Author: Michael Goode

Like Digg, but useful

After a first glance, I found Bizzlo.com to be interesting. It aggregates financial blogs and news but like Digg allows users to select the most interesting. I might me adding it to my morning reading. Following is from the email I received that informed me of the site.

“We have started a site called Bizzlo.com. We’re already getting quite a lot of traffic from investors looking for business and investment ideas that aren’t the run of the mill, boring stuff.

Bizzlo is a user generated site, so it is kind of like reddit.com or digg.com, but exclusively focused on investing. If you go to the site and sign up for an account you can post a link and a brief description of any story you want to profile, any time.”

Will the site be successful? My guess is probably not, but I think niche sites like this have a lot better chance of remaining interesting and useful than general use sites like Digg.

Disclosure: I have no relationship with Bizzlo.

Skins: Yet Another Silly Shoe Idea

I have to say that I do not like silly shoes. Crocs (the shoes) are dumb and overpriced and ugly. Heelys wheeled shoes are dangerous and faddish. Of course, that has not kept Crocs [[crox]] and Heely’s [[hlys]] the companies from making some nice money.

But seriously, Skins? At best it is a niche idea. With the price they are selling at they are never likely to go big. While the company is serious and has brought in some substantial outside talent this is a classic case where foolish investors bid up the price of the company to an absurd level. When it had a market cap of $100 million, Skins (OTC BB: SKNN) was priced as if it had already achieved niche status and was growing beyond that. Yet the company had no sales at the time. Reality has caught up with the stock and it has fallen 80% since its high last summer and almost 90% since its 52-week high last December.
Reality often catches up to those who unwarily speculate in ‘the next big thing’. Don’t let reality catch you off guard. Even with a market cap of $16 million I would not touch the stock. That being said, the company’s management is a welcome oasis of decency in the cesspool that is the OTC BB.

Disclosure: I have no position in any stock mentioned above. My disclosure policy loves wearing its Birkenstocks.

Remember, Remember, to Tax-Loss Harvest in November

Tis the season to be jolly and to sell losing positions. Actually, it is always a good time to sell losing positions. But now is about as late as it can be for harvesting tax losses, waiting 31 days so as not to trigger the wash sale rule, and then re-purchasing the sold assets before the new year.

I followed my own advice, selling a number of stocks that I may buy back later. At the moment, my main goal is to reduce my taxable income for the year. I sold the Vanguard Value ETF [[VTV]] and bought the very similar iShares S&P 500 Value ETF [[ive]] to replace it. While the ETFs are similar, they are not ‘substantially identical’, and because of that buying one after selling the other does not trigger the wash sale rule. This is another reason why ETFs are great–there are hundreds of them out there that are similar yet not identical. So sell any in which you have large unrealized losses and replace them with similar ETFs. Assuming the similar ETF does not shoot up greatly in 31 days, sell it and buy back the original ETF. The result is realizing a taxable loss while keeping your equity exposure the same.

I also believe in doing a similar thing with stocks, and I just did that myself this morning. Sell those in which you have large unrealized losses and then just wait 31 days to buy them back. If you wish to maintain your equity exposure, you can buy an index fund or ETF in the meantime. On average any profit you lose from selling the stock will be more than outweighed by the lower taxes you will pay.

Now is the time to estimate your AGI for the year and plan what to do about it. If you are a landlord, watch out for the landlord loss deduction limits that phase in at an AGI over $100k. If you saved money in a Roth IRA, watch out for the limits that phase in at a similar income level. Remember, it is your duty as a productive citizen to minimize the taxes you pay!

Disclosure: I am not a tax lawyer or accountant. This is not to be construed as tax advice. Speak to a tax lawyer with at least 200 years’ experience and at least 50 years experience working as head of the IRS and the treasury department before implementing any tax strategy. Otherwise the IRS reserves the right to hunt you down and kill you like the scum that you are. Remember: it is not your money. It is the government’s money. Remember: it is not your life. It is the government’s life. War is peace. Freedom is slavery. Ignorance and cowardice are strength. Or something like that.

