Category: Stocks

Why I Investigate Penny Stocks

Some may wonder why I investigate and write about penny stocks so aggressively. I have been accused of pursuing this line of research simply to make myself look good so that I can feel important. I do not think that is the case because, as those who know me will attest, I always feel important. In fact, I have occasionally been accused of being a bit of an egotist.

Others may believe that my sole purpose in investigating over-the-counter stocks is to enrich myself for short selling. I do not deny that I make money by selling short OTC stocks. I do not, however, write about all the stocks that short, nor do I short all the stocks about which I write. I started writing about OTC stocks before I even knew that it was possible to short sell them. And I am not convinced that my commentary on the stocks about which I write has any effect on the market price.

The main reason I like to write about penny stocks is because I feel that I can offer something (independent, if not unbiased research) on companies for which there is little information available. Perhaps in writing about such companies I can persuade a few people to avoid speculating in such companies and to choose more appropriate and more profitable investments. It was only with substantial research and a bit of luck that I myself avoided losing a lot of money in a pink sheet stock 2.5 years ago, when I first started investing in individual stocks. If I had not chanced upon some pretty amazing negative information from the CEO’s past business deals, I could easily have lost 99% of the money I would have put into that company.

If you invest in anything, you should always do your due diligence. Do not believe that just because a company is publicly traded (or even because it is listed on the stock exchange) that it is a worthy investment or even a legitimate investment. If I had relied upon the SEC to protect me when I was considering investing in a penny stock, I would have watched 75% of my money vanish in a fraud and would not feel vindicated when four months later the SEC sued the company (US Windfarming, USWF.pk) and its CEO.

Disclosure: I have no position in any stock mentioned. See my disclosure policy.

Continental Fuels: The Most Overvalued Penny Stock I’ve Ever Seen

It is Not Fraud if There are No Lies

Dictionary.com defines fraud as “deceit, trickery, sharp practice, or breach of confidence, perpetrated for profit or to gain some unfair or dishonest advantage.” It has been more succinctly defined as “implicit theft” by Murray Rothbard, among others. The key to fraud is that deception leads to the deceiver gaining economically in a direct transaction with the deceived. Many unlisted penny stocks toe the line on fraud. Management, getting paid large salaries (and tons of stock options) despite crummy financial performance, hypes up the stock, always offering overoptimistic predictions of future performance. Oftentimes management pays ‘independent’ analysts large sums to cover the company. This leads to gullible investors paying out large sums for the stock. When management’s glowing predictions are later belied by stark reality, the investors lose their socks and the executives live happily ever after.

What would happen if management of a worthless penny stock were completely honest about how worthless the company truly was? In that case, there would be no fraud, but anyone buying the stock would be an utter fool. I found a company like this: Continental Fuels (OTC BB: CFUL.ob, $1.70). As of August 13, the company had 571.6 million fully diluted shares outstanding. That gives the company a market cap of $972 million. What do investors get for that $972 million? Not much. They get total assets of $3.8 million, a stockholder’s deficit of $1.1 million, and for the most recent quarter, sales of $5.7 million and an operating loss of $560k. (See the 10Q for the quarter ended June 30, 2007 for details.)

First, I should detail the shares outstanding–this is a tricky computation giving all that the company has done with its shares. To save space I will only discuss the origins of 500 million (88%) of the shares. There is convertible preferred voting stock that is convertible into 500 million shares. This was issued to UNIVERSAL PROPERTY DEVELOPMENT AND ACQUISITION CORPORATION (OTC BB: UPDA.ob) in payment for some assets. From the 10Q:

On April 23, 2007, the Company closed a business combination transaction pursuant to a Stock Purchase Agreement dated April 20, 2007, by and among the Company and Universal Property Development and Acquisition Corporation (“UPDA”), a publicly held Nevada corporation (the “SPA”). Pursuant to the SPA, the Company acquired one hundred percent (100%) of the capital stock of US Petroleum Depot, Inc. and Continental Trading Enterprizes, Inc. f/k/a UPDA Texas Trading (the “Subsidiaries”), two private Nevada Corporations and wholly-owned subsidiaries of UPDA. The consideration paid by the Company for the Subsidiaries consisted of $2,500,000 in cash, payable within 30 days of the Effective Date, and 50,000 shares of our Series A Convertible Preferred Stock valued at $5,000,000 (the “Preferred Stock”). The Preferred Stock is currently convertible into 500,000,000 shares of our common stock and UPDA has the right to vote the shares of Preferred Stock on an “as converted” basis in any matters for which the holders of our common stock are entitled to vote.

