Category: Microcap

Background checks are a good thing

Penny stock Energytec (OTC BB: EYTC) had found a new CEO, Don Lambert, and things looked good. However, according to the SEC, Lambert “failed to disclose his prior federal securities fraud conviction, his multiple bankruptcies, and that he had forfeited his Texas law license to avoid being disbarred.” One would think a public company, even a tiny company traded OTC, would think to do a background check or a credit check. But they didn’t. Because the company’s SEC filings did not include this material information, the SEC went after Lambert and made him pay a $50,000 fine. He consented to the judgment “without admitting or denying the allegations.”

Disclosure: I have no position in EYTC.

Research Frontiers Proxy Madness

Few companies can release a proxy statement to which stockholders react by dropping the company’s stock price by 15%. However, Research Frontiers [[refr]] does earn that dubious distinction. When I last wrote about Research Frontiers, the stock closed at $14.93. At a recent price of $5.19 per share, the stock is down over 64% since I called it a ‘failed company’.

While the proxy contains the standard stock options (including $900k to the chairman), stock appreciation rights, and other payments to executives, the interesting part is the company’s take on a shareholder proposal. The proposal reads in full (bold text mine):

 “RESOLUTION: Provide more detail information on film
production quantities and sales.

BE IT RESOLVED: On a quarterly basis beginning within 30
days of the 2008 annual meeting with the previous quarter’s
data, the company shall separately report revenue by license
fees and royalties; and report total royalty revenue that the
licensees are required to report by their license agreement
even though it might be below minimum royalty payments.
Additionally, the company shall provide information on how
much film is produced for sale as reported by licensees as
required by their license agreement. This information can be
aggregated for all licensees so that any individual licensee’s
information remains confidential.

Rationale for adoption: While there has been reported film
production and sales going back many years, there has not
been any officially reported measure of film produced or
revenue from sales that would inform shareholders of the true
extent of the commitment by licensees to develop SPD
products. In as much as the Company is 100% dependent on
licensees for SPD film production and sales, this information
equates to the viability of the Company and the only way to
fairly value the Company. Additionally, the Company has
over the years, partnered with licensees in the release of
information about SPD products for sale and sold but there
has been no information given to independently verify this.”

Unlike most shareholder proposals, this seems like a reasonable request for Research Frontiers to provide more detail on what its licensees are actually producing. The company’s reason to reject the proposal argues that the proposal would require giving out the licensees’ proprietary information, but the proposal clearly indicates that only aggregate disclosures would be necessary. More likely, the company wants to avoid disclosing that few if any actual products are being manufactured and shipped and all its revenues are coming from license fees and not from royalties on actual products.  Considering that in 2007 Research Frontiers reported $402,000 in revenue and yet boasts a large lists of licensees (see the 10k for details), I find it hard to believe that any of the licensees are shipping actual products and paying royalties.

More information:

2007 10K
2008 14A (Proxy Statement)

Disclosure: I have no position in REFR. I have never smoked reefer or coral reefs. I once took one puff on a cigarette but I did not inhale. I have a disclosure policy.

SEC: You can’t always trust press releases

In 2006, the investors in Southwestern Medical Solutions (then traded on the Pink Sheets) were informed via multiple press releases of the joyous news that the FDA had approved the company’s diagnostic tests. However, the SEC alleges that these were not true:

The complaint also alleges that Southwestern submitted false and misleading information about its business to the Pink Sheets, an inter-dealer electronic quotation and trading system in the over-the-counter securities market. The complaint further alleges Hedges, Powell, and Meecham were responsible in various capacities for preparing and disseminating the false press releases and false information provided to the Pink Sheets.

See the litigation release or the detailed complaint (pdf). If history is any guide, those individuals behind the company will only be forced to pay a small fine.

An Eclectic Guide to Discount Brokerages

There are many people with opinions on stock brokerages, but few who have used as many as I have. While I would love it if there were one broker that was best for everyone, there is not. So here are my picks and pans. I note when I have used a broker.

Best Broker for Investors

Scottrade is far and away the best broker for long-term investors who do not trade very often. Trades are cheap ($7), nuisance fees are minimal, and fills on orders are good. There are a large number of no-transaction fee mutual funds, and trades of other mutual funds are just $17 each. There is also a low minimum balance of $500. While my account at Scottrade is currently inactive, I will likely transfer some IRAs to Scottrade from E*Trade.