The Ethics of Bashing Stocks

My last post reminded me of Gary Weiss’ criticism of Mark Cuban’s website Sharesleuth. Cuban pays a reporter to dish up dirt on public companies, and to fund the venture he shorts the stock of those companies before the articles are published. Cuban calls it a new business model for investigative journalism, Weiss calls it unethical, and I think it is a good thing.

I have in the past been criticized by anonymous message board posters for writing critically about several companies in which I held short positions. I was even called “the scum of the earth” by one poster in response to my criticisms of Document Security Systems [[dmc]]. The coincidental and fitting end to the story of my involvement with Document Security Systems is that while I closed my short position at a loss, the stock later dropped 30%. So was it ethical because I lost money and would it have been unethical if I had made money?

But what is so bad about writing about stocks in which I have an interest? I always disclose a position, as does Sharesleuth. A similar website is CitronResearch.com, run by Andrew Left, who has a blanket statement on his website that he may short any of the companies about which he writes. Is this any different from a mutual fund manager who appears in the pages to talk up stocks in his portfolio? And yet such mutual fund managers get superstar treatment and short sellers like myself earn nothing but the enmity of a bunch of anonymous hooligans.

Is it Unethical to Withhold Information?

While I know that many people frown on writing about stocks in which the writer has a financial interest (at least if that interest is short), what about the opposite situation–someone shorting a stock and unwilling to write about what they know because they are attempting to build up a big short position at a high price or just because they don’t have the time? I have blogged about only a fraction of the companies whose stock I have sold short. I would argue that it is far more unethical for me to withhold my information about unknown companies that I have sold short from the public than it is for me to write about such companies. What do you think?

I think investors in Skins (OTC BB: SKNN) would have wanted to hear a critical view of the company back before the stock dropped by 2/3. Even if they did not want to hear such negative information it probably would have done them some good. The same goes for YTB International (Pink: YTBLA), Hepalife (OTC BB: HPLF), Parkervision [[prkr]], and NNRF (Pink: NNRI). All of these companies I sold short over the last few months and yet I did not publish my analyses. In all cases these stocks have fallen very far since I chose not to write about them. So again I ask the question: which is worse, not writing about these companies or writing about them at the same time I was short?

If a critic says that I should have written about them without being short at all, then that critic misunderstands this blog. I am a trader. I make a portion of my living in the stock market. Nobody pays me to write this blog. Since I have started this blog I have put in hundreds of hours and I have received only about $7 in revenues from my Google Ads. If anyone wishes to pay me to investigate penny stocks, that is fine–I’ll adopt any code of ethics my employer wishes me to adopt. But the reality is that my choice is between me publishing information on some of these stocks (and being potentially biased) and no one but the hype-loving CEOs and shareholders publishing information on these stocks. I do not have the choice of doing this work just for the fun of it.

Is it the Order that Matters?

If it is unethical to write about a stock that I hold, would it be ethical for me to write about it and then after some delay follow my published advice? This is exactly what happened to me with Sun Cal Energy (OTC BB: SCEY). I wrote a negative article about the company and only later I found out that I could short sell the stock. I then sold it short and profited. I cannot imagine that anyone would find this to be unethical. And yet the only difference between this and taking the position before my article is how much profit I make from my work. So is it unethical to make money? Or is it only unethical to do so if I am not paid by a newspaper or financial magazine?

Is the world better off after I expose horrid penny stocks? The obvious answer is yes because I only write the truth and that is usually sorely lacking in the coverage of penny stocks. The good act of publishing the truth and countering untruth is not prevented or stopped just because I profit from it. And the act of profiting is not wrong in and of itself. So I see nothing wrong with profiting in my way from the information I promulgate.

Disclosure: I have no interest in any stock mentioned above. I have a strict disclosure policy. Please note that the last paragraph of this article was replaced after I published it because my first attempt at a closing paragraph was rather bad.

