Category: Stocks

Where is the value premium?

One of the quandaries of finance research has been why the value premium (the tendency for low P/B or P/CF or P/E stocks to outperform the market) has not been reflected in the performance of ‘value’ active mutual funds. A new paper by Ludavic Phalippou in the Financial Analysts’ Journal argues that the reason for this is that only the small-caps and micro-caps exhibit a large value premium. What this means is that an investor should either focus on buying small cap value index funds or should buy individual micro-cap value stocks.

The article is not available free online. Following is an excerpt from the paper’s conclusion:

The premise of this article is that if the value premium is a result of both pricing errors and limited arbitrage, then the value premium should be concentrated in stocks that are both held by relatively less sophisticated investors and expensive to arbitrage. Such a concentration is suggested in the literature but has not been quantified. In this article, I show that, indeed, at least 93 percent of market capitalization is free of a value premium. Using institutional ownership (IO) as a parsimonious way to classify stocks by their mispricing likelihood, I show that the value premium monotonically decreases from a high 185 bps for low-IO stocks to a negligible 13 bps for high-IO stocks. This result also holds when returns are value weighted and, importantly, is driven mainly by the long side. Low-IO value stocks are those with the most abnormal returns. The anomaly is a value premium, not a growth discount, as is sometimes argued …

The extreme concentration of the value premium has important practical implications. First, arbitrageurs can expect to face substantial costs when trying to arbitrage the value premium, and those focusing on the stocks most held by institutional investors (the larger, more liquid stocks) will have difficulties generating arbitrage profits. The value premium concentrates where arbitrageurs usually do not go. This reason is also why studies have found that value and growth mutual funds perform the same. Second, studies that select a subsample of stocks that, for instance, either have at least two to five analysts following the stocks or are traded on the NYSE end up with a sample that is almost free of the value anomaly. Such a fact is important to bear in mind when interpreting the results found in such samples.

Sex may sell, but it sure ain’t profitable

The old adage that sex sells may be true, but if an investor wanted to invest in publicly traded peddlers of sex (in all its legal incarnations), that investor would have only a few poor choices. While those choices may soon expand (when Penthouse goes public, as it is expected to do soon), the anti-prude investor should steer clear of this field.

The largest publicly-traded sex-related company, Playboy [[pla]], is the quintessential poor investment. Over the last two decades Playboy stock is up 42%, while the Dow Jones Industrial Average is up 520%. Even as Hugh Heffner continues to cavort with silicone-enhanced playmates one-third his age, the company’s centerpiece magazine continues to lose subscribers.

The story is much the same at cable-smut purveyor New Frontier Media [[noof]], where the stock has appreciated 2% over the last decade. The DJIA is up 64% over the same time period. The problem with cable porn is that it will suffer the same fate as newspapers: it is going to be crushed by internet competition. So despite a cheap P/E of 15, New Frontier will likely be a poor investment.

Rick’s Cabaret International [[rick]], a chain of strip clubs (see a commercial for it here), has been kinder to its investors than the above companies. Over the last decade it has outperformed the DJIA, 270% to 64%. But Rick’s is trading now at a stratospheric P/E of 34, which is out of line with companies most comparable to it: staffing companies such as Administaff [[asf]] and Manpower [[man]], both of which trade at P/E ratios under 15. While Rick’s provides stripping services in branded locations, it is not really that different from staffing firms that provide administrative and other services to companies. It relies upon its ability to recruit skilled workers, and its brand is far less important than the actual capabilities of its workers. Also like the staffing firms, it is vulnerable to a recession.

The last public sex company of which I am aware is the worst, yet it comes with the most wholesome reputation. This company is Berman Center Inc. (Pink Sheets: BRMC). This is a sex therapy center and website that caters to couples looking to improve their sex lives. Its eponymous founder, Dr. Laura Berman, is not only knowledgeable but also good at getting press. She has appeared on Oprah Winfrey’s show and she is a columnist for the Chicago Sun-Times. Despite the advantages the company has, its financials are a mess. The company, with a market capitalization of $12.5 million, has a book value of negative $1.3 million (see the most recent 10Q for details). The company lost $1.3 million over the first nine months of 2007 and lost $1.2 million over the first nine months of 2006. The company is also delinquent in filing its 2007 annual report.

