Avoid this stock!

Here are my notes on SCEY.OB. I wish I could short it, but retail investors like you or me cannot short OTCBB stocks [edit 8/15/07–actually, yes they can, but only through certain brokers. I will deal with that in a future post]. I bet this stock will be down 90% within a year.
$265 million market cap (78.2 million shares outstanding @ $3.39 per
share) and $1 million in assets.
see article here: http://biz.yahoo.com/seekingalpha/070713/41002_id.html?.v=1
“neutral” analyst report here: http://investrend.com/Admin/Topics/Articles/Resources/466_1182751792.pdf
(not a pump & dump, but the analyst company is paid a flat fee to
cover the company. The report is way too optimistic.)
Following are notes on their assets. Yes, the predecessor company was
capitalized with 23 million shares purchased for $0.001 per share. Not
a bad return for the current CEO/President/Director/Secretary.
from: http://www.sec.gov/Archives/edgar/data/1315373/000106299307000972/for…
Note A .
On January 31, 2007, we entered into a Share Exchange Agreement with
the shareholders of Sun Cal Energy, Corp. (“Energy”) to acquire all of
the issued and outstanding shares of common stock of Energy. Under the
terms of the exchange agreement, we will issue one share of our common
stock for each common share of Energy we purchased. On the acquisition
date, Energy had 26,925,000 shares outstanding. After we acquire
Energy, we will have a total of 78,175,000 shares of our common stock
issued and outstanding
Of the 26,925,000 shares of Energy shares issued and outstanding, our
president, Mr. George Drazenovic, owns 23,000,000. After the
acquisition, Mr. Drazenovic will own a total of 42,800,000 shares of
the 78,175,000 shares of our common stock issued and outstanding
(54.75% of our total common shares outstanding).
Energy was formed in the State of Nevada on June 2, 2006. It was
originally capitalized by Mr. George Drazenovic with $23,000 for which
he received 23,000,000 shares of Energy’s $.001 par value common
stock. During 2006, the Company received $1,125,000 in several
installments through a private offering in exchange for issuing
1,125,000 of Energy’s common shares. As discussed further in Note B,
Energy issued 2,800,000 shares of its common stock in connection with
the purchase of its oil and gas interests.
Note B.
On October 18, 2006, Energy entered into an agreement to purchase 1.5%
of 8/8ths overriding royalty in the City of Hobart lease located in
Oklahoma for $525,000 and 1,500,000 shares of its common stock. Under
the terms of the agreement, $375,000 was paid and 1,500,000 shares of
Energy common stock were issued in October 2006. The remaining
$150,000 was paid in January 2007. Energy is required to issue an
additional 1,000,000 shares of common stock following the permitting
of a second well as stipulated in the agreement.
On October 4, 2006, Energy entered into an agreement to purchase a 45%
undivided interest in 34 separate leases known as the Lokern leases in
addition to any leases taken in the prospect area. The Lokern leases
are located in California. The Company purchased its interest for
$125,000 and 1,300,000 shares of common stock. The $125,000 was paid
and 1,300,000 shares were issued in October 2006. Under the terms of
the purchase, Energy will receive 75% of the net revenue produced by
wells located on the leased properties. In addition, Energy is
responsible for its allocated share of all costs associated with the
leased properties including, but not limited to land, title, lease
bonuses, and drilling
The properties acquired by Energy are in the exploratory stage. In
valuing the properties acquired in the merger, we assigned no value to
the shares issued due to the status of the properties acquired and the
lack of marketability of the shares issued.
Disclosure: I currently have no interest in scey.ob, although I wish I could short it. My disclosure policy is rock solid, unlike this company’s balance sheet.

Oops! The problems of cut and paste

Loeb Hedge Funds just filed a 13D form with the SEC, stating the funds had taken a stake in Mercer Insurance Group (MIGP) and would seek a sale or liquidation of the company. It turns out that they are not seeking a sale or liquidation–whoever filled out the form just copied that phrase from a previous 13D filing. So while MIGP was up big on Friday, it fell back down big yesterday. The revised 13D is online here. Today (Tuesday), the stock is down some more. It still looks like a good value to me, trading at a P/E of 11 and a pric to tangible book value of 1.15.