Valuation

Now comes the fun part. Continental Fuels, its 88% owner UPDA, and major shareholders of the two companies have repeatedly said that the stock is not worth 1% of its current market value. Following are the statements and transactions that show this:

1. The acquisition of a majority of CFUL stock by UPDA. The preferred stock (representing at that time 77% of the total stock of Continental Fuels) was in payment of a debt of $5 million incurred when CFUL bought some assets from UPDA. By this metric, Continental Fuels is rightly worth $6.5 million. This puts the value of its stock at $0.011 per share.

From a recent 8k filing regarding the merger: “The consideration received by us from CFI for the Subsidiary Shares consisted of $2,500,000 in cash, payable within 30 days of the Effective Date, and 50,000 shares of CFI’s Series A Convertible Preferred Stock valued at $5,000,000 (the “Preferred Stock”). The Preferred Stock is currently convertible into 500,000,000 shares of CFI common stock and the Registrant has the right to vote the shares of Preferred Stock on an “as converted” basis in any matters for which the holders of CFI’s common stock are entitled to vote. Based on the number of shares of CFI common stock currently outstanding, as of the Effective Date the Registrant controlled seventy-seven percent (77%) of the voting stock of CFI.”

2. A large shareholder recently sold 100 million shares of CFUL to UPDA in exchange for 10,000 shares of UPDA Series preferred stock. That preferred stock is convertible into 200 million shares of UPDA stock, which at a recent market price of $.042 per share values the preferred stock at $8.4 million. Why would someone sell stock valued at $170 million for stock in a different company, worth $8.4 million? The simple reason is that CFUL is way overvalued, and Ms. Sandhu was rightly afraid that by the time she could sell her stock (it was restricted until February 2008) the stock would have tanked. If Ms. Sandhu gained nothing from this transaction, then this stock swap values CFUL at $48 million and each share at $.084.

From UPDA’s most recent 10Q: “On August 13, 2007, Ms. Karen Sandhu sold 100,000,000 shares out of 141,000,000 shares of Continental’s outstanding $.001 par value common stock held by her to UPDA for 10,000 shares of UPDA Series B Preferred Stock. UPDA made the purchase on behalf of Continental as treasury stock and was retired on the same day.”

also from the 10Q: “In July of 2007, certain holders of Series B preferred shares converted 3,520 Series B preferred shares into 70,400,000 common shares.”

3. Those shares (plus 40 million others) of CFUL that were sold by Karen Sandhu were acquired by her in a private placement in exchange for $200,000 on February 6, 2007.

From CFUL’s 10Q: “On February 6, 2007, Company completed the sale of 141,000,000 restricted shares of its post-2007 Reverse Split common stock to Ms. Karen Sandhu for $200,000 cash. Company used the proceeds from this offering to pay outstanding debts and liabilities.”

4. Continental’s 88% owner, UPDA, has a market cap of $33 million. If Continental Fuels was worth its current implied market cap, UPDA would be not only greatly undervalued but it would be the best investment of all time.

5. On August 17, 2007, Continental Fuels issued 12.6 million restricted shares to pay off a $100,000 debt, valuing those shares at $0.008 per share. Assuming a modest discount (20%) for the restricted shares, the company so much as said that it is worth $0.01 per share or $5.7 million.

From the 8k: “On August 17, 2007, the board of directors of the Registrant approved the conversion of an aggregate of one hundred thousand dollars ($100,000) of outstanding notes of the Registrant (the “Notes”) into shares of the Registrant’s common stock. Based upon the current assets and capitalization of the Registrant, the conversion price of the shares of common stock to be issued upon conversion of the Notes was valued at $0.008 per share by the Registrant’s board of directors. The conversion of the Notes to shares of the Registrant’s common stock is at the discretion of the Note holders. However, convertibility of the Notes is subject to certain limitations based on the number of shares of the Registrant’s common stock then outstanding. Upon the eventual full conversion of the Notes to common shares, the approved conversion of the Notes to common stock will result in the issuance by the Registrant of an aggregate of 12,615,326 restricted shares of its common stock.”

6. A similar transaction to #5 above took place back in April, valuing the company’s stock at $0.012 per share.

from the 8k dated 23 April 2007: “On April 25, 2007, the board of directors of the Registrant approved the conversion of an aggregate of one hundred thousand dollars ($100,000) of outstanding notes of the Registrant (the “Notes”) into shares of the Registrant’s common stock. Based upon the current assets and capitalization of the Registrant, the conversion price of the shares of common stock to be issued upon conversion of the Notes was valued at $0.012 per share by the Registrant’s board of directors. The conversion of the Notes to shares of the Registrant’s common stock is at the discretion of the Note holders. The eventual full conversion of the $100,000 in Notes to common stock will result in the issuance of an aggregate of 8,326,115 restricted shares of our common stock.”