Best Broker for Short Sellers

At the moment this is a tie between Think or Swim and Interactive Brokers. I have been using Interactive Brokers for awhile and I am just trying out Think or Swim. These are the only two discount brokers of which I am aware that allow short selling of stocks under $5 and OTC and Pinksheets stocks. They also both have decent systems for telling if shares are shortable. Interactive Brokers has a color-coded alert in its Trader Workstation, while Think or Swim will tell you whether a stock is hard or easy to borrow. Most brokers will not tell you that information prior to placing a short sale trade. Think or Swim and Interactive Brokers have different pricing systems, so depending upon how you trade one may be cheaper than the other.

Best Broker for Mobile Traders

While many brokerages have WAP trading platforms for mobile phone browsers, Think or Swim has dedicated applications for Blackberries, Windows smart phones, and (coming soon) iPhones. If you think you might do significant trading from your phone or PDA, Think or Swim is the best bet.

Best Brokerage for Trading Foreign Markets

While E*Trade garnered much attention when it introduced foreign trading, Interactive Brokers has been doing it longer and does it much better. Trades are cheap, market data is accurate, and Interactive Brokers allows trading in many more countries than does E*Trade.

Brokers with Interesting Fee Structures

There are many discount brokers nowadays, some with interesting or unusual fee structures. Sogotrade offers some of the cheapest trades around ($3 per trade or $1.50 per trade with a monthly fee of $10) and I find it quite easy to use (although I quit using it when I consolidated my accounts at Interactive Brokers). It also offers automatic investments so it could be a good choice for both active traders and long-term investors. Zecco offers 10 free trades a month if you have at least $2500 in equity. FolioFN allows creation of what are essentially your own mutual funds and allows you to trade those funds at very low cost. Considering the proliferation of ETFs, FolioFN seems less and less worthwhile to me.

Potentially Worthwhile Brokers

Tradeking has been rated highly by others and it has cheap trades on stocks and options. OptionsXpress is not as highly rated as it used to be, likely because its commissions have not fallen much over the last couple years. Charles Schwab is geared towards people who want a bit of handholding.

Worst Brokerages

E*Trade and Ameritrade win this dubious award. Both charge many nuisance fees and relatively high commissions. The extras that they offer are not useful to anyone who has any clue what they are doing. Furthermore, E*Trade earns a special demerit for being the broker most likely to go bankrupt, due to its ill-fated foray into mortgage-backed securities. I started out with E*Trade, although I moved most of my money out of it last summer and I will transfer a couple IRAs this summer.

Also Rans

There are a number of other me-too brokerages that don’t seem to offer much of anything that better brokers do not offer. Firstrade is pretty much identical to Scottrade, except without all the Scottrade local offices and the size of Scottrade. Ameritrade iZone is a cheaper ($5 per trade) version of Ameritrade, but it does not offer as many features as some other discount brokers and it is not nearly the cheapest. I used iZone for a year and I was not always happy with my order fills.

Disclosure: I have no position in any company mentioned. I currently have funded accounts at Scottrade, Interactive Brokers, E*Trade, and Think or Swim.

Where is the value premium?

One of the quandaries of finance research has been why the value premium (the tendency for low P/B or P/CF or P/E stocks to outperform the market) has not been reflected in the performance of ‘value’ active mutual funds. A new paper by Ludavic Phalippou in the Financial Analysts’ Journal argues that the reason for this is that only the small-caps and micro-caps exhibit a large value premium. What this means is that an investor should either focus on buying small cap value index funds or should buy individual micro-cap value stocks.

The article is not available free online. Following is an excerpt from the paper’s conclusion:

The premise of this article is that if the value premium is a result of both pricing errors and limited arbitrage, then the value premium should be concentrated in stocks that are both held by relatively less sophisticated investors and expensive to arbitrage. Such a concentration is suggested in the literature but has not been quantified. In this article, I show that, indeed, at least 93 percent of market capitalization is free of a value premium. Using institutional ownership (IO) as a parsimonious way to classify stocks by their mispricing likelihood, I show that the value premium monotonically decreases from a high 185 bps for low-IO stocks to a negligible 13 bps for high-IO stocks. This result also holds when returns are value weighted and, importantly, is driven mainly by the long side. Low-IO value stocks are those with the most abnormal returns. The anomaly is a value premium, not a growth discount, as is sometimes argued …

The extreme concentration of the value premium has important practical implications. First, arbitrageurs can expect to face substantial costs when trying to arbitrage the value premium, and those focusing on the stocks most held by institutional investors (the larger, more liquid stocks) will have difficulties generating arbitrage profits. The value premium concentrates where arbitrageurs usually do not go. This reason is also why studies have found that value and growth mutual funds perform the same. Second, studies that select a subsample of stocks that, for instance, either have at least two to five analysts following the stocks or are traded on the NYSE end up with a sample that is almost free of the value anomaly. Such a fact is important to bear in mind when interpreting the results found in such samples.