Disclosure: I hold shares of MIGP. I have an airtight disclosure policy.

Screening for Stocks

One of the most important skills a stock-picker has is the ability to screen for stocks using criteria that can reduce the stock universe to a reasonable size. With over 6,000 stocks listed in the United States, looking into even 5% of them would be overwhelming. By using company fundamentals to screen for stocks we can reduce the number of companies we have to look at while increasing the odds of finding good investments.

Screening stocks based on fundamentals is not the only way to find stocks but it is usually the best way. If we can devise a stock screen that on average would have in the past chosen stocks that beat the market, then we can beat the market even if our more detailed analysis adds no value.

MSN Money offers the best free stock screener, although it requires you to use Internet Explorer to use it. Yahoo Finance offers a good stock screener that can be used with any internet browser. I encourage you to play with both screeners to see which you like better. Each of them has many different criteria you can use to screen for stocks. The choices are quite overwhelming at first. I will detail some of the more important.

First, there are valuation ratios. These are the most important because these tell you how much you are paying for the company. For all of these ratios, lower numbers are better. The most common ratio is the P/E ratio, which tells you how much you are paying per dollar of earnings. This is useful, but do not use it by itself. My favorite valuation ratio is the P/CF ratio, which shows how much you pay for each dollar of cash flow from operations. Other common ratios include the P/B (Price / Book) ratio, which tells you how much you are paying for each dollar of book value (assets minus liabilities). Another valuation ratio that may be of use is the P/S (price / sales) ratio. This is particularly useful, along with the P/B ratio, when looking for companies that are experiencing losses. You can make good money by finding companies in this situation that are on the verge of a turnaround.

After valuation ratios, profitability and efficiency ratios are the most important criteria for stock screening. Higher numbers are better for all of the following ratios. Return on assets (ROA) along with return on equity (ROE) show how much profit a company makes for each dollar of assets or equity. Net margin and gross margin (also known as operating margin) detail how much profit (or operating income) a company makes for each dollar of sales. Besides the standard profitability measures listed above, I like to use certain measures of efficiency, such as inventory turnover (the number of times the company sells off its inventory each year) and asset turnover (sales / assets). Along with looking at absolute numbers for these ratios, it can be useful to screen for companies that are increasing their inventory turnover and asset turnover.

Debt is the last thing I usually screen for. It is generally good to avoid companies with excessive debt, because they are at risk of bankruptcy. The most common way to do this is to use the debt / equity ratio. This is a measure of how much of the funding from the company is from debt and how much is from stock. Companies with a debt / equity ratio above 1 are generally considered to have too much debt. Another useful ratio to use is the quick ratio. This is a measure of how much current assets (excluding inventory) a company has in relation to its current liabilities (those due in under one year). Numbers above 1 are good. The current ratio is a similar measure that includes inventory. Current ratios should be above 2.

There are many other criteria you can use when screening for stocks, but those above are the most important. Even just using these criteria, you can create many different screens: you can look for companies based on the values of the above criteria or you can look for companies with improvement in those criteria (such as improving profitability). I hope this article has given you some ideas for screening for stocks. Remember to always look at a company in more detail after it pops up on a stock screen.

Cheap isn’t always cheap

I found American Realty Investors (ARL) by searching for cheap stocks–those trading below book value. It is down 15% since I found it, and it is now selling at half of tangible book value. I think that, if anything, the company’s book value understates the true value of its assets, because all its recent land and property sales have resulted in gains relative to the prices those properties were carried at on the books.

However, one man who is highly involved in ARL through various private companies that own a majority of ARL and manage it, Gene Phillips, is not exactly the kind of guy you would want to bring home to meet the parents. In fact, he and the outside company that manages ARL (Basic Capital Management) have previously been fined $850,000 by the SEC for failing to report certain stock holdings. Even that does not bother me much. But Gene Phillips has been involved in other problems, such as two high-profile bankruptcies of previous real estate companies: his private company, Phillips Development, went bankrupt in 1973 with $30 million in debt in what was then the largest bankruptcy in South Carolina. In the 1980s, Phillips helped to grow Southmark Corp. through prodigious deal-making. But by 1989 the house of cards collapsed and Southmark went bankrupt, ending with a book value of negative $759 million, a drop of over $1.5 billion from the company’s 1987 book value of $861 million. Through the entire 1980s there had been numerous instances of self-dealing and dealings with questionable characters, including loans to Herman K. Beebe Sr. or companies controlled by him; Beebe had months previously been convicted of defrauding the SBA (small business administration).

