The Best Source for Penny Stock Insight
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.
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.
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.
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.
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.
Youtube video. I discuss why you aren’t as smart as you may think you are and why beating the market is so hard.
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.]
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.
I’ll take a break from disparaging penny stocks and fraud to discuss some hyped up claims of certain investment services.
The first ‘victim’ (I put that in quotes because everyone listed deserves to be excoriated) is Doug Casey (or Dave Forest, who is listed as the managing editor of the Casey Energy Speculator). This advertisement I received in the mail receives my ‘duh’ award. Is it not amazing that some of his picks have been up 570% (Cameco), 1500% (International Uranium), or 1000% (Strathmore Resources)? It would be, until we realize that the newsletter in question specializes in energy. Even a chimpanzee specializing in energy stocks, picking them randomly, could have easily compiled a similar short list of stocks with great returns, simply because we have been in an energy bull market these past few years.
Some might argue that point, saying that at least they knew to invest in energy. That is not the case–the newsletter has been around for awhile, so that is simply their specialty. But what if they predicted this energy bull market back in the late 1990s? Since they are specialized, they have to believe that their specialty will do well. In other words, no specialized newsletter can succeed if the author does not believe that his area will do well. Therefore, specialty newsletters, whether they be in technology or energy, will attract perma-bulls. Those that become bearish will leave the specialty or the field.
So do I think Dave Forest is an idiot? No. He may be brilliant. I simply do not know. In fact, if one had invested only in energy for the past 20 years, one would have done very well. That being said, a specialist in energy is in no place to say whether energy is a better investment now then real estate or chemicals. His expertise in one area will prevent him from impartially considering which industries will do better or worse than his own specialty. So if you do subscribe to a specialized investment newsletter or service, be wary of any claims about anything but that newsletter’s specialty. Also, make sure to diversify into other industries as well.
Okay, so Doug Casey is not exactly a charlatan. At worst, his newsletter was guilty of exaggerated advertising claims. Let’s move onward and upward to criticize worse investment advice. This time, let’s play with options.
If you do not know what an option is, then let me first tell you: do not use them. That being said, if you wish to learn more, then visit Investopedia’s article on options.
Now before I start with my rant, I will regal you with my analogical abilities. Let us say that you and I have a bet on who will win the Superbowl next year. I bet on the Chicago Bears; you bet on everyone else. Because the odds of some team other than the bears winning are so good, I will get a large payout should the Bears win (say, $100). However, should any other team win, you get a small payout (say, $1). Now, let us suppose that I am really sure the Bears will win. Why not increase my bet by 10 times? Then if they win I’ll make ten times as much, and if they lose I lose only a little? That is how leverage works–it does not change the odds of winning or losing, but increases the possible losses and gains.
In the above analogy, I am like a buyer of an option, whereas you are like the seller (writer). The buyer pays a small amount of money, has a relatively low chance of winning, but will generally make much money if he is right. The seller is almost certain of being paid a small amount of money, but has the risk of losing a whole lot more.
When looking at actual stock options, it is important to realize that the sellers are mostly divided into two types: one type is the arbitrage seller or market maker, which is only interested in making a small, guaranteed profit (basically, their profit amounts to a fee for the service of writing the option the buyer wants). These sellers will always take the opposite side of their bet in the stock market, so they do not have any risk. If this is above you, do not worry–the important thing to realize is that no matter what, they make a small profit. The other types of options sellers are in it to profit from superior knowledge. They are usually quite smart and experienced. In fact, they have to be, since their risk is huge if they miscalculate. For example, Richard Russell has a side business selling options.
The vast majority of options that are bought expire worthless. Keep that in mind as you read on about THE BULL MARKET THAT NEVER ENDS! That is what the advertisement for the Mt. Vernon Options Club screamed at me. Steve McDonald, I have to say, is either an idiot or a charlatan.
I will explain the common idiocy of covered calls a bit later, but first I have to take umbrage with his winning LEAP strategy with Chesapeake Energy (CHK). He recommended buying a $12.50 call option (option to buy) when the stock was below $10. Smart move. The next move was not so smart: he recommended selling the $15 call option. While this turned out okay, what this did was remove any possible gains should the stock continue to appreciate, while the downside risk was still present. What is even more amusing about this example is that for a heck of a lot less risk, an investor could have simply bought the CHK shares at $10 per share, and would now have a 300% profit!
Next up on my list of charlatans is Bernie Schaeffer, of Schaeffer Investment Research. Now, I have subscribed to his Options Advisor newsletter and found it to be okay–I did not lose much money. Of course, I did not pay for it–my brokerage gave me the subscription for free to try to increase my trading. (The long term record of the newsletter, according to Mark Hulbert, is horrid, though–an average annual loss of 4.7% per year for over 20 years, during the greatest bull market in history.) Besides a horrid track record, why do I suddenly call Bernie a charlatan? I do this simply because he leaves me no choice: his most recent actions have proven that he has no respect for his subscribers. He decided to offer a covered-call options newsletter for the low price of only $795 per year! What a great deal! So why do I not like covered calls?
A covered call is simply writing (selling) a call option when you own the underlying shares of stock. With a covered call, you benefit if the stock does nothing or goes up a little, and you lose when it goes down a bunch. Hmm, that sounds an awful lot like selling a put option! Wait, umm, yes–it is! A covered call is mathematically equivalent to selling a put. The only differences between the two are that with a covered call, you receive any dividends that the stock pays, and you pay twice as many commissions to your stock broker. Also, a put has more leverage. To be truly equivalent to writing a put, a covered call writer would have to have a lot of margin.
