Author: Michael Goode

H2Diesel Down 40% Five Days After I Criticize it: Am I That Goode?

Today H2Diesel (OTC BB: HTWO) stock dropped 43% on no news. The only news since I wrote critically about the company five days ago is that the company filed a boring proxy statement. So is it just because of me that the stock has dropped? It seems like this, but sometimes overvalued stocks will fall on no news just because a few people realize that the stock is overvalued.

The decline in the stock price is depressing for me because I considered shorting the stock and would now be a lot richer if I had done that. However, the company has more than made up for this lost income in amusement value. I have already been contacted by a hedge fund manager who is long the stock and by some random person who gave me some information about the company and encouraged me to continue to write critically about it. That critic of the company acted like a spy and used only a pseudonym. Ah, the joy of financial blogging.

Disclosure: I am neither long nor short HTWO. I have worked as a spy for Mossad, the KGB, the CIA, The Church of Scientology, The Illuminati, and the Gou’ald. My disclosure policy, unlike me, is not a traitor to the human race.

Financial Columnists have no Stockpicking Talent

At least according to a new study by Dan Palmon, Ephraim Sudit and Ari Yezegel. After properly adjusting for stock size and value metrics the picks of columnists in Businessweek, Fortune, and Forbes slightly underperformed the market. For a summary of the article, see my favorite blog, CXOAG Investing notes.

This is yet another reason why I like index funds. Buying them will save you on magazine subscriptions.

Personal Finance and Happiness

Most people need at least a little help getting their finances in order — the personal finances of the average American are in a horrendous condition. One thing that most people do not consider when talking about personal finances is when spending actually makes us happier and when it does not. The key is to avoid spending money when we get little joy from spending and to freely spend it when it is on something that will give us joy (as long as we have the money — debt and worry are two of the greatest causes of unhappiness).

So what gives us happiness? First and foremost, our relationships make us happy. Giving to our friends and to our spouse can be very important, especially when you consider the pain of loneliness or divorce. So never hesitate to spend money to go on dates with your spouse or to get him or her gifts (again, as long as the spending is reasonable). Now think of what you do during your free time. You probably sleep: we all spend much of our time doing it and yet how much time or money have we invested in a good mattress and good pillow so that we sleep well? Speaking of which, if you do not get enough sleep, you will be unhappier, stupider, and less productive than if you get enough sleep. What is another thing that people spend a lot of their time on? How about TV? I find it odd that people who spend much of their free time watching TV are often unwilling to spend money on getting a good TV, such as a large screen LCD HDTV. (Of course, I would argue that most people would probably be happier and healthier if they spent less of their time watching TV).

Now that I have encouraged everybody to spend some money, it is time to look at those things that we spend much money on that do not really make us any happier or better. The first item on this list is going to restaurants. Eating at restaurants is expensive relative to cooking a meal yourself and restaurant meals are more unhealthy than home-cooked meals. Eat at home more often, and use some of the money that you save to splurge occasionally for really nice meals at fancy restaurants on dates with your spouse.

Another thing that people spend money on but derive little enjoyment from is expensive or deluxe versions of everyday items, whether clothes, appliances, electronics, or computers. Do you really derive more happiness from having a $5,000 stainless steel refrigerator than from having a more average model? The same can be said of many of the things we buy. Are you really happier because you have $300 purse? Or would a cheap knockoff that looked almost as good be good enough? Some people do actually get more enjoyment from the more expensive items, whether they are an audiophile who can tell the difference between a $10,000 and a $20,000 speaker, or whether they are an aesthete who finds happiness in having the perfectly decorated home. But for most of us and for most consumer goods, we are just fooling ourselves into believing that we must have the more expensive item.

Go through the money that you spend each month and ask yourself if spending that money makes you happier, healthier, or wiser. If it does not, do not spend the money. Save a portion of the money that you save, and feel free to spend a portion of that money on things that will actually make you happier, healthier, or wiser.

H2Diesel’s Biodiesel Miracle

The Technology Cannot Work

Today’s whipping boy is H2Diesel Holdings Inc. (OTC BB: HTWO.ob). I do not believe that the company’s product, a new method for making biodiesel, can possibly work. It would be great if it worked, but a cursory reading of the company’s description of the process makes no sense whatsoever to anyone who understands chemical manufacturing.