Overall, sex makes for a poor investment, at least in terms of public companies.

Disclosure: I have no position in any stock mentioned. My disclosure policy is considered obscene in Utah, because it is transparent and it prohibits stock fraud, front-running, pump-and-dump scams, and MLM schemes.

Leveraged buyouts and EV/EBIT

As I mentioned previously, screening for companies using EBIT / EV allows for easier comparisons between companies with different levels of debt. However, what truly matters to the investor is earnings yield (or FCF yield, which accounts for necessary reinvestment). A company can change its earnings yield simply by taking on debt and buying back stock.

I’ll take the example of Barbeques Galore, my first great stock pick, which was trading for a 5-year average P/E of 12 at the time I recommended it (in a stock bulletin board and in a defunct stock newsletter). Because the company is a retailer it has very little depreciation and amortization and thus little need for reinvestment—for these reasons earnings should be about equivalent to free cash flow. So this translates into an 8.5% free cash flow yield. There was very little debt on the books. We’ll assume for simplicity’s sake that they had no long-term debt.

BBQZ was taken private for a price of about $9.50 per share, 60% above the price at which I recommended it. This gives the company an earnings yield of only 5% (with earnings at $2 million and cost at $20 million). Was this a good deal?

The answer becomes clear when we take debt into account. Because BBQZ had essentially no debt, they could be loaded with debt to increase the earnings yield. We will assume that ¾ of the purchase price ($30 million) came from debt. With interest at about 5%, that increases the company’s interest expense by $1.5 million per year. Earnings do not fall by that amount, though. We need to look at EBIT and reduce that by $1.5 million, since taxes take a fixed proportion—not a fixed amount—of earnings after interest. Assuming a 40% tax rate, EBIT was $3.3 million before the buyout. After subtracting interest expense of $1.5 million and tax of 40%, we arrive at earnings of $1.1 million. Compared to the equity value of the company outstanding ($10 million), we now have a company with an 11% earnings yield. Not bad. Since the underlying operating characteristics of BBQZ remain the same, EBIT / EV remains the same (although EBIT/EV is lower than before the buyout was announced, since the buyout was at a premium to market price).

After adding a sizable amount of debt to the company the earnings yield doubled. This is the logic behind all leveraged buyouts (LBOs). If a company has consistent cash flow and debt is cheap, it makes sense to increase the debt to increase the earnings yield. The only time this is bad is when too much debt is added and the company risks not being able to pay its debt.

How does this matter to us as investors in public companies? We should try to examine companies by their EBIT/EV ratio rather than just their P/E ratio. This gives us a sense of how profitable the company’s underlying business is. Almost any company can look great if given a lot of cheap debt. A great example of this is Long Term Capital Management. They were a trading company run by the best of the best. They engaged in risk arbitrage. Their unleveraged profit margin was only about 2%. However, because they could obtain so much debt financing at such little cost, their investors saw 30-40% annual returns (until the company imploded, but that is another story).

Timothy Sykes is full of bullship

[Edit 8/18/2009 – Since writing this article I have changed from Tim Sykes’ biggest critic to his biggest fan. Please see this article on my new trading blog about how my opinion  of Tim Sykes changed.]

Timothy Sykes, the boy wonder who turned $12,000 into $1.65 million while still a teenager, has abandoned his hedge fund Cilantro to re-create his day-trading achievement in full view of the internet on his new blog. Sykes is best described as young, brash, egotistical, and annoying. Of course, an impartial observer would describe me in much the same way. Timmay and I also share the preference for shorting stocks over buying them. But rather than being two peas in a pod, we are polar opposites: Tim is the quintessential short-term trader and I am the archetypal buy-and-hold value investor.