Bloggers behaving badly

Gary Weiss is a blogger behaving badly. He never published my insightful criticism of one of his arguments that I made in a comment on his blog two months ago. While he likes to dish out the criticism it seems that Gary cannot take it. Like too many journalists he thinks that he is somehow better than everyone else. Take it from me, Gary: there ain’t no such thing as impartiality. Journalistic ethics are not ‘right’–they can be useful sometimes and sometimes they are pointless or foolish.Let me reiterate that I publish all comments that could possibly contribute something and that are not obviously libelous, even if I think their authors are idiots and even if their authors insult me.

Disclosure: Gary Weiss, despite being pompous, rails like me against stock fraud and manipulation. He is one of the ‘good guys’. A previous version of this post criticized Clyde Milton of Cheap Stocks. He has since explained his action and apologized (see comment below). I see no reason to hold a grudge. I do find his blog interesting and useful.

The Reaper’s Guide to Short Selling Stocks

The point of this article is threefold: to associate the nickname “The Reaper” with me and my short selling activities so that when I become as famous as Jim Chanos or Manuel Asensio or at least Andrew Left, I can appear on the cover of Forbes magazine wielding a scythe (see picture below); to inform investors about short selling so that they realize the folly of buying into stocks just because of a so-called “short squeeze”; and to inform those crazy enough to actually try short selling about different strategies for doing it.

There are a number of websites dedicated to finding stocks that are prone to a short squeeze and recommending that traders buy those stocks. A short squeeze can occur under two different but similar situations. In each case, there is widespread negative sentiment about a stock in which short sellers have sold short a large percentage of the outstanding shares of the stock (leading to a high short interest ratio). In one case, routine speculative buying on the part of traders pushes up the price of the stock, which creates losses for the short sellers and this may lead some of them to cover their short positions (buy back the shares they borrowed and sold), and this buying on the part of the short sellers drives the stock price up even further.

The other case is where some good news comes out about the company which leads to the same outcome. In this case, a quick witted daytrader or momentum trader can easily make a lot of money. The trader might see the headline and quickly buy the stock at the same time the quickest shorts start covering, and by the end of the day there can be a whole lot of profit as mounting losses cause most of the other shorts to cover as well. I found myself on the wrong end of this kind of short squeeze in early February 2007 with Onyx Pharmaceuticals [[ONXX]] (see chart of squeeze). The market expected poor results from a drug trial, but the company reported outstanding results. Considering that the drug in question was one of only a few that the company was developing, this was incredibly good news for Onyx. Shares doubled from $12 to $24 in one day. I was quick and got out of my short position in the stock with only a 50% loss. A quick witted trader could have read the same headlines I read and bought as I was covering and realized a 30% profit in one day. Of course, I do not recommend such daytrading because most people are very bad at it, but I do recognize that some people do it well and they serve a purpose in the markets.

Non-news-driven short squeezes are much different despite looking very similar on the price charts. The problem with this kind of short squeeze is that there is no fundamental reason for the stock price to go up. As I have previously written (and written elsewhere), stocks targeted by short-sellers tend to do worse than the market as a whole, and people who buy a stock just because the short interest is high and just because there’s a possibility of a short squeeze would do well to remember that. Another thing to keep in mind is that if a company is bad enough, the short-sellers are very strongly convinced of their negative opinion of the company, and the short sellers have deep pockets, there is no reason why the short sellers need to cover just because of a temporary increase in the stock price. A good example of this is the various price increase in the stock of Home Solutions of America [[hsoa]]. The critics of the company are convinced that it is both fraudulent and insolvent and that the stock is worth nothing. So they will likely just hold onto their short positions and grit their teeth to withstand the short-term losses because they believe that within a few months or a year they will be sitting on a 100% profit.

Now, because I am a reasonable and conservative person, I feel obligated to warn you that short selling is highly dangerous, speculative, and for most people it is simply dumb to do it. In fact, we expect the return from selling short stocks to be about -10% per year because on average that’s about how much stocks go up per year. So unless a short seller has a lot of time, talent, guts, and knowledge, he or she should expect to lose money over time.

Short Selling for Fun and Profit

The one rule of short selling is this: don’t do it. If you ignore the rule you deserve what you get, whether it be fortune (if you have great talent and good luck) or poverty (if you have modest talent or great talent and bad luck). Consider yourself warned.

