I answer the questions your searches pose

It is always fun to see what search terms people use to find my blog. Here are my responses to a few of the most memorable, with the search terms phrased as questions:

Q: Are covered calls a bad investment
A: Yes. Mathematically, selling covered calls is just like writing puts. Small reward, big downside. Plus, the commissions for options at most brokerages are very high.

Q: Is Bernie Schaeffer a fraud/scam?
A: No. But you shouldn’t listen to him if you want to make money in investments. You’d do better in an index fund. Plus, his fees are outrageous.

Q: Cheap disclosures on felonies?
A: Huh?

Q: Can I earn $100k per year on my investments?
A: Yes, if you have $2 million and invest it in stocks or bonds yielding 5%.

Q: Is Fox Petroleum (OTC BB: FXPE) a good buy?
A: No. If you think it might be, please find a nice Vanguard index fund for 99% of your money and amuse yourself at the horse track with the other 1%.

Q: Have I made a bad investment?
A: If you have to ask, then yes, you probably have.

Q: I lost all my savings trading.
A: Work hard, save some more, and this time invest it in a target-date retirement fund from Vanguard. Over time you should do okay.

Q: I recommend Fox Petroleum.
A: I don’t.

Q: [Can I] make a million shorting stocks?
A: Easily. Just start with two million. After awhile, you’ll have $1 million. Keep in mind that when short selling, you are going against the long-term trend of the market. Are you good enough to beat those odds?

Q: [Are there] microcaps with dividends?
A: TSR [[tsri]] comes to mind.

Q: [Are there] otc value stocks?
A: Yes, and I bought one a couple weeks ago. I won’t tell you what it is, though. I may wish to buy more, and it is very risky.

Q: UPDA why is it a bad investment?
A: Actually, it might not be. Considering that the company owns 87% of another penny stock, which has an implied market cap over $200 million, and its market cap is $30 million, it could be profitable to buy it. Of course, my bet is that the company it owns will see its share price decrease, so a prudent person would avoid UPDA.

Disclosure: I am long TSRI. I have no pecuniary interest in any other stock mentioned. My disclosure policy, by the way, invests in index funds and low-cost ETFs.

Taking my own advice on ETFs & ETF Tax Avoidance Tricks

Do not accuse me of being a hypocrite. Since my article, An ETF Asset Allocation Plan for Everyone, I have bought a large number of shares in DEM, VTV, VWO, and EFV. And I will hold those funds in those ETFs ad infinitum. One thing to keep in mind regarding asset allocation with passive funds–make sure that you take into account any active funds you have or any individual stocks when deciding how to allocate. I personally own a large number of US small-cap and micro-cap value companies (examples include TSRI, MSI, SCVL, and LAD), so I do not need to duplicate that with ETFs. On the other hand, I own only one foreign stock, so I needed to drastically increase my portfolio weighting to foreign and emerging markets.

One advantage of using ETFs is that they are tax efficient. Also, if an ETF shows a loss towards the end of the year, an investor can always sell the ETF and buy back a similar one (although check with your CPA on this). That way an investor can reduce his or her taxes while avoiding the wash-sale rule. Of course, this should not be done unless the tax savings would be large, because commissions and bid/ask spreads can eat up gains from this strategy.

Disclosure: I am long all the stocks and ETFs mentioned above. I am not licensed to give tax advice: please consult with your tax attorney or CPA regarding legal tax avoidance strategies. I have a disclosure policy that is based in the tax haven of the Jersey Islands. It is also Amish, but only so that it can legally avoid paying social security taxes.

Growth is Also Value

The only thing that matters in valuing a company is the company’s future ability to pay dividends. That is all. If we buy a company such as Frontline Shipping [[FRO]], we may receive great dividends in the near term. However, the oil shipping industry is likely at the back side of a cyclical peak in prices. So while we would get great dividends now, and the P/E of the company is low, the company’s future dividend-paying ability will likely fall off drastically. On the other hand, with a quickly growing company such as CHC Helicopter [[FLI]], the company can continue to grow and increase its dividend far into the future.

