price/earnings ratio cannot be calculated, because the firm lost $7.5 million in the fourth quarter of 2004. It expects to lose more than twice that amount in the first quarter of 2005.

Notwithstanding the company's misfortunes, Stewart used some of her personal fortune to improve life for prisoner's relatives by donating linens, comforters, pillows and towels to the Alderson Hospitality House, according to the Wall Street Journal. And, in classic Living magazine style, the couple who run the house told the reporter, "We're feverishly trying to paint the rooms to match the linens." Sounds like good advice for potential investors. Buy the sheets, not the stock, and start painting.

Lesson No. 3: As goes Martha's popularity, so goes the stock market's. Although she lost the titles of chairman and CEO (she's now known merely as the founder), Stewart is riding this stock market rally well. When she was released from prison March 3, not only did MSO hit a new high, so did the stock market. The Dow Jones Industrials reached their highest level in 3-1/2 years.

Is it a coincidence or a telling turning point? The analysts at Elliott Wave International see a connection between Martha Stewart's ups and downs, as they point out in the March 2005 issue of The Elliott Wave Financial Forecast:

"… As long as the trend is rising, MSO can bask in its optimistic potential of the future. But Stewart's smiling visage on the cover of the March 7, 2005, Newsweek suggests that another peak is near. A similarly beaming Martha appeared on a January 2000 cover of Business Week, just as the Dow was topping. Newsweek says Stewart will emerge from prison, thinner, wealthier and ready for prime time,' but the early celebration over her 'recovery' is a sure sign that the countertrend rally is ending. As the bear market reasserts itself, Stewart will find her return to the business world a lot less accommodating than her jail cell."

The flip side of the "absence makes the heart grow fonder" saying is now coming into play. Judging from the downward trend of MSO's share price, it looks as though Stewart is about to understand the full meaning of the saying, "familiarity breeds contempt." And if she is indeed an avatar of the bull market, it will be instructive to see how she and her company fare. If MSO keeps heading south, it may well foretell the trend in the Dow.

Susan C. Walker writes for Elliott Wave International, a financial analysis company. She has been an associate editor with Inc. magazine, a newspaper writer and editor, an investor relations executive and a speechwriter for the Federal Reserve Bank of Atlanta. She received her B.A. in Classics from Stanford University.