Sex may sell, but it sure ain’t profitable

The old adage that sex sells may be true, but if an investor wanted to invest in publicly traded peddlers of sex (in all its legal incarnations), that investor would have only a few poor choices. While those choices may soon expand (when Penthouse goes public, as it is expected to do soon), the anti-prude investor should steer clear of this field.

The largest publicly-traded sex-related company, Playboy [[pla]], is the quintessential poor investment. Over the last two decades Playboy stock is up 42%, while the Dow Jones Industrial Average is up 520%. Even as Hugh Heffner continues to cavort with silicone-enhanced playmates one-third his age, the company’s centerpiece magazine continues to lose subscribers.

The story is much the same at cable-smut purveyor New Frontier Media [[noof]], where the stock has appreciated 2% over the last decade. The DJIA is up 64% over the same time period. The problem with cable porn is that it will suffer the same fate as newspapers: it is going to be crushed by internet competition. So despite a cheap P/E of 15, New Frontier will likely be a poor investment.

Rick’s Cabaret International [[rick]], a chain of strip clubs (see a commercial for it here), has been kinder to its investors than the above companies. Over the last decade it has outperformed the DJIA, 270% to 64%. But Rick’s is trading now at a stratospheric P/E of 34, which is out of line with companies most comparable to it: staffing companies such as Administaff [[asf]] and Manpower [[man]], both of which trade at P/E ratios under 15. While Rick’s provides stripping services in branded locations, it is not really that different from staffing firms that provide administrative and other services to companies. It relies upon its ability to recruit skilled workers, and its brand is far less important than the actual capabilities of its workers. Also like the staffing firms, it is vulnerable to a recession.

The last public sex company of which I am aware is the worst, yet it comes with the most wholesome reputation. This company is Berman Center Inc. (Pink Sheets: BRMC). This is a sex therapy center and website that caters to couples looking to improve their sex lives. Its eponymous founder, Dr. Laura Berman, is not only knowledgeable but also good at getting press. She has appeared on Oprah Winfrey’s show and she is a columnist for the Chicago Sun-Times. Despite the advantages the company has, its financials are a mess. The company, with a market capitalization of $12.5 million, has a book value of negative $1.3 million (see the most recent 10Q for details). The company lost $1.3 million over the first nine months of 2007 and lost $1.2 million over the first nine months of 2006. The company is also delinquent in filing its 2007 annual report.

Overall, sex makes for a poor investment, at least in terms of public companies.

Disclosure: I have no position in any stock mentioned. My disclosure policy is considered obscene in Utah, because it is transparent and it prohibits stock fraud, front-running, pump-and-dump scams, and MLM schemes.

Leveraged buyouts and EV/EBIT

As I mentioned previously, screening for companies using EBIT / EV allows for easier comparisons between companies with different levels of debt. However, what truly matters to the investor is earnings yield (or FCF yield, which accounts for necessary reinvestment). A company can change its earnings yield simply by taking on debt and buying back stock.

I’ll take the example of Barbeques Galore, my first great stock pick, which was trading for a 5-year average P/E of 12 at the time I recommended it (in a stock bulletin board and in a defunct stock newsletter). Because the company is a retailer it has very little depreciation and amortization and thus little need for reinvestment—for these reasons earnings should be about equivalent to free cash flow. So this translates into an 8.5% free cash flow yield. There was very little debt on the books. We’ll assume for simplicity’s sake that they had no long-term debt.

BBQZ was taken private for a price of about $9.50 per share, 60% above the price at which I recommended it. This gives the company an earnings yield of only 5% (with earnings at $2 million and cost at $20 million). Was this a good deal?