Now that we have that out of the way, there are two ways to profit from short selling stocks: momentum shorting and what I call steel-gut shorting.

Momentum shorting

As mentioned above, selling on negative news can be profitable. It is hard to tell what will continue to fall and what will bounce back. There are a few strategies to use. I have tried using certain influential blogs as my ‘news’ sources.

I receive emails of updates to those blogs or see the postings within an hour of them being published because I subscribe via RSS and I check my RSS reader often. If I see a negative comment about a stock I can quickly check to see if I can short it and then I can quickly short sell it.

This strategy has been a mixed bag and I have probably broken even. While Terra Nostra Resources (OTC BB: TNRO) gave me a nice profit, and Uranerz [[urz]] gave me a respectable profit, I saw small losses on several others, including Cellcyte Genetics (OTC BB: CCYG).

Steel Gut Short Selling

Imagine selling short a worthless company only to see the market double or triple its market value. You hold on. No–you don’t just hold on. You sell more. You borrow money and sell more. The company approaches a valuation that is absurd and crosses it. You sell more. You take out a loan against your house and you sell more. You borrow from friends and sell more. You sell your car and your house and you sell more of the stock. If the stock returns to only modestly overvalued you will make a fortune. If not, you lose everything.

This story ends in a couple ways. If you were unlucky and sold short Amazon.com or Yahoo or Lucent or any other overvalued tech stock in 1998 or 1997 then you were ruined. If you sold short in late 1999 or 2000 or 2001 then you made a fortune.

There are a few keys to making this work. First, be diversified in time and in stock. Make sure that no loss, no matter how incredible, will put you out of business. Second, stay liquid. Don’t get anywhere close to your margin limit. Have some backup cash or a credit line ready so that if the stock shoots up you can wire in some more money and short more. Third, don’t short a stock unless there is something that will force it down. In other words, don’t go against stock momentum or bet against a ‘high-tech’ company, even if the product is a rumor and the company’s sole asset is a promise and a ‘vision’. At the very least, if you do that, make sure that it is a small part of your overall portfolio.

At the risk of repeating myself I will repeat myself: do not short stocks that are valued at a multiple of promises and dreams. My only significant losses in short selling have come from Research Frontiers [[refr]], Document Security Solutions [[dmc]], and Parkervision [[prkr]]. None of these companies has an operating business worth more than 10% of its market cap. Parkervision and Research Frontiers have great new technologies (that I think are totally bogus) and Document Security Solutions has a patent and a court case. If you take a look at Research Frontiers, you will find that it has been promising for decades that its great technology is just around the corner, and yet it never seems to sell anything (see my previous article on Research Frontiers).

Even after avoiding stocks that sell at a multiple of hope, it is important to avoid companies where there is no clear reason why the stock should go down in the short run. Short sellers of Imergent [[iig]] and Usana [[usna]] would do well to remember that. The sad fact is that companies with a bad business can last far longer than they should.

So what is left to short? There are wildly overvalued stocks that are overvalued only because no one knows about them. This is the type of stock that Continental Fuels (OTC BB: CFUL) was. I sold it short around $2.70 and rode it all the way down to $0.50. It is now trading at $0.60. When I shorted it, its diluted market cap was over $1.5 billion and yet it had maybe $10 million in sales, no promising technology, and a negative book value. However, it is very tough to find such stocks, and getting ahold of their shares to short is very hard.

Then there are the fading stars. These are once-highflying companies that run into problems and have little hope of evading them. Examples include Vonage [[VG]] and Krispy Kreme [[kkd]]. Krispy Kreme I just missed, while by the time I became active in shorting, Vonage was too cheap. This is also the category into which most housing-related stocks would fall. Everything from Countrywide [[CFC]] to New Century Finance (now bankrupt) to DR Horton [[dhi]] and E*trade [[etfc]] (didn’t realize they had a big mortgage operation, did you?). [Note: amusingly enough, when I first wrote about E*trade as a short it was weeks prior to its recent stock market crash. I did not actually short it, though it would have been quite profitable to do so.]