From the company’s website:
“Unlike the complex transesterification process used by most Biodiesel producers H2Diesel’s Biofuel is manufactured using a simple blending, or emulsification process. Water is blended with a combination of commonly available chemicals to make a proprietary additive. The additive is blended with vegetable oil feedstock (commodity or waste) to produce the H2Diesel Biofuel. There are no significant by-products from the process.”

From their comparison of H2Diesel to normal biodiesel:
“H2Diesel biofuel is manufactured using a simple mixing process, using little energy and yielding virtually no by- products”

In the real world, there are very few chemical reactions without significant byproducts. Furthermore, transforming vegetable oils into diesel using any proven method uses significant amounts of energy, yet H2Diesel claims that their process uses very little. This indicates to me that the company does not know what they are talking about and that the method does not work as they indicate. This product is about as likely as perpetual motion machines.

Management Has Little Chemical Experience

I would expect the management of a research company that is revolutionizing chemistry to have a lot of chemistry research experience. Only one of H2Diesel’s top executives has any research experience, and only received his PhD in 2006. All the other executives have financial backgrounds.

Furthermore, the company has spent a total of only $287,000 in R&D since inception in 2006 (see p4 of the most recent 10Q). That is barely enough to support one full time research chemist and necessary chemicals, let alone the cost of analytical equipment.

I should add that the company acquired the exclusive license to their biodiesel production method from an Italian chemist (see the 2006 10-k for details). If the product was perfect when they licensed it, there would be little need for additional R&D expenditures. However, for most chemical products it takes significant R&D to turn a laboratory-proven technique into a commercially-viable technique.

Valuation: Losses, No Assets, Big Market Cap

According to the most recent 10Q, as of August 10, 2007, H2Diesel had 17,266,150 shares outstanding. However, the existence of the company’s Preferred Convertible A stock increases the fully diluted share count by 1,063,750. Warrants from the convertible preferred stock offering add an extra 531,875 fully diluted shares. At a recent price of $7 per share, the company has a fully diluted market cap of $188.6 million. (There are also at least 1.5 million other warrants outstanding that I do not include because they are performance-based for a consulting contract).

Also as of the most recent 10Q, the company had book value of $3.8 million and a loss in the previous 3 months of $3.7 million.

Big Name Partner Lends Credibility?

The company is having an affiliate of Dynegy [[DYN]] do a test-burn of some of its biodiesel. This seems to lend credibility to the company. However this appears to be a no-lose situation for Dynegy–it foots a few small costs and gets some free fuel.

Fuel is Not EPA Approved

The company’s biodiesel does not meet EPA standards for use as a fuel for vehicles. This means that the largest market for diesel fuel is off limits for H2Diesel for the time being.

From the company’s 2006 10K:
“We intend to market the H2Diesel Bio-fuel as a new class of bio-fuel or fuel additive for power generation, heavy equipment, marine use and as heating fuel. We have evaluated whether the H2Diesel Bio-fuel can be formulated to comply with U.S. Environmental Protection Agency (“EPA”) standards to be classified as “Bio-diesel” for vehicular use. EPA standards mandate that “bio-diesel” comply with the specifications of the American Society for Testing and Materials (ASTM) 6751. In particular, ASTM 6751 requires that the fuel be comprised of “mono-alkyl esters of long chain fatty acids.” The H2Diesel Bio-fuel does not comply with this specific requirement of ATSM 6751, and consequently, it is not compliant with EPA standards. However, we are currently investigating whether the ASTM standard can be broadened to include our fuel. Additionally, we are evaluating the regulatory requirements for using our fuel in motor vehicle applications in our territory outside of the United States.”

Conclusion

H2Diesel is speculative at best and utterly worthless at worst. I cannot imagine any reasonable investor buying the company’s stock.

Disclosure: I hold no position in DYN or HTWO. See my disclosure policy.

An ETF Asset Allocation Plan for Everyone

If I have not said it much before, I will certainly say it in the future: the best way to invest is with low-cost index mutual funds or low cost index ETFs. I like Vanguard, but it is even cheaper to get an account at Zecco.com and then invest in low-cost ETFs. They give you a certain number of free trades per month which is more than adequate for a long-term buy-and-hold investor. What I suggest below is not quite as simple as one of Vanguard’s excellent low-cost target date funds (see The Default Investment), but it will give you a portfolio that is more appropriate for your individual circumstances.

