Category: Microcap

I’ve been going over Regulation T (Reg T; you can see it in its full glory here), which is the SEC rule that governs margin loans, as well as the NYSE margin rules for margin accounts. And if I were designing regulations to increase stock fraud, I could think of no better way to do it.

Why is this? The margin requirements for short selling stocks are greater than for buying stocks, at least for cheap stocks (below $2.50 in value). Here is how it works for stocks above $5. You will note the nice symmetry between short and long margin requirements. While the margin requirement for buying stocks is 50%, the requirement for short-selling stocks is 150%. Here’s an example: if I buy a stock for $10 per share (let’s say 100 shares), I only need to put up $500, or half the total value of the stock. If I want to sell the same stock short, I need to put up $500 (plus the $1000 in proceeds from the sale of the borrowed stock). So there is symmetry between short and long margin requirements. (Investopedia has an in-depth explanation of this). If the price of a stock is below $5, there is no margin allowed on either long or short sales. So if I want to buy 100 shares of a stock at $3, I must have $300 in cash (or margin from a higher-priced stock). If I want to short sell the same stock I would likewise need the same amount of cash or margin available.

The symmetry between long and short breaks down, however, with stocks under $2.50 per share. The NYSE has a rule (rule 431 (c) 2) that requires $2.50 in cash or margin for every stock below $2.50 per share sold short. A comparable rule does not exist for long positions. So if I want to buy 1000 shares of a penny stock trading at $0.40, I need $400 in cash or margin ability from marginable stocks. But if I want to short 1000 shares of a $0.40 stock I need $2,500 in cash or margin. So any time someone shorts a stock under $2.50, they have negative leverage: the position value ($400) is but a fraction of the money needed to hold the position ($2,500). For this reason, very few short sellers sell short cheap stocks. Fraudulent companies or worthless shell companies trade at absurd valuations because their share prices are too low to attract short sellers.

Most of the financial fraud in public companies nowadays is with penny stocks. The reason is because short sellers cannot afford to sell short cheap stocks. If the NYSE $2.50 rule were eliminated, more short sellers would be willing to take short positions in such overvalued companies as Hepalife (OTC: HPLF), My Vintage Baby (OTC: MVBY), and YTB (OTC: YTBLA). Pump and dump scams would not be as effective because short sellers like myself would easily be able to short sell the pumped-up stocks earlier, at cheaper prices, reducing the harm to the poor rubes who fall for such scams.

Removing the $2.50 rule would increase the amount of information available about penny stocks as short sellers like myself would write critically about the overvalued stocks they sold short. This would give the poor rubes a chance to learn the truth about the worthless stock they were considering buying and this would further reduce the success of pump and dump scams.

Please, contact the NYSE and urge them to stop supporting scammers and fraudsters. Urge them to remove the $2.50 requirement.

Disclosure: I have no interest in any of the stocks mentioned above.

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.

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.

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.