Trends, no matter what kind, tend to last longer than anyone thinks. So if you had waited until after the first mortgage problems had made themselves evident in January and February and after panic subsided, you could have shorted a large number of financial and house-building stocks at attractive prices.

If you short sell, good luck. If not, good luck. But even if you do not short sell it would behoove you to pay attention if short sellers target your favorite stock. Imagine the happiness of those few Enron shareholders that sold after hearing about Jim Chanos’ shorting of the stock.

Disclosure: I have no position in any stock mentioned. My disclosure policy makes for good reading. The picture of the grim reaper above is me. Yes, I do realize that I need to sharpen my scythe. No, I do not take myself too seriously.

Home Solutions of America Admits Problems, Delays Quarterly Report

See the press release at Yahoo. The stock of HSOA [[hsoa]] is down big on the announcement. The report is delayed because its auditors need more time to investigate related-party transactions. My bet is that some of them turn out to be sham transactions and much of HSOA’s so-called earnings go up in smoke. If that is the case it’s lender could call its line of credit (which is secured by receivables, some of which are from related-party transactions), forcing HSOA into bankruptcy.

This is another good example of why self-dealing is bad and why cash flow trumps earnings. The classic way to commit accounting fraud to pump up earnings is to make sham deals with pliant customers or related parties. The revenues are accrued, going into accounts receivable, and earnings are pumped up, but no cash is ever paid and the ‘earnings’ turn out to be non-existent. That is why I try to steer away from companies that have too many receivables and greater earnings than cash flows. In these cases, even if there is no fraud, the receivables may turn out to be noncollectable and the earnings are never followed by cash flow. So, even if there is no fraud at HSOA, shareholders will likely continue to be disappointed by the lack of cash the company can actually collect.

Disclosure: I have no position in HSOA, long or short. My disclosure policy committed accounting fraud back in 1984 but has since paid its debt to society and now speaks to corporations about the dangers of insider self-dealing.

My Record so Far

Following is my record so far on all stocks I have disparaged or praised in this blog (not just the ones on which I made a good call):

Disparaged:

American Realty Investors [[ARL]]: Down 1.4% since I pilloried this over-indebted real estate company.

Home Solutions of America [[hsoa]]: Down 49.4% since I discussed Andrew Left’s criticism of the company.

Document Security Solutions [[dmc]]: Down 33% since I criticized the company on August 21. While short the company at the time, I closed my short position at a loss to concentrate on other opportunities. Oops.

Remote MDX (OTC BB: RMDX): Up 96% since I criticized the company and its management. I was short at the time and I am short now. Ouch.

Sun-Cal Energy (OTC BB: SCEY): Down 82% since I slammed this stock back in mid-July.

Octillion (OTC BB: OCTL): Down 60% since I wrote about this horrid little penny stock. I was not short at that time but have since been able to sell short some shares.

Fox Petroleum (OTC BB: FXPE): Down 18% since I compared it negatively to Stormcat Energy [[scu]]. Going long Stormcat and shorting Fox would have resulted in a hedged profit of 8% since my article.

Continental Fuels (OTC BB: CFUL): Down 85% since I first pilloried this horrid little company. Down 65% since my second critical article was published October 12. I shorted this stock most of the way down, although I am no longer short. I do believe that the stock has quite a bit farther to fall, eventually to around $.01 per share or less.

H2Diesel (OTC BB: HTWO): Down 43% since I criticized it less than one month ago.

Praised:

International Shipholding [[ish]]: Up 39% since I discussed the sell-off in this stock on August 8.

TSR Inc [[tsri]]: Up 10.3% since I praised this undervalued microcap with lots of cash.

Hastings [[hast]]: Up 23% since I noted its great earnings on August 21. I owned the stock at the time and I sold it off a couple weeks ago at $9.12 per share.

Stormcat Energy [[scu]]: Down 10% since I compared it favorably to Fox Petroleum (OTC BB: FXPE). Going long Stormcat and shorting Fox would have resulted in a hedged profit of 8% since my article.