In the article on the default investment, I suggested talking to a financial planner if you wanted a tailor-made portfolio. However, the problem with financial planners is that they cost a lot of money relative to investable assets, particularly if you are not rich. A couple hundred dollars an hour or .5% of invested assets adds up quickly if you have a small portfolio. So for those with under a few hundred thousand dollars, it may be best to go it alone. You will need to first determine your risk tolerance. Buy Index Funds: The 12-Step Program for Active Investors; this book will help you think through how much risk you can handle. There are also 20 sample portfolios in the appendix for all different risk profiles. Those portfolios are designed for DFA mutual funds (which can only be accessed through a financial advisor). So I found suitable ETF substitutes for those funds and they are listed below along with their ticker and annual expense ratio. So buy the book, choose an appropriate portfolio for the amount of risk you can handle, get an account with Zecco, and then buy the following ETFs in the proportions recommended for your risk profile in the book. You will pay very few fees, your portfolios will be tax-efficient, and you will not have to think very much about your investments.

US Large Company: Vanguard Large Cap (VV), 0.07%
US Large Cap Value: Vanguard Value (VTV or VIVAX), 0.11%

US Microcap Index: iShares Russell Microcap Index (IWC), 0.60%
US Small Cap Value Index: Rydex S&P Smallcap 600 Pure Value (RZV), 0.35% or Vanguard Smallcap Value (VBR), 0.12%

Real Estate Index: Vanguard REIT ETF (VNQ), 0.12%

International Value Index: iShares MSCI EAFE Value Index (EFV), 0.40%
International Small Company Index: SPDR International Small Cap (GWX), 0.60%
International Small Value Index: WisdomTree Small Cap Dividend Fund (DLS), 0.58%

Emerging Markets Index: Vanguard Emerging Markets Index (VWO), 0.30%
Emerging Markets Value Index: WisdomTree Emerging Markets High-Yielding Equity (DEM), 0.63%
Emerging Markets Small-Cap Index: WisdomTree Emerging Markets Small-Cap Dividend Fund (DGS), 0.63%

One-Year Fixed Income Index: (see below)
Two-Year Global Fixed Income Index:
Five-Year Government Income Index:
Five-Year Global Fixed Income Index:

There are no funds that are very close to the above, but you can use different weights on Vanguard’s bond funds to approximate the average duration of the mix of the above funds. Vanguard Short-Term Bond Index (BSV), 0.11%, has an average maturity of 2.7 years, while Vanguard Intermediate-Term Bond Index (BIV), 0.11%, has an average maturity of 5.7 years. Both are invested primarily in Treasury and government agency securities. For very-short term bonds (or just buying government bonds of any maturity), you could enroll in Treasury Direct and buy 1-year treasuries direct from the US Government. If you hold them to maturity you pay no fees.

I see no great need to invest in foreign bonds, considering the safety of the Vanguard funds. While more diversification is good, there is a limit to how safe something can get–and it doesn’t get much safer than one to five year government and AAA-rated bonds. So if Index Funds says that you should have 10% in each of the four bond categories, your weighted-average maturity would be 3.3 years. So you could put 10% of your investable assets in 1-year bonds through Treasury Direct, 15% in the Vanguard Short-Term Bond Index, and 15% in the Vanguard Intermediate-Term Bond Index. This gives you an average maturity of 3.4 years.

When investing in these ETFs, you should rebalance every year. You could also choose to put a portion of your funds in one or more of Vanguard’s target date funds and then just add on the extra funds (value, small-cap) to the main target date fund. Then you would not have to rebalance as often.

If you follow the above plan, you should expect to outperform 80% of other investors, because they will incur more taxes and more fees. You will also end up with investments tailored to your unique circumstances. And you will only have to think about your investments once a year. This sounds like a good deal to me.

Continental Fuels Remains 100-times Overvalued

Company Remains 100-times Overvalued

The problem with so many penny stocks is that they have so few assets and earnings that even after a precipitous drop in the stock price they can remain very overvalued for a very long time. When I last wrote about Continental Fuels (OTC: CFUL) on September 15, its stock price was $1.70 per share and it had a fully diluted market cap of $972 million. At the recent closing price of $.71, the stock has a fully diluted market cap of $406 million. Because the company has a negative book value and no earnings to speak of, I cannot value it using traditional means. Also, I am feeling generous, so I will value the company using its total assets of $3.8 million as of its most recent 10-Q filing. This is the equivalent of $.0067 per share. This, of course, ignores the company’s liabilities. Even using this generous measure of assets to value the company, it still looks over a hundred times too expensive. Needless to say, I still believe that Continental Fuels is one of the worst possible investments that anyone could make right now.