When Will Sanity Return?

I have proven my case that Continental Fuels is incredibly overvalued. When should its valuation return to a realistic level? I am not sure, for it is never possible to predict stock price changes. However, it is a worthwhile exercise to examine a couple factors that will influence the price of the company’s stock.

1. UPDA has begun to convert its preferred shares to common shares of Continental Fuels. Consequently, it has decided to spinoff a number of these shares to its shareholders. A total of 787 million shares were outstanding as of the record date, and one share of CFUL will be distributed for each 50 shares of UPDA. This means that 16.7 million more shares of CFUL will hit the market, although not until August 1, 2008, because these shares are restricted from trading for one year. With only about 2 million shares trading currently (according to Yahoo Finance and verified by me from the company’s SEC filings), selling of a large chunk of those 16 million shares next August as the shares lose their restrictions will quickly depress the price.

From the press release on CFUL’s website: “According to the Board Resolution, one share of CFUL common stock will be distributed to UPDA’s common stockholders for every 50 shares of UPDA common stock held. Every UPDA common stockholder will receive at least one CFUL share in this distribution and fractional shares will be rounded up to the nearest whole number. The date of the distribution will be August 1, 2007 to UPDA’s common stockholders of record on July 11, 2007. Although the distributed shares will be restricted from transfer for one year pursuant to SEC Rule 144, UPDA has obtained an opinion that the shares will have no tax consequence to the recipient until they are sold or transferred.”

2. Every month since April the number of shares of CFUL sold short has increased dramatically. Currently (as of August 2007), 417,000 shares are sold short (see here and search for CFUL for updated numbers). Increased selling is inevitable as more short sellers (and stockholders) become aware of the company’s extreme overvaluation.

Conclusions

The absurd valuation of Continental Fuels despite highlights several problems with capital markets in the United States. In a future post I will address these problems and ways that financial market regulation can change this.

Disclosure: I am short Continental Fuels (OTC BB: CFUL.ob). I do not recommend investing in unlisted stocks or in shorting stocks, as both are very risky. Combining the two is perhaps even more risky and should be left to the brave, the foolhardy, and the professionals. I refuse to disclose to which of these categories I belong. See my disclosure policy.

I love revealing the ignorance of my critics

If you are bored, see SeekingAlpha and the comments on my post about Octillion (scroll to the bottom).

To my critics: if you are going to criticize me, at least try having your facts right. The one universal I have found is that people who ‘invest’ in the penny stocks I disparage tend not to think very deeply before lobbing crazy accusations. And they should be ashamed of themselves, because not only do they lose their own money in bad investments, they give money to fraudsters, fools, and useless dreamers, which means there is less money for legitimate and useful businesses.

Disclosure:  I hate Octillion. I would short it if I could. But I can’t. So I am neither long nor short. My disclosure policy also hates Octillion and thinks it is worthless.

Press Release: Hedge Fund Gets Two Spots on Regent Communications Board

CINCINNATI, Sept. 14 /PRNewswire-FirstCall/ — Regent Communications, Inc. (Nasdaq: RGCI – News) today announced the appointment of John Ahn and Joseph Patrick Hannan to the Company’s Board of Directors. Messrs. Ahn and Hannan are filling two newly created seats, which increase the Company’s Board from five to seven members, including six independent members. Mr. Ahn will serve on the Board’s Nominating and Corporate Governance Committee and Mr. Hannan will serve on the Board’s Audit and Compensation Committees.

The Company also announced today that it has entered into an agreement with Riley Investment Management LLC and SMH Capital Inc. in which all pending litigation has been dismissed.

I previously mentioned Regent Communications [[rgci]] and its lawsuit against hedge fund Riley Investment Management.

Congratulations to Riley and to John Ahn. They can now get down to the business of squeezing value out of Regent.

Disclosure: I hold RGCI stock. My disclosure policy makes for good reading.

Fun with Terax Oil & Gas

Maybe there is something wrong with me, but I find joy in reading the SEC litigation updates. I subscribe via RSS. This is how I learned about Terax Oil & Gas (OTC BB: TEXG.ob). The company as well as its executives have been sued by the SEC, and the company’s assets have been frozen.

Trading in the shares of Terax Oil and Gas has been suspended by the SEC from September 12 until September 25.

Of course, this is small consolation for “investors” who bought shares of the stock at $20 a year ago. They last traded at $2.65 and they are probably worth absolutely nothing now. It just goes to show that caveat emptor definitely still applies when investing in unlisted over-the-counter stocks.