Warren Buffet called companies like this ‘cigar butt’ companies. With a cigar butt, you can get a few smokes before its gone. With these companies, an investor can get a 20-30% gain as the stock returns to fair value, but that is it. These companies are undervalued, but their future prospects are not great.

The other method of value investing is to find companies that may be fairly valued, but have a great business and great future prospects. Since these ‘value growth’ companies are fairly valued at current earnings, we have a margin of safety even if their growth turns out to be much less than we predict. Thus, even if our predictions are wrong, we will not stand to lose much money. If, on the other hand, we simply bought great growth companies without regard for valuation, we would have no such margin for error.

Warren Buffett once said that he’d rather buy a great company at a fair price than a fair company at a great price. A great company can continue to show great improvements for years, as its business expands. In other words, our potential profit is a lot greater with a fairly valued ‘growth’ company than with a cheaply valued ‘value’ company.

Disclosure: I own no shares of FRO or FLI. My disclosure policy grows its earnings at a rate of 5% per year while paying a 15% dividend yield.

H2Diesel Down 40% Five Days After I Criticize it: Am I That Goode?

Today H2Diesel (OTC BB: HTWO) stock dropped 43% on no news. The only news since I wrote critically about the company five days ago is that the company filed a boring proxy statement. So is it just because of me that the stock has dropped? It seems like this, but sometimes overvalued stocks will fall on no news just because a few people realize that the stock is overvalued.

The decline in the stock price is depressing for me because I considered shorting the stock and would now be a lot richer if I had done that. However, the company has more than made up for this lost income in amusement value. I have already been contacted by a hedge fund manager who is long the stock and by some random person who gave me some information about the company and encouraged me to continue to write critically about it. That critic of the company acted like a spy and used only a pseudonym. Ah, the joy of financial blogging.

Disclosure: I am neither long nor short HTWO. I have worked as a spy for Mossad, the KGB, the CIA, The Church of Scientology, The Illuminati, and the Gou’ald. My disclosure policy, unlike me, is not a traitor to the human race.

Financial Columnists have no Stockpicking Talent

At least according to a new study by Dan Palmon, Ephraim Sudit and Ari Yezegel. After properly adjusting for stock size and value metrics the picks of columnists in Businessweek, Fortune, and Forbes slightly underperformed the market. For a summary of the article, see my favorite blog, CXOAG Investing notes.

This is yet another reason why I like index funds. Buying them will save you on magazine subscriptions.

Personal Finance and Happiness

Most people need at least a little help getting their finances in order — the personal finances of the average American are in a horrendous condition. One thing that most people do not consider when talking about personal finances is when spending actually makes us happier and when it does not. The key is to avoid spending money when we get little joy from spending and to freely spend it when it is on something that will give us joy (as long as we have the money — debt and worry are two of the greatest causes of unhappiness).

So what gives us happiness? First and foremost, our relationships make us happy. Giving to our friends and to our spouse can be very important, especially when you consider the pain of loneliness or divorce. So never hesitate to spend money to go on dates with your spouse or to get him or her gifts (again, as long as the spending is reasonable). Now think of what you do during your free time. You probably sleep: we all spend much of our time doing it and yet how much time or money have we invested in a good mattress and good pillow so that we sleep well? Speaking of which, if you do not get enough sleep, you will be unhappier, stupider, and less productive than if you get enough sleep. What is another thing that people spend a lot of their time on? How about TV? I find it odd that people who spend much of their free time watching TV are often unwilling to spend money on getting a good TV, such as a large screen LCD HDTV. (Of course, I would argue that most people would probably be happier and healthier if they spent less of their time watching TV).

Now that I have encouraged everybody to spend some money, it is time to look at those things that we spend much money on that do not really make us any happier or better. The first item on this list is going to restaurants. Eating at restaurants is expensive relative to cooking a meal yourself and restaurant meals are more unhealthy than home-cooked meals. Eat at home more often, and use some of the money that you save to splurge occasionally for really nice meals at fancy restaurants on dates with your spouse.