Just for fun, I did a little more research on Continental Fuels and I found out some more interesting information about the company.

Yet Company Spent Money to Hype its Stock

Continental Fuels paid an internet stock tout company, Crosscheck Capital LLC of Arizona, $525,000 to pump up the stock in a mass mailing to 500,000 people. The company states this in its May 2007 10-Q filing. From the filing:

“On March 15, 2007, the Company entered into an agreement with Crosscheck Capital, LLC (“Crosscheck”) to pay aggregate advance retainers of $525,000 to prepare and distribute to no less than 500,000 US residents an advertising/advertorial mailing package that prominently features a report on the company. As of March 31, 2007, the Company has remitted $150,000 of the advance retainers due to Crosscheck. The remaining amount, $375,000, was paid in April 2007.”

The company touted its stock at a time when it admitted elsewhere that its stock was worth much less than the market price. Considering that Continental has acknowledged in many instances that its stock is overpriced, I can conclude only that the company acted immorally in willfully soliciting new investors for its stock so as to maintain the absurdly high share price. Unfortunately, I do not have copies of the materials sent by Crosscheck Capital, so I cannot determine whether the company’s actions crossed the line between misleading statements and lies.

If you have any copies of the materials sent out by Crosscheck Capital, please let me know. If you are a fan of the company or are associated with the company, I would be interested in knowing your opinion as to why the company spent a significant chunk of its assets to promote its stock, then priced at $1.93 per share, when the company itself valued its shares just five months later at $0.008 per share.

Disclosure: I am short CFUL. I have not traded shares of CFUL since I first shorted the stock 12 days prior to my last article on it. I have a disclosure policy.

How to Spot Accounting Fraud

Thanks to Tracy Coenen for pointing this out.

Joseph Wells has a good article on how you can use time series of financial ratios to spot accounting fraud. He uses ZZZZ Best (Barry Minkow’s fraudulent company) as an example of how this works. When there is fraud, there will usually be excessive accruals, or non-cash items, relative to the actual cash flow of the business. This is because such accruals can be faked, whereas actual cash flows cannot easily be faked. If a company has $10 million in cash in the bank is easy for the auditor to verify. It is much harder to verify sales that have been billed but not yet paid. Any two-bit criminal can falsify a sales record and added big number to the Accounts Receivable line.

Accruals have already been shown to lead to poor stock performance, so this is just one more reason to avoid companies with high accruals.

See the article.

P/E Ratios: Part 2

In a previous post, I discussed how to find the appropriate P/E ratio of a company based on current earnings and I gave a rough estimate for appropriate P/E ratios if the company’s earnings are increasing or if they are decreasing. In this article, I will address historical average P/E ratios in the stock market.

Please take a look at the graph of historical PE ratios vs. the price of the DJIA over the last 100 years. The most obvious conclusion we can draw from the chart is that there are distinct cycles in the market: bear markets with decreasing P/E ratios are followed by bull markets and increasing P/E ratios. Another obvious fact we can see is that for most of its history, the average P/E on the S&P 500 has been between 10 and 20. Also, the stock market’s returns have been greatest following periods of low P/E ratios than in periods following high P/E ratios.

Unfortunately, these trends do not bode well for our near-term performance. There are two likely possibilities in the near term (5-10 years): stock prices will fall, perhaps precipitously, or stock prices will neither fall nor rise. In the first case, P/E ratios would also fall quickly, and by the time they fall to about 10 on average, we would want to be fully invested. In the second case, P/E ratios will gradually decline as profits increase but stock prices go nowhere.

I am not an expert on forecasting the future, but there are forecasters who predict both of the above possibilities. John Mauldin, in his book Bullseye Investing (an excellent book by the way), predicts what he calls a ‘muddle-through economy.’ Mauldin sends out a free weekly newsletter to which everyone should subscribe.

Richard Russell, on the other hand, in keeping with Dow Theory, argues for a standard bear market with falling stock prices. Russell, by the way, is ranked as the second best market-timer by Mark Hulbert since 1980. The best market timer is a system based solely on the date.

