Fun with Terax Oil & Gas

Maybe there is something wrong with me, but I find joy in reading the SEC litigation updates. I subscribe via RSS. This is how I learned about Terax Oil & Gas (OTC BB: TEXG.ob). The company as well as its executives have been sued by the SEC, and the company’s assets have been frozen.

Trading in the shares of Terax Oil and Gas has been suspended by the SEC from September 12 until September 25.

Of course, this is small consolation for “investors” who bought shares of the stock at $20 a year ago. They last traded at $2.65 and they are probably worth absolutely nothing now. It just goes to show that caveat emptor definitely still applies when investing in unlisted over-the-counter stocks.

Disclosure: I have no pecuniary interest in Terax. My disclosure policy makes for good reading and is best accompanied by a glass of Muscat.

Kiplinger profiles my favorite overhyped penny stocks

In a recent article on hyped-up penny stocks, Kiplinger wrote about three stocks, two of which I have previously profiled in this blog, including SunCal Energy (OTCBB: SCEY). I warned investors about SunCal fully two months ago, and my warning was timely–since then, the stock has fallen from around $3.40 per share to about $1.20 per share.

Kiplinger writers should start reading my blog–if they had, they could have found these companies (and many more similar companies) much earlier, making their lives easier and informing their readers sooner.

Disclosure: I have no position in SCEY, although I did short it a month ago.

Are stock buybacks good?

I will tell you the answer first, and this is an answer that I will use a lot. It depends. Stock buy-backs can be good or bad, depending on whether the stock is over- or under-valued. It’s that simple. Now let’s go over the details.
When a company makes a profit, it can do one of five things with the money:
1. Pay a dividend
2. Buy back shares of stock
3. Re-invest money in the company so that it can expand
4. Buy other companies to expand
5. Pay obscene amounts of money to management
In the future, I will deal with expansion and M&A (mergers and acquisitions). There are pitfalls to both paths, but both can also be good. Needless to say, I do not approve of Option 5. So let’s talk about stock buy-backs and dividends.

The traditional course for a company with little room for expansion and no opportunities for acquiring other companies is to pay out most of earnings in dividends. This is what utility companies do (see Progress Energy [[PGN]], for example). There is one problem with this, though. The company’s earnings, which have already been taxed as corporate earnings, are taxed again as dividend income to shareholders (now at a 15% rate). Much of that money therefore benefits Uncle Sam rather than the shareholders. Why not find a way to benefit the shareholders without giving the government a cut?

The way to do this is for the company to buy back shares of its own stock. Let’s say our company, Acme Brick, earned $1 million in 2004. They are in a mature industry and have little room to grow. Therefore, they decide to buy back shares of their stock. Let’s say there are one million shares outstanding, each selling at $10. The company is thus valued at $10 million. With its $1 million in profit, Acme buys back 100,000 shares, bringing the total number of shares down to 900,000. Each share now has 10% more value, since it represents 10% more of the company.

Rather than being paid in cash, the shareholders have been paid in ownership. They get no extra cash, but they now own a 10% larger stake in the company. The price of the shares should not actually change, since the 10% larger stake in the company is offset by the company now having $1 million less in cash, and thus being worth 10% less.

If the money had instead been paid out as a dividend, the shareholders would have received a 10% dividend in cash, but would have been taxed on that dividend, so they would only receive 85¢ on the dollar due to taxes. Again, because the company, after paying the dividend (it is now ex-dividend), no longer has $1 million in cash, it’s value will fall by that amount. The company will now be worth $9 million, with shares worth $9. Like with a stock buyback, there is no net gain or loss to the shareholders (except for the taxes on the dividends). (See box on the previous page for a longer explanation.)

Note that with small dividends, the market price of the stock may not change after the dividend date. However, with larger dividends, the price will drop by an amount equal to the dividend. We have seen that, because of the tax benefits, stock buybacks are often better than dividends. There is just one last factor to consider: the price of the stock. If a company buys back shares for less than the intrinsic value of those shares, then the buyback really benefits shareholders. The company is buying something for less than it is worth, and that is always good.