Another thing that people spend money on but derive little enjoyment from is expensive or deluxe versions of everyday items, whether clothes, appliances, electronics, or computers. Do you really derive more happiness from having a $5,000 stainless steel refrigerator than from having a more average model? The same can be said of many of the things we buy. Are you really happier because you have $300 purse? Or would a cheap knockoff that looked almost as good be good enough? Some people do actually get more enjoyment from the more expensive items, whether they are an audiophile who can tell the difference between a $10,000 and a $20,000 speaker, or whether they are an aesthete who finds happiness in having the perfectly decorated home. But for most of us and for most consumer goods, we are just fooling ourselves into believing that we must have the more expensive item.

Go through the money that you spend each month and ask yourself if spending that money makes you happier, healthier, or wiser. If it does not, do not spend the money. Save a portion of the money that you save, and feel free to spend a portion of that money on things that will actually make you happier, healthier, or wiser.

H2Diesel’s Biodiesel Miracle

The Technology Cannot Work

Today’s whipping boy is H2Diesel Holdings Inc. (OTC BB: HTWO.ob). I do not believe that the company’s product, a new method for making biodiesel, can possibly work. It would be great if it worked, but a cursory reading of the company’s description of the process makes no sense whatsoever to anyone who understands chemical manufacturing.

From the company’s website:
Unlike the complex transesterification process used by most Biodiesel producers H2Diesel’s Biofuel is manufactured using a simple blending, or emulsification process. Water is blended with a combination of commonly available chemicals to make a proprietary additive. The additive is blended with vegetable oil feedstock (commodity or waste) to produce the H2Diesel Biofuel. There are no significant by-products from the process.”

From their comparison of H2Diesel to normal biodiesel:
H2Diesel biofuel is manufactured using a simple mixing process, using little energy and yielding virtually no by- products

In the real world, there are very few chemical reactions without significant byproducts. Furthermore, transforming vegetable oils into diesel using any proven method uses significant amounts of energy, yet H2Diesel claims that their process uses very little. This indicates to me that the company does not know what they are talking about and that the method does not work as they indicate. This product is about as likely as perpetual motion machines.

Management Has Little Chemical Experience

I would expect the management of a research company that is revolutionizing chemistry to have a lot of chemistry research experience. Only one of H2Diesel’s top executives has any research experience, and only received his PhD in 2006. All the other executives have financial backgrounds.

Furthermore, the company has spent a total of only $287,000 in R&D since inception in 2006 (see p4 of the most recent 10Q). That is barely enough to support one full time research chemist and necessary chemicals, let alone the cost of analytical equipment.

I should add that the company acquired the exclusive license to their biodiesel production method from an Italian chemist (see the 2006 10-k for details). If the product was perfect when they licensed it, there would be little need for additional R&D expenditures. However, for most chemical products it takes significant R&D to turn a laboratory-proven technique into a commercially-viable technique.

Valuation: Losses, No Assets, Big Market Cap

According to the most recent 10Q, as of August 10, 2007, H2Diesel had 17,266,150 shares outstanding. However, the existence of the company’s Preferred Convertible A stock increases the fully diluted share count by 1,063,750. Warrants from the convertible preferred stock offering add an extra 531,875 fully diluted shares. At a recent price of $7 per share, the company has a fully diluted market cap of $188.6 million. (There are also at least 1.5 million other warrants outstanding that I do not include because they are performance-based for a consulting contract).

Also as of the most recent 10Q, the company had book value of $3.8 million and a loss in the previous 3 months of $3.7 million.

Big Name Partner Lends Credibility?

The company is having an affiliate of Dynegy [[DYN]] do a test-burn of some of its biodiesel. This seems to lend credibility to the company. However this appears to be a no-lose situation for Dynegy–it foots a few small costs and gets some free fuel.

Fuel is Not EPA Approved

The company’s biodiesel does not meet EPA standards for use as a fuel for vehicles. This means that the largest market for diesel fuel is off limits for H2Diesel for the time being.

