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.

Improving the ETF Asset Allocation Plan for Everyone

I just learned that WisdomTree introduced an emerging markets small cap dividend ETF (DGS, 0.63% expense ratio). This fills a small whole in my previous ETF asset allocation plan (I just added it to that post). I just bought a bit today. The bid/ask spread on this is huge for an ETF, 1%, so place a limit order in between bid and ask. However, if you buy and hold for a number of years, the bid/ask cost will become less and less important as the years pass by.

Disclosure: I bought DGS this morning. 

The best companies you can’t buy

Here is my list of some of my favorite private companies or subsidiaries of public companies in which I would love to invest:

  • Chemtool — how can you not love lubricants? These guys mint money and their customers don’t care because lubricants are such a small but vitally important part of all sorts of machinery.
  • Logoworks — Bought in Spring 2007 by Hewlett Packard [[hp]]. This company is to logo and website design what Infosys [[infy]] is to technology outsourcing.
  • Forever21 — Excellent merchandising and great distribution make this one of the best clothiers to fashion-conscious teenyboppers. The husband/wife team that runs the company has no intention of taking it public.
  • Trader Joe’s — Whole Foods quality at Aldi’s prices. Did I mention Aldi’s? TJ’s is owned by the same German family that owns Aldi’s. The original Trader Joe sold out back in the late 1970s.
  • Ted Drewe’s — The original frozen custard. With only two locations it could easily expand in St. Louis–there is certainly enough demand.
  • PlentyofFish.com — Dating website has only 3 employees (the founder, his girlfriend, and one PR person). It also has at least $10 million in annual profits. Not bad.

Leave a comment if you have any favorite private companies.

Disclosure: I am a customer of Logoworks and Trader Joe’s and Aldi’s.

The Classic Blunder: Going up against a short seller with death on the line

See my article at the Motley Fool on why buying highly-shorted stocks is a bad idea.

By the way, my editor cut what I thought was one of the most important paragraphs, the second to last:

“However, Finance professors have done similar research on much larger samples of stocks and have ended up with the same result. The article An Investigation of the Informational Role of Short Interest in the Nasdsaq Market, by Desai, Thiagarajan, Ramesh, and Balanchandran, explains how as short interest increases, the future returns of stocks
decrease. A more recent paper, by Boehmer, Erturk, Sorescu of Texas A&M University, Why do short interest levels predict stock returns? finds that the reason highly shorted stocks under-perform the market is because short sellers tend to be well-informed.”

If you like the article, please give it a recommendation.

The best retirement account for the self-employed

What is the best retirement plan for a self-employed person with no employees and modest income? With SIMPLE IRAs, KEOGH plans, SEP IRAs, and 401(k)s, the choices abound and they are all confusing. Now there is a clear winner.

Without a doubt, the winner is the 401(k), with Roth 401(k) option available, from T. Rowe Price. This is a great option for a few reasons:

  1. Low costs. There are no setup fees. There are no ongoing fees except for a $10 yearly fee for each fund with under $4,000. I would investing in just one fund until it is over $4,000 and then starting other funds for diversification. This should keep fees under $10 per year for the first couple years (you should need no more than a couple different funds).
  2. There are a couple decent index funds and other funds with low expense ratios. I’d prefer there to be more and cheaper index funds, but there are some. I like the International Equity Index Fund (PIEQX) with an expense ratio of 0.50%, the US Total Equity Index Fund (POMIX) with expenses of 0.40%, and I like a little less the target date funds (such as the 2055 fund, TRRNX, with expenses at 0.74%).
  3. Roth 401(k) option. For most people, Roth IRAs and Roth 401(k)s are better than the normal options. With a Roth option, you invest post-tax money. You get no deduction, but your retirement money (including the money you make in it) is never ever taxed again.
  4. 401(k)s allow for greater contributions as a percentage of income (particularly for low-income people) and greater total contributions for high earners than SEP IRAs or SIMPLE IRAs.