I am not like some people who say that day trading is a crock and that it never works. It can work for some people some of the time. The problem with Tim Sykes is that he encourages others to follow in his footsteps by buying his $297 DVD trading seminar. There are several problems with buying a trading system such as Tim’s:

  1. Even assuming that some strategy works, if enough people follow that strategy it will cease to work. This is exactly what happened to Richard Dennis, the noted commodities trader, who famously lost tens of millions of dollars in 1988 after his trend-following strategy stopped working. Sykes of course likes trading microcap stocks with relatively thin markets. This means that his system is especially prone to break when too many people start using it.
  2. Trading takes a lot of time; this is particularly true for Timmay’s day trading and momentum trading. Most people have jobs, and very few people have enough in savings and enough trading talent to make a lot of money trading. So for most people, time learning to trade would be better spent nurturing their career or working a second job.
  3. Trading any system takes incredible self-restraint and guts. Very few people have the self-control to be able to stick to a system even when it is not making money. This is even harder if a trader buys a system (say, from Tim Sykes), because it is harder to become truly convinced in the system if that trader did not invent it himself or herself.

Traders and investors should steer clear of Sykes’ DVD and his trading system. Those few who could be good traders would likely do better developing their own system rather than following Tim’s. Of course, I find Tim amusing, so I encourage you to read his blog for its amusement value.

Disclosure: I had no connection to any person mentioned at the time I first posted this. Since I first published this post I have bought many of Sykes’ products, successfully used his trading system, and am now an affiliate of his (earning a commission on anyone who buys his DVDs using a link from my site).

Stifel, Nicolaus, and a Broker’s Theft of Client Money

Stifel, Nicolaus & Company [[sf]] has a reputation as a straight-shooting company. The regional brokerage, based in St. Louis, avoided accusations of biased stock research that ensnared many other brokerages at the time of the tech-stock bust. The company has not previously seen any of its Missouri brokers charged with securities violations by the state Securities Division. But all is not well with the company. In fact, Stifel, Nicolaus has recently shown that it has little concern for its brokerage clients, beyond its desire to extract as much money as possible from them. One of the company’s brokers, Girard Augustus Munsch Jr., was recently sanctioned and fined by the Missouri Securities Division for excessive trading in client accounts. How excessive?

One client, an 81-year old with a net worth below $250,000 and a liquid net worth under $100,000 (according to brokerage documents), paid $63,861 in commissions over three years on a total of 262 stock trades. In his deposition, the broker (Munsch) stated that for many of the trades, he was the only one to benefit. In other words, the trades were executed solely to garner trade commissions.

Another client, 72-years old when the client began with Munsch, had 122 stock trades over three years in her account, generating $32,389 in commissions for Stifel, Nicolaus. According to brokerage documents, this client had liquid assets of under $100,000. When interviewed by securities regulators, the client stated that she wanted to keep her money in mutual funds and to avoid high risk stocks. Girard Munsch acknowledged that he was was aware that he was the only beneficiary of many of his client’s trades, and that did not bother him.

Stifel’s Culpability

There are of course bad apples in every bunch. But Stifel, Nicolaus showed willful negligence and a casual disregard for the financial well-being of its clients in how it managed Munsch. Back in 2000 Munsch was put under heightened supervision due to customer complaints of unauthorized trading. Due to client complaints of unsuitable investments, Munsch was again put on heightened supervision in March of 2003 and 2004. Munsch’s supervisor, while requiring a phone log to make sure that he was acting appropriately, never checked that log or instructed Munsch in completing the log. Evidently it takes more than repeated mistreatment of clients to get a broker fired from Stifel.

The Punishment

The punishment meted out by the Missouri Securities division is of course insufficient. Munsch should be barred from working as a broker. Instead, he has to be closely supervised and pays a meager fine of $105,700. For a successful broker, such a sum is far less than one year’s salary.

Stifel, Nicolaus, despite failing completely to supervise Munsch and to fire him after earlier violations of the law, gets off without a fine. A fine of $10 million would have been appropriate. However, the broker did one thing right : when I checked with Stifel, Nicolaus, I was told that Munsch had “retired”.