Anyway, future stock returns do not look good at this point, at least for the averages. If we look at individual stocks, though, there are still some that are good values. Unfortunately, that list is small, and I can find few great values. Even if the market goes against us (or does not move at all), we can do fine. I do not think that we should anticipate average returns exceeding 10% per year over these next few years. That being said, an overvalued market is a stockpicker’s market. Whereas Sir John Templeton could buy 100 cheap European stocks in 1939, including many in bankruptcy, and make fabulous profits on almost all, we will have to pick and choose carefully. There are still companies that are undervalued, with a potential for giving us outsized profit.

As investors concerned with value, we must remind ourselves that a bear market is a good thing. This is where time diversification benefits us. As stock prices fall (or, as they do not move but profits increase), and P/E ratios fall, we must gradually increase our allocation of assets to stocks. Thus, as value gradually returns to the market, we should gradually sell bonds (or use cash) to buy more stocks.

I am not a market timer. I can think of very few times when it actually made sense to be out of the market. In 1929 it would have been advisable. But in 1937, 1966, and 2000 there were still some fairly valued stocks. For example, we would have been fine buying Sysco [[SYY]] in 2000, but not Cisco [[CSCO]].

Disclosure: I own no shares in any of the companies mentioned. See the disclosure policy.

[This was originally published October 2005 . The market’s performance since then validates my belief that market timing is not worth the effort.]

P/E Ratios: Part 1

What is a good P/E ratio? Well, good P/E ratios are low. But how low is low enough? Is 20 good? Is 15 good? There are a couple ways to look at this–in terms of a business in general, and in terms of what the markets have determined to be an average P/E in the past. I address historical P/E ratios in the stock market in a future post.

Let’s say you own Acme Brick, and your company makes an average profit of $1 million per year. As the owner, you can pay that to yourself or reinvest it in the business. Let’s say you want to sell, though. What is a fair value? To do this, you need to compare the return that you would make on your business relative to the risk-free interest rate (the rate of interest that you could earn on a U.S. government bond). The rate is now about 5%.

The person to whom you are selling Acme Brick should (at a fair selling price) be able to make a somewhat better return on his money than if he just bought government bonds. This is because he is taking on more risk in buying a company than he would be if he bought government bonds. The company may see its profits shrink, whereas the return on a government bond is guaranteed. So we then fire up a handy interest rate calculator and learn that at 5% interest, it takes about 14 years to double your money.

So what price would a buyer of Acme Brick have to pay so that it would take him 14 years to double his money? He would have to pay $14 million dollars. (In 14 years, his $1 million per year profit would have doubled his original investment to a value of $36 million, including both the company and cash.) I must note that it would actually take less than 14 years for Acme Brick to double the initial investment, because when earnings are paid out each year, they can be invested elsewhere and will thus compound, just like interest on a bond compounds.

Because there is more risk in Acme Brick than in the U.S. government, $14 million is too high, so we subtract some money from his buying price to compensate the buyer for his risk. Therefore, about $10-12 million should be a fair price for buyer and seller. This price translates to a P/E ratio of 10-12. So is this the fair P/E ratio of all businesses? No. In our example, we assume Acme is not growing more profitable. If the company is growing its profits rapidly, a higher price would be in order. However, if the company is becoming less profitable, a much lower price is in order. But the price is always determined from the future profits we can expect from the company. When we take into account the other possible uses of our money, such as buying government bonds, what we have done is an over-simplified discounted cash flow analysis (only the really courageous should follow that link). Again, this is simplified, but the future introduces so much uncertainty that more precise calculations are rarely helpful.

So, with current interest rates very low (around 5% for medium-term government bonds), a fair P/E for a company that is not growing more profitable is about 12. We don’t want to buy companies when they are fairly valued. We want to buy them when they are good values or great values. Thus, for companies that do not show strong growth, we will prefer to pay less than $9 for every $1 in earnings (or, a P/E ratio of 9). For companies with strong growth, we may be willing to pay up to around a P/E of 20 (although the lower, the better).

By paying less than the fair value, we give ourselves a margin of safety, so that we are protected in case we make a mistake in our calculations or in case the company in which we are investing suddenly starts to do worse. Half the battle of making money in the stock market is avoiding big losses, so in buying great values, we are halfway to success.