If a company’s stock is overvalued, however, it should pay a dividend rather than buy back its shares. In buying its shares, it would be paying too much, and thus destroying the wealth of the shareholders. So, in the end, it comes down to whether the stock is a good value or not. If it is not a good value, then the company should not be buying it. Then again, neither should we.

Some companies that have recently announced large stock buybacks include Progressive [[pgr]], Home Depot [[hd]], and Wyndam [[wyn]].

Disclosure: I own no shares in any company discussed in this post. See the disclosure policy.

Dividends and stock buybacks do not affect a company’s value

When you own a share of stock, you own a portion of the company. Therefore, when a company makes an initial profit, and the money in their bank accounts increases, the company increases in value. As a shareholder, that money is already yours, even though it is not in your account.

Let’s look at it from the perspective of a person who owns 100% of his company, Acme Chemical. Let’s say they make a $5 million dollar profit this year. The owner can do whatever he wants with the money: re-invest the money in the company, pay himself a dividend, or buy another company. No matter what our owner does with the money next, he is already $5 million richer. The money has been his since the day it made its way into the company’s bank account. Therefore, the choice of what to do with that money should depend only on what the best investment is. If there are no good investments (either inside or outside the company), the owner can pay himself a nice dividend and take a vacation.

So think of Acme when you read about a dividend or a stock buyback. As a part-owner of a company, you were richer once the company made a profit. What the company should do with the money once it has it depends only on what the best investment is. If the company’s stock is cheap, a buyback is a good investment. If the company can expand profitably, then re-investment in the company is a good course. If competitors are for sale cheap, then an acquisition could be good. If nothing else seems good, smart management will pay a dividend.

If, however, a company spends its profits on buybacks of expensive stocks or overpriced acquisitions, then management is being stupid. That is a good time for smart value investors to sell.

Octillion (OTC:OCTL): Another Worthless Penny Stock

CEO Previously Fined by SEC

First, see David Phillips’ article on the company’s CEO, Harmel S. Rayat, and his other failed companies. Then take a look at the SEC’s website to find out that Octillion’s CEO and majority shareholder was previously fined $20k for stock promotion. Andrew Left of StockLemon wrote a nice (if dated) article on Rayat’s company Hepalife (OTC:HPLF) back in 2003. David Phillips (of The 10Q Detective) wrote a more recent attack on Hepalife.

The CEO is still working at a number of his other penny stock companies. Therefore, the company states (in the May prospectus):

“Our officers and directors are also officers, directors, and employees of other companies, and we may have to compete with the other companies for their time, attention and efforts; none of our officers and directors anticipate devoting more than approximately twenty-five (25%) percent of their time to our matters.”

That the officers of the company are not full time is not exactly a good sign!

Valuation

As of June 29, 2007, the company had 51.125 million shares outstanding. At a recent closing price of $4.40 per share, that gives the company a $225 million market cap. The company has a book value of just under $1 million.

Back in mid-April (see the 8k) the company sold shares for $0.50 apiece in a private offering (actually, three warrants were included with each share, so this overstates the price). Has the company really become 10 times more valuable in the last 5 months?

Misleading Statements

Octillion triumphantly announced that NREL research had validated its own methods. However, as of right now, Octillion has nothing more than an idea and some silicon dust. Sure, the method they claim to use seems to work well. But I doubt Octillion, with a minuscule R&D budget, will be the company to get this technology to work consistently in the lab, let alone in a commercialized product. Octillion has issued another press release to claim that other solar power breakthroughs validate its technology.

The company likes to mention that the solar technology is covered by 10 US patents. However, the company does not own those patents–they are owned by U of Illinois Urbana/Champaign. It is only working to commercialize the patents. Since the company first started working with UIUC in August 2006 until May 2007, it has paid a grand total of $89,000. Not exactly a world-class research budget (see page 4 of this prospectus for details). Over the last three months, the company spent $151k on investor relations and only $27k on R&D.