Disclosure: I have no pecuniary interest in Terax. My disclosure policy makes for good reading and is best accompanied by a glass of Muscat.

Kiplinger profiles my favorite overhyped penny stocks

In a recent article on hyped-up penny stocks, Kiplinger wrote about three stocks, two of which I have previously profiled in this blog, including SunCal Energy (OTCBB: SCEY). I warned investors about SunCal fully two months ago, and my warning was timely–since then, the stock has fallen from around $3.40 per share to about $1.20 per share.

Kiplinger writers should start reading my blog–if they had, they could have found these companies (and many more similar companies) much earlier, making their lives easier and informing their readers sooner.

Disclosure: I have no position in SCEY, although I did short it a month ago.

Are stock buybacks good?

I will tell you the answer first, and this is an answer that I will use a lot. It depends. Stock buy-backs can be good or bad, depending on whether the stock is over- or under-valued. It’s that simple. Now let’s go over the details.
When a company makes a profit, it can do one of five things with the money:
1. Pay a dividend
2. Buy back shares of stock
3. Re-invest money in the company so that it can expand
4. Buy other companies to expand
5. Pay obscene amounts of money to management
In the future, I will deal with expansion and M&A (mergers and acquisitions). There are pitfalls to both paths, but both can also be good. Needless to say, I do not approve of Option 5. So let’s talk about stock buy-backs and dividends.

The traditional course for a company with little room for expansion and no opportunities for acquiring other companies is to pay out most of earnings in dividends. This is what utility companies do (see Progress Energy [[PGN]], for example). There is one problem with this, though. The company’s earnings, which have already been taxed as corporate earnings, are taxed again as dividend income to shareholders (now at a 15% rate). Much of that money therefore benefits Uncle Sam rather than the shareholders. Why not find a way to benefit the shareholders without giving the government a cut?

The way to do this is for the company to buy back shares of its own stock. Let’s say our company, Acme Brick, earned $1 million in 2004. They are in a mature industry and have little room to grow. Therefore, they decide to buy back shares of their stock. Let’s say there are one million shares outstanding, each selling at $10. The company is thus valued at $10 million. With its $1 million in profit, Acme buys back 100,000 shares, bringing the total number of shares down to 900,000. Each share now has 10% more value, since it represents 10% more of the company.

Rather than being paid in cash, the shareholders have been paid in ownership. They get no extra cash, but they now own a 10% larger stake in the company. The price of the shares should not actually change, since the 10% larger stake in the company is offset by the company now having $1 million less in cash, and thus being worth 10% less.

If the money had instead been paid out as a dividend, the shareholders would have received a 10% dividend in cash, but would have been taxed on that dividend, so they would only receive 85¢ on the dollar due to taxes. Again, because the company, after paying the dividend (it is now ex-dividend), no longer has $1 million in cash, it’s value will fall by that amount. The company will now be worth $9 million, with shares worth $9. Like with a stock buyback, there is no net gain or loss to the shareholders (except for the taxes on the dividends). (See box on the previous page for a longer explanation.)

Note that with small dividends, the market price of the stock may not change after the dividend date. However, with larger dividends, the price will drop by an amount equal to the dividend. We have seen that, because of the tax benefits, stock buybacks are often better than dividends. There is just one last factor to consider: the price of the stock. If a company buys back shares for less than the intrinsic value of those shares, then the buyback really benefits shareholders. The company is buying something for less than it is worth, and that is always good.

If a company’s stock is overvalued, however, it should pay a dividend rather than buy back its shares. In buying its shares, it would be paying too much, and thus destroying the wealth of the shareholders. So, in the end, it comes down to whether the stock is a good value or not. If it is not a good value, then the company should not be buying it. Then again, neither should we.

Some companies that have recently announced large stock buybacks include Progressive [[pgr]], Home Depot [[hd]], and Wyndam [[wyn]].

Disclosure: I own no shares in any company discussed in this post. See the disclosure policy.

Dividends and stock buybacks do not affect a company’s value

When you own a share of stock, you own a portion of the company. Therefore, when a company makes an initial profit, and the money in their bank accounts increases, the company increases in value. As a shareholder, that money is already yours, even though it is not in your account.

Let’s look at it from the perspective of a person who owns 100% of his company, Acme Chemical. Let’s say they make a $5 million dollar profit this year. The owner can do whatever he wants with the money: re-invest the money in the company, pay himself a dividend, or buy another company. No matter what our owner does with the money next, he is already $5 million richer. The money has been his since the day it made its way into the company’s bank account. Therefore, the choice of what to do with that money should depend only on what the best investment is. If there are no good investments (either inside or outside the company), the owner can pay himself a nice dividend and take a vacation.