The answer becomes clear when we take debt into account. Because BBQZ had essentially no debt, they could be loaded with debt to increase the earnings yield. We will assume that ¾ of the purchase price ($30 million) came from debt. With interest at about 5%, that increases the company’s interest expense by $1.5 million per year. Earnings do not fall by that amount, though. We need to look at EBIT and reduce that by $1.5 million, since taxes take a fixed proportion—not a fixed amount—of earnings after interest. Assuming a 40% tax rate, EBIT was $3.3 million before the buyout. After subtracting interest expense of $1.5 million and tax of 40%, we arrive at earnings of $1.1 million. Compared to the equity value of the company outstanding ($10 million), we now have a company with an 11% earnings yield. Not bad. Since the underlying operating characteristics of BBQZ remain the same, EBIT / EV remains the same (although EBIT/EV is lower than before the buyout was announced, since the buyout was at a premium to market price).

After adding a sizable amount of debt to the company the earnings yield doubled. This is the logic behind all leveraged buyouts (LBOs). If a company has consistent cash flow and debt is cheap, it makes sense to increase the debt to increase the earnings yield. The only time this is bad is when too much debt is added and the company risks not being able to pay its debt.

How does this matter to us as investors in public companies? We should try to examine companies by their EBIT/EV ratio rather than just their P/E ratio. This gives us a sense of how profitable the company’s underlying business is. Almost any company can look great if given a lot of cheap debt. A great example of this is Long Term Capital Management. They were a trading company run by the best of the best. They engaged in risk arbitrage. Their unleveraged profit margin was only about 2%. However, because they could obtain so much debt financing at such little cost, their investors saw 30-40% annual returns (until the company imploded, but that is another story).

Timothy Sykes is full of bullship

[Edit 8/18/2009 – Since writing this article I have changed from Tim Sykes’ biggest critic to his biggest fan. Please see this article on my new trading blog about how my opinion  of Tim Sykes changed.]

Timothy Sykes, the boy wonder who turned $12,000 into $1.65 million while still a teenager, has abandoned his hedge fund Cilantro to re-create his day-trading achievement in full view of the internet on his new blog. Sykes is best described as young, brash, egotistical, and annoying. Of course, an impartial observer would describe me in much the same way. Timmay and I also share the preference for shorting stocks over buying them. But rather than being two peas in a pod, we are polar opposites: Tim is the quintessential short-term trader and I am the archetypal buy-and-hold value investor.

I am not like some people who say that day trading is a crock and that it never works. It can work for some people some of the time. The problem with Tim Sykes is that he encourages others to follow in his footsteps by buying his $297 DVD trading seminar. There are several problems with buying a trading system such as Tim’s:

  1. Even assuming that some strategy works, if enough people follow that strategy it will cease to work. This is exactly what happened to Richard Dennis, the noted commodities trader, who famously lost tens of millions of dollars in 1988 after his trend-following strategy stopped working. Sykes of course likes trading microcap stocks with relatively thin markets. This means that his system is especially prone to break when too many people start using it.
  2. Trading takes a lot of time; this is particularly true for Timmay’s day trading and momentum trading. Most people have jobs, and very few people have enough in savings and enough trading talent to make a lot of money trading. So for most people, time learning to trade would be better spent nurturing their career or working a second job.
  3. Trading any system takes incredible self-restraint and guts. Very few people have the self-control to be able to stick to a system even when it is not making money. This is even harder if a trader buys a system (say, from Tim Sykes), because it is harder to become truly convinced in the system if that trader did not invent it himself or herself.

Traders and investors should steer clear of Sykes’ DVD and his trading system. Those few who could be good traders would likely do better developing their own system rather than following Tim’s. Of course, I find Tim amusing, so I encourage you to read his blog for its amusement value.

Disclosure: I had no connection to any person mentioned at the time I first posted this. Since I first published this post I have bought many of Sykes’ products, successfully used his trading system, and am now an affiliate of his (earning a commission on anyone who buys his DVDs using a link from my site).

Stifel, Nicolaus, and a Broker’s Theft of Client Money

Stifel, Nicolaus & Company [[sf]] has a reputation as a straight-shooting company. The regional brokerage, based in St. Louis, avoided accusations of biased stock research that ensnared many other brokerages at the time of the tech-stock bust. The company has not previously seen any of its Missouri brokers charged with securities violations by the state Securities Division. But all is not well with the company. In fact, Stifel, Nicolaus has recently shown that it has little concern for its brokerage clients, beyond its desire to extract as much money as possible from them. One of the company’s brokers, Girard Augustus Munsch Jr., was recently sanctioned and fined by the Missouri Securities Division for excessive trading in client accounts. How excessive?