Would the dividends make the covered call strategy more effective than simply selling puts? Maybe if the stock pays a large dividend, but it turns out that stocks that pay large dividends are either not very volatile, reducing the payment you would receive for selling the call (such as utilities and REITs), or they are smaller or thinly traded, meaning that there is no market for the options. So that is not generally a good reason to use covered calls. The only good reason I can think of is in the case of large institutions that perhaps become short-term bearish on a stock, but cannot exit a large position in that stock without depressing its price. In that case, selling covered calls may make sense.
So why do so many advisors recommend covered calls? They do this simply because it is much easier to qualify (with a stock broker) to sell covered calls than to sell puts. In other words, they give this advice because there are plenty of fools who can take it. Shame on them.
Okay, now it is time for the worst investment advice of the day! I will now debunk the art (do not dare call it a science) of what I call squiggles, or chart analysis. At the very least I will debunk post-hoc model development and back-testing.
What is chart analysis? Simply put, it derives from the idea that everything that is known about a stock is evident in the price action of that stock. Therefore, certain types of price action (certain chart patterns) should predict certain near-term outcomes. At some level, this is quite logical. For example, as William O’Neil emphasizes with his CANSLIM stock trading method, big increases in the price of a stock are often caused by big money (institutional investors) buying that stock. Therefore, seeing a series of days in a short period of time during which the stock is up on very high volume would be a good indicator that a big mutual fund has started buying.
I have problems with technical analysis in general and charting specifically, because too often those who engage in it either do things wrong or they give themselves too much leeway, by saying “it may go up, but if this happens and it goes down, then it may go down some more,” or similar things. However, that is not the purpose of this article. The problems with charting I mention here are egregious and are not problems of the best technical analysts.
In the advertisement for The Options Optimizer, there are plenty of great examples of how much money could have been made using the system. There are pretty graphs of the prices of commodities and stocks with arrows saying “sell” right before a big price decrease or “buy” right before a big price increase. There are statistics of all the millions of dollars that you could have made by following this system on these occasions.
There is only one problem with this. Nobody made any profits using this system. Every single example is a hypothetical example of trades the system would have chosen. What’s wrong with this? In statistical terms, selection. It is incredibly easy to examine past results of any strategy, no matter how bad, and find some examples where the strategy worked. In fact, your strategy could be as simple as selling companies whose names begin with vowels on Mondays and buying them on Fridays while doing the opposite with companies whose names begin with consonants.
Amazingly, this strategy would work about half the time; the results in any given week will be randomly determined. When you later start your investment newsletter a year later, you can give hundreds of examples where your system worked beautifully. Just ‘forget’ to give any examples of when your system failed and you will be on the road to riches.
A second problem with many trading strategies that is also a problem with the Options Optimizer is that it suffers from over-optimization. Here is an example not from investing: let’s say I have an algorithm for predicting college grades from SAT scores. It is only correct about 60% of the time (which is nevertheless good). I want it to be better. So I use my sample of past students and I look at other factors. I throw in high-school grades, ethnicity, and a measure of the difficulty of their high-school curriculum. All these are logical predictors of college grades. However, I am still only correct 70% of the time. I look back through my data and find that when I factor in eye color, waist size, length of name, and number of vowels in the last name my predicative power increases to 95%.
The problem comes when I use this new algorithm on a new sample. I suddenly find that its predicative power has fallen below 50%. Where did I go wrong? Simply put, I optimized the algorithm for a specific group and I included many variables that most likely have no effect on college grades. This is called over-optimization. If you include enough variables, you can develop a system that is right 100% of the time for the sample from which it was developed. For all other samples (of students or periods of time in the stock market) the system will be very bad. Thus, any successful trading system should have as few variables as possible so that it can be effective with wildly different samples.
So what can you do to protect yourself from these problems? The simplest answer would be to stick to a simple, effective, proven investment strategy (such as value investing). If you wish to take large risks and probably lose money, then at least make sure that any ‘trading’ system you use has actually been used profitably by someone.
Disclosure: Net, I have made money buying and selling options. I do not subscribe to any of the services I mention above. I used to subscribe to Ricard Russell’s newsletter, and I enjoyed reading it, but I stopped because it was too expensive. I own CHK. I have a disclosure policy.
In this recent final judgment, issued yesterday (September 17, 2007), the SEC revealed what is wrong with its enforcement efforts against penny stock manipulators. There was no punitive fine; the accused were only required to give up their profits. This was despite the “egregious nature” of the offenses. If I were to steal $100 from my neighbor I would be ordered to pay restitution plus a fine (often larger than the restitution), and yet these people allegedly stole hundreds of thousands of dollars and they paid no penalty besides giving up their ill-gotten gains and promising not to do it again.
“The Court ordered Barnwell to disgorge $31,700 and prejudgment interest thereon. Casias was ordered to disgorge $334,097. Keener was ordered to disgorge $162,000 and was permanently barred him from acting as an officer or director of any publicly traded company. The Court did not order penalties.”
Disclosure: I believe that the SEC is incompetent. I have never committed fraud or any other securities violations.