It turns out that Octillion does not even have an exclusive license to develop and market the technologies it is investigating:

From page 17 of the company’s recent 10Q: “During the term of our ISURF Agreement and the UIUC Sponsored Research Agreement, we will determine whether to acquire an exclusive license from, respectively, ISURF and UIUC to the technologies underlying the agreements. The final terms and conditions of any such licenses cannot now be determined. If the results of the continuing research projects do not warrant our exercise of our option to negotiate an exclusive license to market the ISURF Nerve Regeneration Technology or the UIUC Silicon Nanoparticle Energy Technology, we may need to abandon our business model, in which case our shares may have no value and you may lose your investment.”

So even if these technologies end up working, the universities could demand more money for the licensing rights than Octillion could pay, and another company with deeper pockets could end up buying the license.

Knowing When to Sell

The brothers of CEO Harmel S. Rayat sold a large chunk (1.7% of the company’s shares) of their stake in the company in May (or soon thereafter, as set forth in the May prospectus, page 46). Other selling shareholders included two corporations that were wholly-owned by employees of Octillion (6.5% of the total shares outstanding).

Is Smart Money Buying?

David Gelbaum (a noted philanthropist) recently filed a 13D, stating that he (actually, a trust benefiting him and his wife) owned 6.7% of the outstanding shares of Octillion. However, considering his large stake in another OTC stock that I consider to be greatly overvalued (Worldwide Water, WWAT.ob), I doubt his investing prowess.

Conclusion: Stay Away

I peg Octillion’s fair value at $1 million, its book value. More aggressive speculators might believe it to be worth 10x book. Cynics might value it at $0 considering its CEO’s track record. No matter what it is at least 25x overvalued. For more information, as always, check out the company’s SEC filings.

Disclosure: I am neither long nor short OCTL. See my disclosure policy.

The Intelligent Investor

It was Ben Graham who taught me how to invest. Sure, I had played around with stocks before him, but I didn’t really know what I was doing. His book, The Intelligent Investor, is a one-book course on investing by understanding value.I recommend (and link to) the most recent edition, which has the 1970 edition of Graham’s writing, plus a 2002 commentary by financial writer Jason Zweig. This swells the book to over 600 pages, but it is all useful. I will try to outline below a couple of Graham’s key points.

The most important point that Graham emphasizes is that because we cannot accurately predict the future, we must have an adequate margin of safety. That is, we do not buy a company when it is fairly valued, because there is no room for error. Rather, we buy a stock that is very undervalued; even if the business starts to do a little worse it will still be a great value.

There are two ways we can look at value in companies. We can look at value from the viewpoint of the present value of the future earnings of the company or we can look at the present value of the assets of the company.

Graham liked to buy companies that were trading below 2/3 of their net tangible asset value. You calculate net tangible assets by subtracting all the debts of a company from all ‘hard’ assets, such as cash, receivables, investments, property (while ignoring goodwill, patents, and other hard to value assets).

In buying a company trading at a fraction of its tangible asset value, we are in essence buying it for less than its assets; theoretically, we could close the company and sell off its assets and make a decent profit.

Graham was not usually looking to do this, but in buying a company like that, he knew that its price could not fall much further–if it did, someone would buy up a majority of the company and sell off its assets for a profit. This gave the investor a very small downside risk but a lot of chance for a large profit on the upside.

Companies selling for less than their assets are rare nowadays, although if we wait until the next bear market, we will be able to find some and profit from them. In the meantime, though, we will most often buy companies that are undervalued in terms of their earning potential.

Another important point that Graham made is that, for an intelligent investor, there should be no difference between ‘growth’ and ‘value’ investing. If a company is increasing its earnings at a rapid pace, then its present value will be higher than a company that is not growing.

Thus, a rational value investor will be willing to pay more for a fast-growing company than for a slow-growing company. The problem with most so-called ‘growth’ investors is that they are willing to pay so much for stellar growth that they are left with no margin of safety. During the internet stock bubble, companies such as Yahoo [[YHOO]] and Amazon.com [[AMZN]] sold at astronomical P/E ratios. If you had bought Yahoo in late 1999 and held until today, you would have lost over half your money. Buying Amazon would have netted you a small loss–better than Yahoo, but not good considering it has been 8 years since 1999.

Even today, with P/E ratios of 44 and 108, these companies are not cheap. Most likely holding them for the next few years will not be a great investment.