From the company’s 2006 10K:
We intend to market the H2Diesel Bio-fuel as a new class of bio-fuel or fuel additive for power generation, heavy equipment, marine use and as heating fuel. We have evaluated whether the H2Diesel Bio-fuel can be formulated to comply with U.S. Environmental Protection Agency (“EPA”) standards to be classified as “Bio-diesel” for vehicular use. EPA standards mandate that “bio-diesel” comply with the specifications of the American Society for Testing and Materials (ASTM) 6751. In particular, ASTM 6751 requires that the fuel be comprised of “mono-alkyl esters of long chain fatty acids.” The H2Diesel Bio-fuel does not comply with this specific requirement of ATSM 6751, and consequently, it is not compliant with EPA standards. However, we are currently investigating whether the ASTM standard can be broadened to include our fuel. Additionally, we are evaluating the regulatory requirements for using our fuel in motor vehicle applications in our territory outside of the United States.

Conclusion

H2Diesel is speculative at best and utterly worthless at worst. I cannot imagine any reasonable investor buying the company’s stock.

Disclosure: I hold no position in DYN or HTWO. See my disclosure policy.

An ETF Asset Allocation Plan for Everyone

If I have not said it much before, I will certainly say it in the future: the best way to invest is with low-cost index mutual funds or low cost index ETFs. I like Vanguard, but it is even cheaper to get an account at Zecco.com and then invest in low-cost ETFs. They give you a certain number of free trades per month which is more than adequate for a long-term buy-and-hold investor. What I suggest below is not quite as simple as one of Vanguard’s excellent low-cost target date funds (see The Default Investment), but it will give you a portfolio that is more appropriate for your individual circumstances.

In the article on the default investment, I suggested talking to a financial planner if you wanted a tailor-made portfolio. However, the problem with financial planners is that they cost a lot of money relative to investable assets, particularly if you are not rich. A couple hundred dollars an hour or .5% of invested assets adds up quickly if you have a small portfolio. So for those with under a few hundred thousand dollars, it may be best to go it alone. You will need to first determine your risk tolerance. Buy Index Funds: The 12-Step Program for Active Investors; this book will help you think through how much risk you can handle. There are also 20 sample portfolios in the appendix for all different risk profiles. Those portfolios are designed for DFA mutual funds (which can only be accessed through a financial advisor). So I found suitable ETF substitutes for those funds and they are listed below along with their ticker and annual expense ratio. So buy the book, choose an appropriate portfolio for the amount of risk you can handle, get an account with Zecco, and then buy the following ETFs in the proportions recommended for your risk profile in the book. You will pay very few fees, your portfolios will be tax-efficient, and you will not have to think very much about your investments.

US Large Company: Vanguard Large Cap (VV), 0.07%
US Large Cap Value: Vanguard Value (VTV or VIVAX), 0.11%

US Microcap Index: iShares Russell Microcap Index (IWC), 0.60%
US Small Cap Value Index: Rydex S&P Smallcap 600 Pure Value (RZV), 0.35% or Vanguard Smallcap Value (VBR), 0.12%

Real Estate Index: Vanguard REIT ETF (VNQ), 0.12%

International Value Index: iShares MSCI EAFE Value Index (EFV), 0.40%
International Small Company Index: SPDR International Small Cap (GWX), 0.60%
International Small Value Index: WisdomTree Small Cap Dividend Fund (DLS), 0.58%

Emerging Markets Index: Vanguard Emerging Markets Index (VWO), 0.30%
Emerging Markets Value Index: WisdomTree Emerging Markets High-Yielding Equity (DEM), 0.63%
Emerging Markets Small-Cap Index: WisdomTree Emerging Markets Small-Cap Dividend Fund (DGS), 0.63%

One-Year Fixed Income Index: (see below)
Two-Year Global Fixed Income Index:
Five-Year Government Income Index:
Five-Year Global Fixed Income Index:

There are no funds that are very close to the above, but you can use different weights on Vanguard’s bond funds to approximate the average duration of the mix of the above funds. Vanguard Short-Term Bond Index (BSV), 0.11%, has an average maturity of 2.7 years, while Vanguard Intermediate-Term Bond Index (BIV), 0.11%, has an average maturity of 5.7 years. Both are invested primarily in Treasury and government agency securities. For very-short term bonds (or just buying government bonds of any maturity), you could enroll in Treasury Direct and buy 1-year treasuries direct from the US Government. If you hold them to maturity you pay no fees.