Neutral:

Movie Star Inc. [[msi]]: Down 14% since I discussed it July 10. In that article I explained that I thought it was fully valued despite being a good company.

Regent Communications [[rgci]]: Down 24% since I discussed the company’s annoying management back on August 16. I sold out my stake at a loss since then, although with John Ahn of Riley Investment Management (an activist hedge fund) getting on the board, maybe the future will be brighter.

My Overall Record

I was perfect on stocks that I liked (if we consider Stormcat to be a pair trade with shorting Fox Petroleum). I was 8 out of 9 on stocks I disliked. Both the stocks on which I was neutral or uncertain went down.

So should you buy the stocks I like and short the ones I dislike? Buying the stocks I like might work, but I like few enough that it would not lead to a diversified portfolio. Avoiding the stocks I dislike would be a very good idea. My record on stocks I dislike reveals an excellent reason why shorting stocks is so risky (and why most people should avoid it): while 8 of 9 stocks I criticized dropped, often by a lot, the 9th stock almost doubled.

Disclosure: I am currently short Octillion (OTC BB: OCTL) and Remote MDX (OTC BB: RMDX). Ending prices used in the return calculations are as of November 2, 2007 when this article was written (one week before it was published). My disclosure policy is batting 1.000.

How the SEC & NYSE aid and abet stock fraud

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.

The effects of index funds on the market

I admit it. I am a glutton for knowledge. My daily reading includes many different websites and financial blogs. I also try to investigate new companies multiple times per week, often by running stock screens at Yahoo Finance or Morningstar. I occasionally go to the local university library and just pick up a magazine or journal and start reading.

I read a lot, yet I find very little of what I read to be truly illuminating or even interesting. Every so often I have an ‘aha!’ moment, and today I had one as I read John Mauldin’s Outside the Box newsletter, written this week by Louis-Vincent Gave and Anatole Kaletsky of GaveKal research. The text of the newsletter can be found online at Mauldin’s website. This letter is an excerpt from their new (if un-originally entitled) book, Our Brave New World.

I have yet to buy the book, but I certainly will do so because of my enthusiasm for this letter. I will not summarize the newsletter, so read it before you continue.

It may seem odd, but I disagree with much of the authors’ reasoning. I do agree with their main point, however, that indexing can only work when it is the minority strategy and when active investing is the majority strategy. To explain this, I will give a simplified analogy.

Imagine that we live in the country of Tinagra. There are only two public companies: Darmok Inc. and Jilanco. Both companies combined produce most of the goods and services. They each have revenues of $1 trillion and earnings of $100 billion. Thus, any difference in their market capitalization is due to investors’ prognoses of the companies’ respective growth prospects.

We will assume that the vast majority of investors actively deploy their funds and make their own investment decisions. Most of these investors believe that Darmok has better growth prospects, so they bid the stock up to a point where the company’s market cap is $1.5 trillion (for a P/E of 15), while Jilanco has a market cap of $1 trillion (P/E of 10). Over time the market caps of the two companies will fluctuate as the investors continually evaluate their future prospects. For the moment, let us assume that those fluctuations are small and thus irrelevant.

Suddenly, some investment advisors start to herald the benefits of indexing. They say (rightly) that any fool could have invested his money in an index fund over the last 10 years and received a return equal to that of the market while paying no fees and doing no work! Proponents of indexing form a company called Rearguard and their index mutual fund becomes very popular.

How the index fund works is simple: it buys shares of stocks according to their market capitalization: for every $2.50 invested, $1.50 is invested in Darmok and $1.00 is invested in Jilanco. Due to the simplicity and ease of this index investing, everyone switches too it and there are no more active investors. Now this would be fine if the past perfectly predicted the future. This is not the case. There is a scandal at Darmok: their newest blockbuster drug is found to have caused blindness in millions of people. The prospects for future lawsuits and lost sales means that Darmok will be a worse investment than before.