While a company with a high valuation may continue to grow impressively, if its growth starts to slow even a bit, the stock will get hammered. This is why we stay away from overvalued companies, no matter how good they are. There is just too much risk.

Well, in one page I cannot do Ben Graham justice. Buy his book. If you buy only one investment book, this should be it.

Disclosure: I am neither long nor short any of the stocks mentioned above. I own The Intelligent Investor. See my disclosure policy.

A tale of two oil companies: Stormcat Energy (SCU) and Fox Petroleum (OTC: FXPE)

Sometimes the stock market is completely irrational. I will illustrate this with two wildcat oil companies (or junior exploration companies as similar companies often prefer to be called). Both companies are highly risky and may never make any profit. They are both highly speculative. Given the risks, however, one seems cheap while the other seems priced for perfection in this world and in the next.

The first company, StormCat Energy [[SCU]] seems cheap to me. It is trading at an all-time low, just about at its net tangible asset value (about $60 million). It is producing some oil, although still not very much. It remains unprofitable. While I am no oil and gas expert, I know that paying no more than the net value of all the company’s property and equipment (not even considering the value of the oil and gas underground) will lead to success more times than not. As long as the company’s management has some clue what they are doing the company should eventually become profitable. There is a decent chance of management having a clue–the company’s executive roster reveals a decent amount of experience.

Fox Petroleum (FXPE.ob) is a different story. The company has no employees and no assets other than a few mineral leases on property on Alaska’s North Slope and in the North Sea. The company has a market cap of $116 million and its leases are worth at best $50 million (and that is being very generous)–if the company cannot raise enough money to explore or does not find oil, its leases are worth $0. Other than its leases, the company has assets of $2 million. The company’s management does not inspire confidence, either. Only one of the executives has any oil operating experience–while one was involved on the financial side of mining companies and the third has no previous similar experience. Perhaps the only good thing I can say about Fox Petroleum is that management is not being paid absurd salaries.

Fox Petroleum’s contract with its President and CEO does not inspire confidence either: it requires that he work a minimum of three days per week (see the 8k where this is reported). For $140k per year that seems like a very minimal requirement. See the company’s most recent 10Q and 10K for details.

FXPE 6-month chart

While I am no expert on valuing oil exploration companies, I cannot think of any logic behind the divergent valuations of these two companies.

Disclosure: I have no pecuniary interest in either SCU or FXPE.ob. My disclosure policy never capitalizes its exploration costs.

Behavioral Finance

This comes courtesy of the World Beta Blog (post):

Whitney Tilson has a nice slidshow discussing how human decision-making causes investment problems.

Martin Sewell has a paper that is essentially a chronological annotated bibliography of behavioral finance research.

I know the literature fairly well and I believe it is imperative for investors to understand how their process of making decisions can lead them to making the wrong investment decisions.

Hedge funds for everyday investors

If you are intrigued by hedge funds and want a mutual fund or two that are less correlated with the market, then you are in luck. I am invested in one such fund and just came across another.

The fund I just came across is Weitz Partners III  Opportunity (WPOPX). This fund is a partially-hedged mutual fund. Wally Weitz has the discretion to short sell stocks and borrow to increase the long positions as well. Currently the fund is 18% short, 103% long, and 15% in cash. While the fund has not done well in the past two months, very few long/short funds have. The fund’s short positions should give it some downside protection, and if they are good shorts, could juice returns even in an up market. The modest proportion of short selling and leverage in this fund means that even if the short-selling is not very good, the fund will still do okay. This fund has a 1.21% expense ratio, very low for a fund that does short selling.

The other fund I would recommend is the Merger Fund (MERFX). I have been invested in this myself for a couple months. The fund practices merger arbitrage–buying the shares of companies that have agreed to be bought out. This strategy is risky if you or I were to do it, because there is a risk of a large loss with each trade and only a small possible gain. However, a fund such as The Merger Fund is diversified enough so that its returns are not very volatile. This fund should not outperform the S&P 500 in the long run, but it is a consistent performer with low-volatility. It is high-turnover, which means that it belongs in an IRA. Consider it as a replacement for a small portion of your bond portfolio. The fund’s expense ratio is 1.37%.

Disclosure: I am invested in MERFX.