Rule #1 Investors

If you have read and liked Phil Town’s book Rule #1, you may like the investment blog “Investmestment Jungle“. The author of this blog looks at various companies from a Rule #1 perspective.

I have yet to read Town’s book, though from what I have read about it, I have a couple problems with his investment methodology: first, it is too formulaic, and second, the strategy tends to lean towards buying growth companies. The only major valuation criteria appears to be that a stock trade below its historical average P/E. Yet this can lead to buying very expensive companies, which will be a problem if they stop growing so fast and their great returns on invested capital decrease (as it the fate of almost all companies).

Do you like cheap stocks?

One of my favorite investing blogs is Cheap Stocks. I have added a link to it on my blogroll (right hand side of the page) for your convenience. I have found such stocks as CALL (which gave me a 30% profit in a couple months) through this blog. Clyde searches for stocks trading at low multiples of their net current asset value (NCAV: current assets minus all liabilities).

The current post on Cheap Stocks is on profitable companies trading at less than 2x NCAV. Most of the companies are not that interesting to me, except for maybe Adaptec (ADPT). I will probably write more about Adaptec in the future. Following is Clyde’s list of the top 5 largest profitable 2x NCAV companies:

Ingram Micro (IM)
Sycamore Networks (SCMR)
Exar Corp (EXAR)
Adaptec (ADPT)
Farmer Brothers(FARM)

See Cheap Stocks for more details.

Errata on my portfolios

I track my portfolio performance on and I link to those portfolios here. So I should note that icarra is currently not accounting for short sales correctly. Correct accounting of those sales would modestly reduce the performance of my iZone Quant Portfolios and somewhat reduce the recent return in my Stockpicking portfolio.  On the plus side, my portfolio betas and R-squared are actually lower than shown because of this error.

Asset Allocation for Dummies

I will tell you now, and I will repeat myself as necessary: I am not an expert on asset allocation. That being said, I doubt that anyone else is, either. It is impossible to describe any investing philosophy without touching on asset allocation, so following is my philosophy.

Total up all the assets of significant value you have. That includes your car, house, savings and checking accounts, expensive objects (any object worth over $1,000 is worth counting), bonds, and mutual funds and stocks.

The first key to asset allocation is that you should eliminate any high-rate debt you have. If you have bonds or mutual funds that are not in a retirement account, then you should sell them off to pay off credit card debt. It is very hard to get better returns on your stocks than the credit companies get from you. Look at paying off credit cards as a safe, easy, guaranteed investment that will yield 18%.

Now, it is my firm belief that you should always have at least six months worth of living expenses in cash-type accounts (checking accounts, savings accounts, and money market accounts). A portion of this money can be in a higher yielding short-term CD, though. Some would say this is high. At the very least, you should have two months’ worth of expenses saved. Otherwise, if an emergency comes up, you will be forced to rely upon credit card debt or to liquidate your stocks.

After you have taken care of the basics, stick the first $10,000 of your money destined for stocks into a low cost index mutual fund. I recommend Vanguard funds. This is for a few reasons. First, it ensures that even if you do something really stupid and lose the rest of your stock money, you will still be exposed to possible gains in the stock market. Second, your individual stocks may be quite volatile, and having some of your stock in an index fund will probably help you sleep at night.

Now for the rest of the money. The traditional two investments are stocks and bonds. How should you allocate how much you have in bonds versus how much you have in stocks (including your mutual fund)? Ben Graham recommended that as a value investor, you should be most highly invested in stocks when the stock market is at a low (in the depths of a bear market), and least invested in stocks when the market is at a peak (and when the future seems rosiest). How do you time when the worst of a bear market will hit, or when the peak of the bull market will come?

You don’t. All you do is gradually sell more stocks as the stock market rises, and buy more as it declines. Any cash you generate from selling you put into bonds, and when you are buying stocks, you are selling bonds. You never want to hold all stocks or all bonds, in case you are wrong and the one outperforms the other for a period of time. You do not have to perfectly time the market to do quite well using this method.

Another view on asset allocation is that it should vary with your age. The thinking is that if you are older, you will need your money sooner, and should not have as much money in stocks, which could do poorly for years. Ben Graham thought this idea was bunk, and I would agree, to some extent. While stocks as a whole may underperform bonds for a period of years, if you are doing a good job as a value investor, then the stocks you buy will tend to do okay even in bear markets. When they go down, they will tend to come back up within a period of a couple years.

Thus, I recommend a hybrid approach. As you get very old, put some money in bonds. But if you are a successful stock investor, keep investing in stocks. Also, over time, stocks have generally outperformed bonds (though this is not certain in the future). Therefore, except at the heights of a bull market, keep the majority of your investable assets in stocks.

That being said, the stock market as a whole is not cheap right now, and neither is the bond market, so an allocation of 50% stocks, 40% bonds, and 10% cash in a money market account sounds reasonable.

If even this is too much thinking (and worrying) for you, I suggest investing your retirement money in Vanguard’s excellent target-date retirement funds, which have low fees and choose your asset allocation for you.

The Kelly Criterion

The Kelly Criterion is a formula for choosing how large a bet to make on each trade/investment/gamble. It works for the stock market, though it was originally developed for gambling. The formula is simple: bet the proportion of your investment as defined by the ratio of expected return divided by maximum return. Expected return is what you expect in the long run.

So, the formula is: P_invest = E(r) / M(r)
Proportion of portfolio to invest = P_invest
Expected return= E(r)
Maximum return = M(r)

Now, a couple of examples:

1. If you flip fair coin and win $1 if heads and lose $1 if tails, the expected return is $0 (.5 x $1 + .5 x -1). The maximum return is $1 (if heads). Therefore, the Kelly criterion suggests you bet no money ($0/$1). This makes sense, because you should not invest money where you expect to only break even.

2. You want to short Apple (AAPL) because you think there is an 80% chance the stock will go down in the next month. You think if that happens, the stock will go down 10%. You figure that there is a 20% chance that the stock will go up 5%. The expected return is 7% (.8 x 10% + .2 x -5%). The maximum gain is 10%. The Kelly formula suggests that you invest at most 70% (7/10) of your portfolio.

3. Same thing, shorting AAPL. You like the odds, so you increase your leverage by buying put options. You buy just out of the money options. Now, there is a 70% chance that your options expire worthless (-100% return) and a 30% chance that you make 300%. The expected return is +20% (.7 x -100 + .3 x 300). The maximum gain is 300%. The Kelly formula says that you should bet less than 1/15 (about 6.5%) of your portfolio (20/300).

One thing to consider is that the Kelly formula seeks only to maximize gains. If you wish to minimize portfolio variability as well, you should invest significantly less than the maximum allowed by the Kelly formula. Also, keep in mind that the formula is only as good as your guesses of probability.

I recommend a Legg Mason article on the Kelly Criterion, or this paper by Edward Thorp (who used it to great effect).

Visit Cisiova’s website for their advanced online Kelly Criterion calculator, which allows you to enter a large number of possible outcomes.

If you liked this post you may want to check out William Poundstone’s book Fortune’s Formula.

Disclosure: I own no Apple stock, long or short. Unfortunately, I did once lose money shorting AAPL. My disclosure policy never loses me money.

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:
“neutral” analyst report here:
(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.
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.