For those making a lot of money, it may make since to choose another 401(k) provider that charges higher fees but offers funds with lower expense ratios. While Fidelity offers a good solo 401(k) plan, it currently does not offer the Roth option. If Fidelity does offer that, it would probably be a better choice.

The one problem with 401(k)s is that they were designed for bigger businesses. The paperwork is a hassle but the increased contribution limits relative to SIMPLE and SEP IRAs is worth the effort. Remember to also contribute the maximum to a Roth IRA as well as to a 401(k).

Disclosure: I use T. Rowe Price for my solo 401(k) for my freelance writing business.

Should you buy individual stocks?

Before you go out and start buying stocks on your own, let me say that not everyone should invest on their own. Only those that Ben Graham called ‘enterprising investors’ should do this. Those that fit in the category of ‘defensive investors’ should only own broad-based index funds or ETFs.

If you are not willing to spend at least five hours per week on your investments, then you are a defensive investor. If the thought of losing large amounts of money scares you greatly, then you are a defensive investor. If you do not know anything about investing and do not want to take the time to learn, then you are a defensive investor. If the thought of making a fortune in the stock market makes you giddy, then your emotions will interfere with your intellect, and you would be better off as a defensive investor.

There is nothing wrong with being a defensive investor. There is more to life than investing. If you fit the profile of a defensive investor, then stick your money in a low-cost stock index fund (such as those run by Vanguard). I particularly like Vanguard’s target-date funds. You will not beat the market, but you will do about as well as the market as a whole, and you will have plenty of time to enjoy life.

Now, for those of you who fancy yourselves as enterprising investors. Picking stocks is not for the faint-hearted. There will be times when your stocks will decrease in value. You will need the courage to either hang on to them (if they are still good companies) or sell them (if they are becoming bad companies). If you do wish to continue, though, you should know that value investing is the most tried and true approach to investing in the stock market.

Ben Graham averaged over 20% returns per year for two decades. Besides his two partners, there were four employees of Graham-Newman Investing. Three of those four later made incredible money investing on their own. Walter Schloss was one; he averaged a 16% annual return over 25 years, doubling the average yearly return of the S&P 500 of 8%. Tom Knapp was another; his investment firm doubled the average yearly return of the S&P over 15 years (16% per year). The third was Warren Buffett. Over the last 28 years, his Berkshire Hathaway has averaged over 20% annual returns.

So, if you choose to be an enterprising investor, know that in investing based only on value and price, you will do well. You may not always beat the stock market averages, but if you work hard and are willing to learn from your mistakes, you just might be the next great value investor.

Before you begin buying stocks, think about how much money you have to invest. If you do not have more than $10,000 to invest, then take that money and put it in a low-cost index fund (again, I like Vanguard). If you have less than $10,000, you will not be able to achieve adequate diversification, and the ups and downs of your portfolio will be harder for you to take.

Once you have your $10,000 in the mutual fund, keep it there. As you get more money, you can take that money and buy individual stocks. That way, if you do some really stupid things and lose a lot of money on your individual stocks, you will still have money sitting in your mutual fund. This will also help you sleep at night.

Now, as to buying individual stocks, the key is diversification. There are three kinds of diversification. First, diversify in time. If you buy all your stocks at one time, events that harm the market in general could cause your investments harm. Since you know value investing works in the long run, buying stocks for the rest of your life will give you this diversification. The next kind of diversification is industry diversification. If you were in tech stocks in 2000 you know what I mean. Also, certain industries can do badly for long periods (like the airline industry).

The last kind of diversification is diversification as to country. It is hard to buy many foreign stocks, so I recommend putting some money in an international index fund or two (Vanguard has those as well).

Disclosure: I invest in Vanguard ETFs. I have no connection to the company. My disclosure policy wears a wombat on its head to keep warm.

What is a Company Worth?