So, while American Realty Investors (ARL) may seem cheap, it is not a Goode value. Neither are the similar companies Transcontinental Realty Investors (TCI) or Income Opportunity Realty Investors (IOT). All three companies are advised by Basic Capital Management, trade below book value, and suffer from the same conflicts of interest and self-dealing that have pervaded other companies that Gene Phillips has touched.

While the last five years have been one of the largest real estate booms ever in the US, shareholders in ARL would have lost money over that time period. This article should serve as a reminder that it is a good idea to check out a company’s management (and controlling shareholders) before investing, lest your fate be similar to that of previous ARL shareholders.

Disclosure: I hold no shares of any of the companies mentioned. In fact, I own no REITs or public real estate companies, although I do directly own some real estate.

Warren Buffett, My Hero

I have already mentioned a few of the greatest value investors of our time in this short guide. I want to take a bit of a longer look at the best, though. By examining what Warren Buffet has done, we can perhaps learn from both his mistakes and his successes.

Warren Buffett worked for the father of value investing, Ben Graham. Afterwards, he started multiple investment partnerships with himself as the managing partner, and friends, relatives, and acquaintances as limited partners. In 1967 he bought Berkshire Hathaway, a money-losing textile mill, and in 1969 he closed his investment partnerships.

Buffet made many great investments before buying Berkshire, but it is convenient to start analyzing his record starting with Berkshire. First off, Berkshire Hathaway was probably Buffet’s worst investment: the textile mill never made much money, and Buffet was forced to shut it down in 1985. Until that time, the rest of Berkshire Hathaway, composed of Buffet’s other investments, had to support the textile business.

Why was Berkshire Hathaway (the textile business) a bad investment? Buffet bought it cheap, but he bought a company that had no special competitive advantage; even worse, it was in a dying industry (also a dyeing industry).
Now let’s look at one of Buffett’s successes: Berkshire Hathaway bought shares of The Washington Post Company in 1973. This was a better investment, because it was undervalued, plus its assets were highly desirable. In addition, the management was good. This was quite different from Berkshire Hathaway; Berkshire’s assets, even at the time Buffet acquired the company, were not desirable. Also, the management was not very good, and Buffet had to replace the management of the textile mill.

The rest of the 1970s saw Berkshire Hathaway buy shares of GEICO insurance along with all of National Indemnity Company and Cypress Insurance. All of these are insurance companies.
What’s so special about insurance? There are some details that I cannot address here due to a lack of space, but one of the key reasons why Buffet has bought so many insurance companies is that the stock market tends to undervalue small insurance companies. See the low P/E ratios of, for example, ASI, BER, and UFCS (this does not constitute a recommendation of these companies, however).

Buffet has continued his interest in insurance; since 1990, GEICO was completely bought, General Reinsurance was bought, and many other smaller insurers were bought as well. In fact, much of Berkshire Hathaway’s income is from its insurance businesses.

What can we learn from this? What is important is that we find profitable companies that are undervalued. We won’t find many high-profile companies that are undervalued, and we certainly won’t find many stocks in hot industries that are undervalued. Therefore, many of our investments will be in companies in boring, unglamourous industries, like insurance.
As if to emphasize that point, in recent years Berkshire Hathaway has acquired such exciting companies as Acme Brick, Shaw Industries (a carpet manufacturer), and Clayton Homes (a manufacturer of mobile homes).

One last example of a good move that Buffet made was in buying many Washington Public Power Supply (WPPS) bonds in 1983 and 1984. Two new nuclear units had begun construction but had then defaulted on their bonds. The market reacted and even the price of the bonds secured by the old facilities (that were still generating money to pay off those bonds) fell drastically. There was nothing fundamentally wrong with the old bonds, so they made a nice profit for Buffet. The market will often unduly punish good companies in bad industries, just like with these bonds. That is when adroit value investors will buy.

If you wish to read more about Buffet’s investment style, I highly recommend reading his annual letters to his shareholders, available for free at the Berkshire Hathaway website.