So think of Acme when you read about a dividend or a stock buyback. As a part-owner of a company, you were richer once the company made a profit. What the company should do with the money once it has it depends only on what the best investment is. If the company’s stock is cheap, a buyback is a good investment. If the company can expand profitably, then re-investment in the company is a good course. If competitors are for sale cheap, then an acquisition could be good. If nothing else seems good, smart management will pay a dividend.

If, however, a company spends its profits on buybacks of expensive stocks or overpriced acquisitions, then management is being stupid. That is a good time for smart value investors to sell.

Octillion (OTC:OCTL): Another Worthless Penny Stock

CEO Previously Fined by SEC

First, see David Phillips’ article on the company’s CEO, Harmel S. Rayat, and his other failed companies. Then take a look at the SEC’s website to find out that Octillion’s CEO and majority shareholder was previously fined $20k for stock promotion. Andrew Left of StockLemon wrote a nice (if dated) article on Rayat’s company Hepalife (OTC:HPLF) back in 2003. David Phillips (of The 10Q Detective) wrote a more recent attack on Hepalife.

The CEO is still working at a number of his other penny stock companies. Therefore, the company states (in the May prospectus):

“Our officers and directors are also officers, directors, and employees of other companies, and we may have to compete with the other companies for their time, attention and efforts; none of our officers and directors anticipate devoting more than approximately twenty-five (25%) percent of their time to our matters.”

That the officers of the company are not full time is not exactly a good sign!

Valuation

As of June 29, 2007, the company had 51.125 million shares outstanding. At a recent closing price of $4.40 per share, that gives the company a $225 million market cap. The company has a book value of just under $1 million.

Back in mid-April (see the 8k) the company sold shares for $0.50 apiece in a private offering (actually, three warrants were included with each share, so this overstates the price). Has the company really become 10 times more valuable in the last 5 months?

Misleading Statements

Octillion triumphantly announced that NREL research had validated its own methods. However, as of right now, Octillion has nothing more than an idea and some silicon dust. Sure, the method they claim to use seems to work well. But I doubt Octillion, with a minuscule R&D budget, will be the company to get this technology to work consistently in the lab, let alone in a commercialized product. Octillion has issued another press release to claim that other solar power breakthroughs validate its technology.

The company likes to mention that the solar technology is covered by 10 US patents. However, the company does not own those patents–they are owned by U of Illinois Urbana/Champaign. It is only working to commercialize the patents. Since the company first started working with UIUC in August 2006 until May 2007, it has paid a grand total of $89,000. Not exactly a world-class research budget (see page 4 of this prospectus for details). Over the last three months, the company spent $151k on investor relations and only $27k on R&D.

It turns out that Octillion does not even have an exclusive license to develop and market the technologies it is investigating:

From page 17 of the company’s recent 10Q: “During the term of our ISURF Agreement and the UIUC Sponsored Research Agreement, we will determine whether to acquire an exclusive license from, respectively, ISURF and UIUC to the technologies underlying the agreements. The final terms and conditions of any such licenses cannot now be determined. If the results of the continuing research projects do not warrant our exercise of our option to negotiate an exclusive license to market the ISURF Nerve Regeneration Technology or the UIUC Silicon Nanoparticle Energy Technology, we may need to abandon our business model, in which case our shares may have no value and you may lose your investment.”

So even if these technologies end up working, the universities could demand more money for the licensing rights than Octillion could pay, and another company with deeper pockets could end up buying the license.

Knowing When to Sell

The brothers of CEO Harmel S. Rayat sold a large chunk (1.7% of the company’s shares) of their stake in the company in May (or soon thereafter, as set forth in the May prospectus, page 46). Other selling shareholders included two corporations that were wholly-owned by employees of Octillion (6.5% of the total shares outstanding).

Is Smart Money Buying?

David Gelbaum (a noted philanthropist) recently filed a 13D, stating that he (actually, a trust benefiting him and his wife) owned 6.7% of the outstanding shares of Octillion. However, considering his large stake in another OTC stock that I consider to be greatly overvalued (Worldwide Water, WWAT.ob), I doubt his investing prowess.

Conclusion: Stay Away

I peg Octillion’s fair value at $1 million, its book value. More aggressive speculators might believe it to be worth 10x book. Cynics might value it at $0 considering its CEO’s track record. No matter what it is at least 25x overvalued. For more information, as always, check out the company’s SEC filings.

Disclosure: I am neither long nor short OCTL. See my disclosure policy.