I see no great need to invest in foreign bonds, considering the safety of the Vanguard funds. While more diversification is good, there is a limit to how safe something can get–and it doesn’t get much safer than one to five year government and AAA-rated bonds. So if Index Funds says that you should have 10% in each of the four bond categories, your weighted-average maturity would be 3.3 years. So you could put 10% of your investable assets in 1-year bonds through Treasury Direct, 15% in the Vanguard Short-Term Bond Index, and 15% in the Vanguard Intermediate-Term Bond Index. This gives you an average maturity of 3.4 years.

When investing in these ETFs, you should rebalance every year. You could also choose to put a portion of your funds in one or more of Vanguard’s target date funds and then just add on the extra funds (value, small-cap) to the main target date fund. Then you would not have to rebalance as often.

If you follow the above plan, you should expect to outperform 80% of other investors, because they will incur more taxes and more fees. You will also end up with investments tailored to your unique circumstances. And you will only have to think about your investments once a year. This sounds like a good deal to me.

Continental Fuels Remains 100-times Overvalued

Company Remains 100-times Overvalued

The problem with so many penny stocks is that they have so few assets and earnings that even after a precipitous drop in the stock price they can remain very overvalued for a very long time. When I last wrote about Continental Fuels (OTC: CFUL) on September 15, its stock price was $1.70 per share and it had a fully diluted market cap of $972 million. At the recent closing price of $.71, the stock has a fully diluted market cap of $406 million. Because the company has a negative book value and no earnings to speak of, I cannot value it using traditional means. Also, I am feeling generous, so I will value the company using its total assets of $3.8 million as of its most recent 10-Q filing. This is the equivalent of $.0067 per share. This, of course, ignores the company’s liabilities. Even using this generous measure of assets to value the company, it still looks over a hundred times too expensive. Needless to say, I still believe that Continental Fuels is one of the worst possible investments that anyone could make right now.

Just for fun, I did a little more research on Continental Fuels and I found out some more interesting information about the company.

Yet Company Spent Money to Hype its Stock

Continental Fuels paid an internet stock tout company, Crosscheck Capital LLC of Arizona, $525,000 to pump up the stock in a mass mailing to 500,000 people. The company states this in its May 2007 10-Q filing. From the filing:

On March 15, 2007, the Company entered into an agreement with Crosscheck Capital, LLC (“Crosscheck”) to pay aggregate advance retainers of $525,000 to prepare and distribute to no less than 500,000 US residents an advertising/advertorial mailing package that prominently features a report on the company. As of March 31, 2007, the Company has remitted $150,000 of the advance retainers due to Crosscheck. The remaining amount, $375,000, was paid in April 2007.

The company touted its stock at a time when it admitted elsewhere that its stock was worth much less than the market price. Considering that Continental has acknowledged in many instances that its stock is overpriced, I can conclude only that the company acted immorally in willfully soliciting new investors for its stock so as to maintain the absurdly high share price. Unfortunately, I do not have copies of the materials sent by Crosscheck Capital, so I cannot determine whether the company’s actions crossed the line between misleading statements and lies.

If you have any copies of the materials sent out by Crosscheck Capital, please let me know. If you are a fan of the company or are associated with the company, I would be interested in knowing your opinion as to why the company spent a significant chunk of its assets to promote its stock, then priced at $1.93 per share, when the company itself valued its shares just five months later at $0.008 per share.

Disclosure: I am short CFUL. I have not traded shares of CFUL since I first shorted the stock 12 days prior to my last article on it. I have a disclosure policy.

How to Spot Accounting Fraud

Thanks to Tracy Coenen for pointing this out.

Joseph Wells has a good article on how you can use time series of financial ratios to spot accounting fraud. He uses ZZZZ Best (Barry Minkow’s fraudulent company) as an example of how this works. When there is fraud, there will usually be excessive accruals, or non-cash items, relative to the actual cash flow of the business. This is because such accruals can be faked, whereas actual cash flows cannot easily be faked. If a company has $10 million in cash in the bank is easy for the auditor to verify. It is much harder to verify sales that have been billed but not yet paid. Any two-bit criminal can falsify a sales record and added big number to the Accounts Receivable line.

Accruals have already been shown to lead to poor stock performance, so this is just one more reason to avoid companies with high accruals.

See the article.