Disclosure: I hold shares of BRK.B and I am also a customer of GEICO. See the disclosure policy.

The value investing philosophy

What would you pay for a gallon of milk? Would you pay $2? $3? Would you pay $4? What if it was very popular milk, and everyone was buying this particular brand of milk? Would you then be willing to pay $5 for a gallon? No?
Why not? Because milk at $5 is overpriced–it’s a bad value. Stop and think about it–why is milk any different from stocks? A stock is not a piece of paper that has no true value that is meant to be traded back and forth among a group of people acting like manic-depressive lemmings. A stock is part-ownership of a company. Companies, like the goods you buy at the grocery store, have a true value.

It is true that companies are more complicated than milk; however, they still have a fair value that can be calculated. Actually, in some ways, companies are simpler to value than milk, because we can measure and attempt to predict the profits they produce and the assets they hold. Measuring the benefits that milk gives us, on the other hand, can be quite hard.

If you agree with what I have just said about the possibility of calculating (albeit approximately) the fair value of a company, then you are well on your way to being a successful value investor. The secret to value investing is this: find a company that is being sold below its true value and then buy it.

It is incredibly simple, and its simplicity puts all of the stock market hucksters to shame. There are many investment newsletters that claim to be able to help you achieve spectacular gains quickly. Their cachet is the complexity of their methods. (See, for example, the Delta Society.) However, the complexity of their methods keeps you from understanding them and deciding for yourself whether they actually work. I’ll admit that some methods of speculation may actually work. However, even the methods that work have large risks, and you can lose a lot of money really quickly. Why not use a simple system that you can understand, a system that works, and a system that you can use without a PhD or 30 hours a week studying, without having to pay for expensive seminars or thousand dollar per year newsletters?

The only thing that is difficult about value investing is that it is not for those who lack ‘intestinal fortitude’. Value investing will often call for buying a stock precisely when everyone else is screaming ‘sell!’ Value investing often requires buying unknown companies in unglamorous business. Value investing will often involve buying stocks that are selling at all-time lows, rather than all-time highs.

Therefore, in value investing, you will not sell a stock just because its market price has gone down (nor should you sell it just because the price goes up). If the price of a gallon of milk goes down, the milk is an even better value. Therefore, you would buy more (up to a point). Likewise with stocks, if a good company is available for half as much, it is twice the value. The only situation which would change that would be if the company’s business were to start deteriorating. Just as you avoid paying any amount for sour milk, you should avoid paying any amount for a bad company (or, at the very least, pay very little and only do so if you are confident the company can turn itself around).

You Should Walk Alone

You have probably heard the term ‘contrary investor’ or ‘contrarian’ before. If not, why not look it up on Investopedia? At its heart, the concept of benefiting by going against the crowd is both incredibly stupid and incredibly smart.

Going against the crowd would be stupid when you do it right in the middle of the crowd’s actions. A good example of stupidly going against the crowd would have been going short technology stocks in 1999, just a year before the internet bubble burst. You could have easily lost everything.

So if you want to profit from speculating (benefiting from future stock price moves that you predict), it would be foolish to go against the crowd. But what about value investors? Does being a contrarian hurt or help us?

When everyone is selling, there is usually panic and fear. When there is panic and fear, there is very little reasoned thought. When people are not being reasonable, prices in the stock market will tend to go far away from fair values. In this case, this usually means there is a good chance for a stock to be bought really cheap. It is our job to buy from panicked sellers, and thus make easy money later on when we can sell those same stocks at fair values.

The opposite situation, selling when everyone else appears bullish, applies to speculators but not to us. A smart speculator could have foreseen the bursting of the Internet stock bubble that burst in 2000.  Early in that year, there was IPO mania, executives were exuberant, and people talked of naught but their tech stocks. That would indicate that everyone who was going to buy stocks already had. There was no one left to buy, and the stocks had no where to go but down. The smart speculator would then have sold, reaping enormous profits. If he were adventurous, he could have even sold tech stocks short, making even more money.

We would not have acted in the same manner, though. None of those tech stocks were good values in 1999. Value investors may have bought into some of them earlier on, but a value investor will always sell out when prices become way overvalued, before they become obscene.