I have established my strategy of buying the stock of good companies that for some reason are undervalued by the stock market. Now comes putting that simple strategy into action. The details are a bit harder than the basic strategy.
Returning to my milk analogy, milk has only one way in which it has value–that is, its ‘asset’ of milky goodness. Thus, we can either consume it or sell it off to someone else who would appreciate its milky goodness. Companies are different, though. They too have their asset value, which is the value of all the inventory, machinery, property, patents and other things that could be sold if we shut the company down. In addition to that, they also have earnings power, or the ability to make a profit. So in evaluating companies, we can judge them to be a good or bad value based either on their actual assets or on their future earnings power. We will start with the evaluation of value based on assets.

The father of value investing, Benjamin Graham, wrote a book that all of you should read, The Intelligent Investor. In his book, Graham asserted that a company would be a good buy if it were valued at less than about 2/3 of its total net tangible asset value. Graham excluded patents and other hard to value ‘assets’ from his calculations, so he only counted the ‘hard’ (tangible) assets. To get the net tangible asset value we take the value of all tangible assets and subtract any debt the company owes. This gives us the company’s net worth, which is just like the net worth of a person.

Why isn’t a company selling at 90% of its net tangible asset value a good deal? The reason is that Graham insisted upon having a margin of safety. In other words, some of those ‘assets’ may be overvalued. To avoid situations where the assets are worth little, we want to only buy companies that are selling for far less than we think they are worth.

You may think that this is unlikely, and recently, this has not been very common. However, during bear markets, this happens a lot. The Washington Post Co. was valued by the stock market at only about $80 million in 1973. However, its assets, including television stations, the magazine Newsweek, and the newspaper, could have easily been sold off for hundreds of millions of dollars.

At least one value investor realized the true value of the company, and he bought many shares of Washington Post. His name? Warren Buffet, the most successful investor in the world. Now the Washington Post Co. is valued at over $8 billion in the stock market, giving Buffett a return of over 100x his original investment.

What if the market never realizes the value of the assets of a company, and the company never sells them off? This is not a likely situation. Nowadays, there are many private equity firms that look for such easy money. These companies will buy a majority or large minority stake in a company and then either find better management or sell off the company’s assets for a profit.

In the current market, however, fairly few companies are valued significantly below their assets. That leads us to the second way of valuing companies, which is based on their earnings power. This is much the same way you would evaluate the relative value of a bond or a savings account.

With a bond or savings account, you receive an interest payment that is your payment for loaning your money. With stock ownership, you have a claim to a portion of the profits of the company. If a company has 10 million shares outstanding and makes a profit of $20 million, then the profit per share (also called the earnings per share or EPS) is $2.
So if you own 100 shares, you have ‘claim’ to $200 in profits. Now, companies almost never pay out all their earnings to their stockholders. Usually they will pay a portion of their earnings to shareholders as dividends. Some don’t pay dividends at all. The profits not paid out as dividends are reinvested in the company.

Presumably, those reinvested earnings benefit the stockholders too, in the sense that they will help grow the company and increase the earnings power of the company. The future value of the company will be greater because of the increased future earnings and the stockholder will be compensated with increased market value of his shares of stock.
Thus, we will treat all of the company’s earnings, even those that are reinvested in the company, as income to us, the shareholders. So, to determine the fair price of a stock, we compare its price to the earnings per share (EPS). We divide the price by EPS to get the Price to Earnings ratio or P/E ratio.

The higher a P/E ratio is, the less current earnings the company has for each dollar we invest. So if we were to invest in a company with a P/E of 20, for each dollar we spend to buy stock, we will only get half as much earnings as if the stock had a P/E of 10. Therefore, we want to find and buy portions of companies that have lower P/E ratios. But how high is too high? Here I will give a brief explanation, but see my post on P/E ratios for a more in-depth explanation.

When you are investing in stocks, you value the stocks based on the future income of the company. To find a fair value for those stocks, though, you need to compare that future income to the future income you could get by just sticking the money in a safe U.S. government bond. Since stocks are riskier than government bonds, the earnings yield on the stock (E/P, the inverse of the P/E ratio) should be higher than the yield on a medium term government bond (let’s say with a 5 year maturity).