Disclosure: I have no position in any company mentioned.

When analysts get paid to provide positive opinions

People will respond to rewards. This is one of the most consistent findings in psychology. Whether the reward is pecuniary, emotional, or philosophical, people will (within reason) do whatever it takes to get rewarded. So if my business partner asks me to do something that is unimportant, I am likely to do it, distracting me from things I consider more important, because it matters to me what he thinks of me. If I am paid by someone to do something, I will make sure I act in such a way as to continue to get paid.

Acting in such a way as to continue to get paid is a problem when a person or company is being paid to give an unbiased opinion about a company. This is why Fitch, Moody’s, and S&P all have given absurdly high ratings to CDOs and other structured bonds: they were paid handsomely by the banks who put those bonds together. Those types of structured finance provided much of the profit growth of the ratings agencies over the last few years.

This same conflict of interest is often present in the micro-cap world. For example, I have previously criticized Beacon Equity Research for being paid by many microcap companies to cover them. Its reports are unfailingly bullish. The problem is that many investors do not take the trouble to investigate the company and they consider the reports meritorious. If an investor had invested in many of the companies covered by Beacon Equity Research, he or she would have lost lots of money. However, if the investor had instead read my blog and taken my advice (on stocks covered by both Beacon and myself), they would have avoided many losses.

For example, on February 6th, Beacon issued a positive report on Continental Fuels (OTC BB: CFUL), when it was trading at $0.28 per share. The analyst’s target price was $0.53. My most recent opinion on Continental Fuel’s valuation came last December 28th, when I said that the stock, then at $0.40 per share “continues to trade at 40x my fair value estimate of $0.01 per share.” The stock has since fallen to $0.03 per share.

Lighting Science Group (OTC BB: LSCG) makes another great example. Jeff Bishop of Beacon Equity Research published a positive article on the company on SeekingAlpha on February 8th. The stock closed that day at $9.80 per share. On February 22nd, I posted a negative article on the company on this blog. The stock price has since fallen from $9.90 per share to $2.85 per share.

Investors should always be careful to examine how analysts are compensated for their services. They would do well not to pay attention to any analyst paid by the company they are covering. In the end, each investor is responsible for his or her own investment performance. Those who are incapable or unwilling to put forth the necessary effort to understand the companies they buy deserve what they get.

Disclosure: I have no position in any company mentioned. I was short LSCG when I last wrote about it, as I disclosed at the time. I have a disclosure policy.

Playing hot potato with the shares of an overvalued microcap

If you are not from Germany then the only time you have probably heard the term “Landesbank” is in relation to the subprime mortgage problem. WestLB and IKB required rescue from their owners after speculating and losing billions of dollars in subprime mortgage securities. Their peer NordLB (or for the German-speaking, Norddeutsche Landesbank Girozentrale) evidently decided to emulate WestLB’s and IKB’s idiocy by purchasing for a client 24% of perennially-overvalued microcap Remote MDX (OTC BB: RMDX). Now, normally this would not be a problem: if the client loses money the bank still gets its fees. However, the bank’s unnamed client refused to take the shares and those shares are now sitting on the bank’s books. NordLB recently filed a form 13D to announce this. Here is an excerpt:

Since November 2007, NORD/LB has been acquiring RemoteMDx Common Stock at the instruction of a client and with the intention to pass the shares on to the client. However, the client now refuses to accept the RemoteMDx Common Stock and to settle the orders. In the course of a review conducted with regard to these business activities, one of NORD/LB’s brokers mistook the trades for settled with the client and entered them into the books accordingly. Because the settlement process with NORD/LB’s client is still disputed, NORD/LB, as a matter of precaution, on February 25, 2008, assigned the shareholding to its own assets and is therefore making this disclosure on Schedule 13D. However, NORD/LB disclaims beneficial ownership of the shares of RemoteMDx Common Stock included in this Schedule 13D subject to resolution of this dispute.