So when investing, look for areas where others are fearful. If you find those fears to be unfounded, you might find yourself a good investment.

MIGP up big today

On news that an activist hedge fund has taken a 5% stake. I bought this company a couple months ago at book value. I continue to believe that there is little risk in buying good insurance companies near book value as long as they do not have large exposure to catastrophes.

Disclosure: I hold shares of MIGP. See the disclosure policy. I own other insurers as well, including RTWI, BRK.B, and the preferred stock of QNTA, QNTAP.

Finding Unloved Stocks

Where do I get my stock ideas? Where does anyone get their stock ideas? Well, the simplest and easiest way, besides listening to perennial blowhard Jim Cramer, is to screen for stocks like one would for a car or a washing machine. Since Consumer Reports doesn’t review stocks, we will have to turn to the Yahoo Finance stock screener. MSN money also has a stock screener, and Morningstar does as well. I like Yahoo’s the best, simply because it is the most flexible.

In screening, we can use our usual suspects: P/E, PEG ratio, dividend yield, market cap, price to book ratio, past earnings growth, as well as ROE or ROA. I’m sure you have done this before, so I won’t dwell on it.

By the way, the PEG ratio is what you get when you divide the P/E ratio by percentage annual earnings per share (EPS) growth. Thus, it is a measure of both current value and recent growth. As with P/E ratios, lower PEGs are better. There are a couple in depth articles about PEG ratios at investopedia linked from the above definition.
While you can calculate PEGs using past growth or predicted future growth, I know that analysts’ projections of future earnings are usually wrong. Yahoo Finance includes PEG ratios (listed under key statistics), but they are based on predicted growth, so I ignore them.

There are other ways to search for stocks, though. Since we are value investors, we will oftentimes be the buyers of last resort. When everyone else has sold a stock, and those who hold it are too shell-shocked to care anymore, when a stock is completely boring, we will buy. Of course, that is assuming that we want the company. Sometimes, companies such as this will be on their way to de-listing and bankruptcy. A few of those companies are good companies, perhaps with a few problems, perhaps just in unglamourous industries.

How can we search for companies such as this? Why not check public bulletin boards on the internet? For example, check out (briefly) the message board for XJT at Yahoo. There have only been a few posts in the last month. Both the bulls and the bears are just bored. That is a good sign that the stock is out of favor.

While we cannot sort the stock message boards at Yahoo by the number of posts, if we go to The Motley Fool, we can. Note: you have to complete a free registration to have guest access to Fool Bulletin Boards, although you do not need it just to glance at them, as we will do.

So, go to the Fool BB, and look at the ‘A’ stock boards. We can then sort by number of posts, and look at only those stocks with, say, 10 or fewer posts. We can look each of them up at Yahoo Finance, and then set aside any that have profits and a reasonable P/E ratio for a more detailed look. I did this today and then screened to remove stocks with lackluster PEG ratios.

Of course, since I was browsing through about 100 stocks and going by the past earnings growth of these companies, I was not actually calculating PEG ratios. I just eyeballed it. That is fine, as my goal was to find a few stocks, not 50 stocks. If I missed one or two, that was fine. Screening for stocks on such an abstract criterion as how ‘forgotten’ they is more of an art than a science. I’ll be mentioning a few of these stocks in detail in this and later letters, plus I will track the group as a whole just as an intellectual exercise. If you care to investigate them yourself, here they are: acu, atpl, aea, bcs, ezpw, gnw, hwg, max, nxy, oxm, oxps, ppp, ttm, vlgea, vsl, wlda. See stock quotes on all of them here.

Notice that a few of those (TTM and VSL) do not really belong on this list, as they are Indian stocks, and thus would likely be discussed less here in the US. Now, this is not an ideal screen, and many of these companies are probably a waste of our time (such as HWG, which has a P/E of 1 only because they sold off a huge chunk of their company). That being said, I hope this serves as a good example of a slightly different way to search for stocks.

[This was originally published October 2005 in The Everyday Investor, my defunct investing newsletter.]

Addendum: in the year since I published this article, the stocks mentioned soundly beat the stock market as a whole. Also, now that Motley Fool has its CAPS paper trading game, you can search for unloved stocks by searching CAPS for highly rated stocks that are rated by only a few people.