One client, an 81-year old with a net worth below $250,000 and a liquid net worth under $100,000 (according to brokerage documents), paid $63,861 in commissions over three years on a total of 262 stock trades. In his deposition, the broker (Munsch) stated that for many of the trades, he was the only one to benefit. In other words, the trades were executed solely to garner trade commissions.

Another client, 72-years old when the client began with Munsch, had 122 stock trades over three years in her account, generating $32,389 in commissions for Stifel, Nicolaus. According to brokerage documents, this client had liquid assets of under $100,000. When interviewed by securities regulators, the client stated that she wanted to keep her money in mutual funds and to avoid high risk stocks. Girard Munsch acknowledged that he was was aware that he was the only beneficiary of many of his client’s trades, and that did not bother him.

Stifel’s Culpability

There are of course bad apples in every bunch. But Stifel, Nicolaus showed willful negligence and a casual disregard for the financial well-being of its clients in how it managed Munsch. Back in 2000 Munsch was put under heightened supervision due to customer complaints of unauthorized trading. Due to client complaints of unsuitable investments, Munsch was again put on heightened supervision in March of 2003 and 2004. Munsch’s supervisor, while requiring a phone log to make sure that he was acting appropriately, never checked that log or instructed Munsch in completing the log. Evidently it takes more than repeated mistreatment of clients to get a broker fired from Stifel.

The Punishment

The punishment meted out by the Missouri Securities division is of course insufficient. Munsch should be barred from working as a broker. Instead, he has to be closely supervised and pays a meager fine of $105,700. For a successful broker, such a sum is far less than one year’s salary.

Stifel, Nicolaus, despite failing completely to supervise Munsch and to fire him after earlier violations of the law, gets off without a fine. A fine of $10 million would have been appropriate. However, the broker did one thing right : when I checked with Stifel, Nicolaus, I was told that Munsch had “retired”.

Disclosure: I have no position in any company mentioned.

When analysts get paid to provide positive opinions

People will respond to rewards. This is one of the most consistent findings in psychology. Whether the reward is pecuniary, emotional, or philosophical, people will (within reason) do whatever it takes to get rewarded. So if my business partner asks me to do something that is unimportant, I am likely to do it, distracting me from things I consider more important, because it matters to me what he thinks of me. If I am paid by someone to do something, I will make sure I act in such a way as to continue to get paid.

Acting in such a way as to continue to get paid is a problem when a person or company is being paid to give an unbiased opinion about a company. This is why Fitch, Moody’s, and S&P all have given absurdly high ratings to CDOs and other structured bonds: they were paid handsomely by the banks who put those bonds together. Those types of structured finance provided much of the profit growth of the ratings agencies over the last few years.

This same conflict of interest is often present in the micro-cap world. For example, I have previously criticized Beacon Equity Research for being paid by many microcap companies to cover them. Its reports are unfailingly bullish. The problem is that many investors do not take the trouble to investigate the company and they consider the reports meritorious. If an investor had invested in many of the companies covered by Beacon Equity Research, he or she would have lost lots of money. However, if the investor had instead read my blog and taken my advice (on stocks covered by both Beacon and myself), they would have avoided many losses.

For example, on February 6th, Beacon issued a positive report on Continental Fuels (OTC BB: CFUL), when it was trading at $0.28 per share. The analyst’s target price was $0.53. My most recent opinion on Continental Fuel’s valuation came last December 28th, when I said that the stock, then at $0.40 per share “continues to trade at 40x my fair value estimate of $0.01 per share.” The stock has since fallen to $0.03 per share.

Lighting Science Group (OTC BB: LSCG) makes another great example. Jeff Bishop of Beacon Equity Research published a positive article on the company on SeekingAlpha on February 8th. The stock closed that day at $9.80 per share. On February 22nd, I posted a negative article on the company on this blog. The stock price has since fallen from $9.90 per share to $2.85 per share.

Investors should always be careful to examine how analysts are compensated for their services. They would do well not to pay attention to any analyst paid by the company they are covering. In the end, each investor is responsible for his or her own investment performance. Those who are incapable or unwilling to put forth the necessary effort to understand the companies they buy deserve what they get.

Disclosure: I have no position in any company mentioned. I was short LSCG when I last wrote about it, as I disclosed at the time. I have a disclosure policy.