Oddly enough, nothing happens to their stock price. Since everyone is investing in a Rearguard index fund, everyone continues to buy more of Darmok than of Jilanco. The price of Darmok cannot fall, nor can the price of Jilanco rise. To any rational investor, this seems irrational, and with good reason. Circumstances have changed and the relative pricing of the two companies (1.5:1) is no longer warranted. Even if investors sell out of the market completely, the relative value of Jilanco will be greater than Darmok because their stocks will be sold off by the index funds in proportionate amounts.
Any intelligent investor would at this point sell out of his index fund, short Darmok and buy Jilanco. While the above is a bit of reductio ad absurdum, the point remains valid even if index investing is not total and even with 7,000 stocks.

As Gavekal points out, many mutual funds now behave like closet index funds because the managers are afraid to deviate too far from their benchmark. Gavekal believes that we have reached the point where this indexation has become a large enough factor to lead to serious mis-pricings in the stock market. The math to back them up is probably beyond me and I lack the data with which to do the calculations, but judging from the amount of money invested in the largest mutual and pension funds I would have to agree with them.

I mentioned before that I do not agree with all of what Gavekal say in their article. One point with which I most strongly disagree is their argument that indexing will lead to lower overall returns for the stock market and slower economic growth. I am not aware of their reasoning, for I have not yet read their book, but my first reaction when reading that is to argue that the stock market has very little to do with the conversion of savings into investment anymore. For a full explanation of why that is the case, consult John Burr Williams’ classic book, The Theory of Investment Value.

Williams’ basic argument is that since buying old stock is simply a transfer of ownership and is rarely used to finance new capital goods (except in the case of IPOs, secondary offerings, and rights offerings), it does not affect the interest rate nor the allocation of capital. The money paid for a share of IBM pays the seller of the share, who may then invest it in a share of a new venture; buying IBM does not allocate money to IBM. Thus, the stock market does not directly affect the economy very much.

Minor caveats aside, while indexing may not cause capital mis-allocation, it does cause investment mis-pricing, leading to exploitable changes in the prices of traded securities. Simply put, indexing helps the stock picker by reducing the price differences between companies that have different values. It remains the stock picker’s job to decide which companies are the better investments.

Are there any a priori identifiable mis-pricings? I believe so. In an efficient market, firms would not be priced differently solely because of their market cap. Index funds cannot invest enough in the smallest mini- and micro-cap stocks, because they must invest according to market cap. Therefore, even though small cap outperformance of the market is well-documented, and such well-documented findings tend to be discounted by the market (and thus disappear), small-cap outperformance of the market is likely to continue. The only thing that could prevent this would be for individual investors to increase their overweighting of small-cap stocks (note that in the last newsletter I mentioned that individual investors already overweight small-caps in their portfolios).

The second clear mis-pricing I can identify a priori is that indexing may lead to stickiness in the prices of some large-cap stocks (or any stock that has a large proportion of shares held by index funds). I must first note that this is a bit speculative. The basic premise is that index funds (and most non-index mutual funds) will own the largest stocks (and thus the majority of these companies’ shareholders will not be prone to selling except when the market cap changes significantly). When the company begins to perform better than expected, the price will not increase nearly as much as it should, because the largest holders, index funds, will not need to buy. The stock price will thus rise more slowly than it should and more slowly than if there were no index funs.

This hypothesis leads to the predictions that stocks without index fund owners will be more volatile (but in a good way—in response to news) than companies with index fund owners. Any problems with the above? Unfortunately, yes. The increasing size and clout of hedge funds should reduce the importance of index funds (and similar managed funds). I do not believe that we can count on indexers making it easy for those of us who choose to invest more actively.

The effect of index funds is not negligible. Any trading strategy that is widely used will affect the market. Unfortunately, we must try to predict how different strategies interact to affect the market. The question of whether the market is becoming more efficient (due to the prevalence of hedge funds) or less efficient (due to increased indexing) is too complex for me to answer at this time. The problem may be too complex to solve. I will certainly return to this question in the future. Even coming up with a poor approximation of a solution to this problem could be quite profitable.

I do believe that indexing could become a much larger part of the market without making the market less efficient. A brief discussion of the issue can be found in this academic paper [pdf].

Disclosure: I first penned the above piece some time ago. It does not necessarily represent my present views.