Medium-term government bonds are yielding about 5% right now, so if we had a perfectly safe stock investment, we would not mind getting a 5% earnings yield (which translates into a P/E of 20). However, stocks are less safe than corporate bonds, which are less safe than government bonds. Therefore, we want to be paid a risk premium for owning stocks. A 2% risk premium is enough for us to consider a stock a good value.

Therefore, stocks that are neither increasing nor decreasing their profits should be a fair value at around a P/E of 14 (and an E/P of 7%). However, because we are value investors, we do not want to pay fair value. Rather, we want to pay below fair value. Therefore, it is a good rule of thumb to avoid companies without significant earnings growth with a P/E over 10. For companies with significant earnings growth, a P/E below 20 should be fine. But, as with buying anything, the cheaper we can buy a good product (in this case, a company), the better.

When we buy something at a price less than it is worth, we give ourselves a margin of safety. That way, we are protected from losing a lot of money should we err in our estimation of the quality of a company. If we were to invest in companies that seemed to be selling at a fair value, we would be at greater risk of losing money if our estimation of the company’s value turned out to be wrong.

Disclosure: I hold no shares of any companies mentioned herein. See the disclosure policy.

Price does not matter

What if I told you that price does not matter? Would you laugh at me? I do believe that, however. Price does not matter–what matters is value. Whether I pay $2 for cereal or $10 matters little–what matters is the value. If the $2 is for 2 cups of Cheerios, while the $10 is for 10 boxes of Cheerios, I would say that the $10 represents a better value. Yet there are plenty of people who will automatically go for the cheaper item, without considering its value.

The same thing happens in investing and in the stock market in particular. People make a big deal out of the price of stocks or stock indexes. Ooh, “the Dow is at a new high, we should buy now”. Or “ooh, the Dow has risen too much–it is bound to fall!” This is stupid. What matters is the value. Sure, stocks have risen a lot recently (before the recent fall), but much of that is rightly due to solid earnings reports. As always, what matters is the cost of a company relative to its future cash flows. To the extent that its future improves, its price should increase; to the extent that its future dims, its price should decrease. Also, the price of the stock itself does not matter–a company could have few shares priced high (such as Berkshire Hathaway) or many shares priced low (such as Nortel), but that does not affect the value.

So buy when you get a good value for your money and sell when your holdings are overpriced. That is the key to winning in any type of investing.

Mark Hulbert has written about how fast price rises do not mean a stock index will likely fall.

Disclosure: I like Cheerios, though I have been known to eat the impostor Joe’s O’s (from Trader Joes). I own shares of BRK-B. See my disclosure policy, which currently sells for $13.89.

Taking my own advice on ETFs & ETF Tax Avoidance Tricks

Do not accuse me of being a hypocrite. Since my article, An ETF Asset Allocation Plan for Everyone, I have bought a large number of shares in DEM, VTV, VWO, and EFV. And I will hold those funds in those ETFs ad infinitum. One thing to keep in mind regarding asset allocation with passive funds–make sure that you take into account any active funds you have or any individual stocks when deciding how to allocate. I personally own a large number of US small-cap and micro-cap value companies (examples include TSRI, MSI, SCVL, and LAD), so I do not need to duplicate that with ETFs. On the other hand, I own only one foreign stock, so I needed to drastically increase my portfolio weighting to foreign and emerging markets.

One advantage of using ETFs is that they are tax efficient. Also, if an ETF shows a loss towards the end of the year, an investor can always sell the ETF and buy back a similar one (although check with your CPA on this). That way an investor can reduce his or her taxes while avoiding the wash-sale rule. Of course, this should not be done unless the tax savings would be large, because commissions and bid/ask spreads can eat up gains from this strategy.

Disclosure: I am long all the stocks and ETFs mentioned above. I am not licensed to give tax advice: please consult with your tax attorney or CPA regarding legal tax avoidance strategies. I have a disclosure policy that is based in the tax haven of the Jersey Islands. It is also Amish, but only so that it can legally avoid paying social security taxes.

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.