The shares were purchased near the stock’s all-time highs. Whoever ends up with the shares will have a mark-to-market loss of $81 million, or 70%. No matter what happens, this situation makes NordLB look incredibly bad.

Note 3/16/08, 7pm: since I first published this I  was made aware that Carol Remond of DJ Newswires published an article about this Friday. She identified the client as Vatas GMBH, a previous 13D owner of RMDX stock. The hedge fund had also left Nord/LB with stock in several other microcaps.

For more information:

Remote MDX (RMDX.OB): A ‘Bit’ Overvalued (August 2007 – GoodeValue.com)
Remote MDX Redux (August 2007 – GoodeValue.com)

Citron Research Comments on Remote MDX (December 2007 – CitronResearch.com)

Disclosure: I have no position in RMDX.

Interim Performance Review

Your humble blogger is not averse to eating crow. So it is time to admit that I have been wrong so far about Frederick’s of Hollywood [[foh]] (Movie Star Inc prior to a recent reverse merger). It is difficult to invest without knowing all the information, and I appear to have been over-optimistic about the growth of the company. Especially with competitors like Limited Brands [[ltd]] (owner of Victoria’s Secret) selling quite cheaply, Frederick’s does not look like a worthwhile stock to buy. Frederick’s stock has recently fallen from $3.60 to $2.80 (its 52-week low after adjusting for a recent 2-for-1 reverse split).

On the other hand, my bearish advice continues to be very good: since scolding Patrick Byrne and Overstock.com [[ostk]] in a Dueling Fools article (for The Motley Fool), the stock has declined from $15.76 to $8.90.

In other news, despite Exmocare (OTC BB: EXMA, formerly 1-900 JACKPOT) being a horridly overvalued useless piece of trash with no sales and no significant book value and no chance of ever being worth one-tenth of its market cap, its stock has gone up since I pledged the profits from my short position in the stock to charity. The 1st Annual GoodeValue.com Short-a-Thon was a failure and raised $0 for charity.

Disclosure: I have no position in any stock mentioned. I trained in the dark arts of Jedi under the Sith Lord himself. My disclosure policy wants you to read it.

A worthless company that shall soon reward its foolish investors

Many things can be said about MaxLife Fund Corp (OTC BB: MXFD). Certainly, it could be called overvalued: the company, trading at a recent $18.89 per share and a market cap of $572.2 million (it has 30.3 million shares outstanding as of January 14), has a book value of $560,000 and revenues for the most recent quarter of $330,000. The company could be called a great speculation: since August 6, 2007 its share price has increased from $1 to $18.89. Since January its shares have doubled.

One thing that is certain about MaxLife Fund Corp is that it will not reward long-term investors. Even if the company does execute on its highly optimistic plan put forth in a recent press release (which I believe to be unlikely), its revenues and earnings will not justify its current market cap. One day its stockholders will realize this and the share price will crash down below $1.

Another ill omen for investors: Itamar (Eddy) Cohen is a 46% owner of the company. Stocks promoted by Cohen have not faired well: two of his recently promoted stocks have fallen 97% from their peaks.

For more information:

Forbes Informer article
10Q filing with SEC

Disclosure: I am short MXFD. I have a disclosure policy.

The fall of a pumped penny stock

I have previously written about Continental Fuels (OTC BB: CFUL) a number of times. I called it the most overvalued penny stock I had ever seen when it was trading around $2.50 per share (although there are now some good competitors for that honor). When its stock price had fallen to $0.70 per share, I said it remained 100-times overvalued. With a current stock price of $0.05 per share, I can finally say that the stock’s inevitable fall is mostly over (although it would still be a poor investment).

The moral of this story is do not invest in over-hyped stocks. Do not invest in stocks mentioned in spam emails, junk faxes, or junk mail. Do not invest in any individual stock unless you have read and understood its financial statements. For those who are not savvy investors, don’t worry: just invest in broad-market index funds and you will do better than most investors and mutual funds.

Disclosure: I have no position in CFUL.