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.

Book Review: Essentials of Corporate Fraud

I have many great things to say about Tracy Coenen, who is a blogger, author, and above all, a forensic accountant. I love her blog and I find her to be witty and intelligent. As a short seller I am also something of a fraud connoisseur, so I appreciate what she does. I eagerly anticipated her first book, Essentials of Corporate Fraud. She was kind enough to let me review before it was published, for which I thank her.

Here is the synopsis of the book from the publisher:

The book guides executives, managers, attorneys, and auditors through the basics of corporate fraud. In order to effectively fight fraud, it is important to understand who commits fraud, why they do it, how they do it, and how it affects the company as a whole.

Essentials of Corporate Fraud is more than a primer on fraud detection and prevention. It is a real-world look at how fraud occurs from an expert who has investigated hundreds of internal frauds, including embezzlement, financial statement fraud, investment fraud, bribery, and corruption. Tracy’s broad experience ranging from law enforcement to traditional auditing and finally to forensic accounting and fraud investigations brings a unique perspective to this publication.

To describe my overall impression of the book I find that I must resort to analogies. The book is like Michael Jordan scoring 18 points or like me only making a 20% return on a stock I have sold short. It is good, and a worthy read, but it is not great. I had expected better. However, I did find the book to be a worthy primer on fraud. There are of course a couple reasons that the book did not live up to my expectations, neither really Tracy’s fault: the book appears to be geared towards management types and it is an introductory book.

While being president of a small company, I am decidedly not a management-type; in fact, I would say that my IQ is about 2 standard deviations higher than the IQ of most managers (or at least people who read management books). The other problem is that this book is an introductory book. To someone who deals with messing up financial statements on a weekly basis (as bookkeeper of my company) and analyzing them on a daily basis (as a short seller), I am already familiar with many ways to defraud.

Despite not being wowed by the book, I found it to be a solid introduction to fraud. It was easily readable, not repetitive (unlike most books geared towards management), and it got me thinking. This book made me reconsider certain ways that my small company operated. Since reading it I have made changes to reduce the risk of fraud. For a book such as this, the best compliment is to say that it was useful, and this book was a useful read for me.

While this book would be useful to many, it is decidedly not useful (nor does it pretend to be) to investors who only care about financial statement fraud. If you are a CPA, manager, or business owner who is not an experienced fraud fighter, this seems to be a good place to start, so you should buy the book.

Whether or not you buy the book I definitely suggest reading Tracy Coenen’s Fraud Files Blog.

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.

Joseph Piotroski and You

As I have mentioned in previous articles, there is much to be gained by quantifying fundamental information that we use in the analysis of companies. I have begun the long and painstaking work of deriving from theory a quantitative investment formula. However, I am no rare genius; others before me have thought of the same idea. One particular person came up with an investment formula that is quite successful. This is Joseph Piotroski and he is a professor at the University of Chicago. His paper, “Value Investing: The Use of Historical Financial Information to Separate Winners from Losers”, available as a PDF here, was published in 2000. In that paper, Piotroski showed that by using a set of nine different fundamental signals to screen among low P/B stocks, an investor could separate the winners from the losers. By buying only those stocks that had the highest scores, an investor could have outperformed the market by an average of 10% per year from 1976 to 1996.

Piotroski started by screening for the stocks with the lowest 20% P/B ratios that were non-negative. This limits the strategy to true value companies. After the price to book ratio, nine other pieces of information were used, as follows:

  1. positive earnings

  2. positive cash flow from operations

  3. increasing ROA

  4. increasing cash flow from operations

  5. decreasing long-term debt as a proportion of total assets

  6. increasing current ratio, indicating increasing ability to pay off short-term debts

  7. decreasing or stable number of shares outstanding

  8. increasing asset turnover ratio, indicating increasing sales as a proportion of total assets

  9. increasing gross margin

Each company is given either a one or a zero on each variable. The strategy calls for buying every company with the requisite low P/B ratio and a score of either eight or nine. As you can see by looking at table 3 in Piotroski’s paper, the composite score does a very good job in discriminating between the stocks that perform well and those that do not perform well. On average, those companies scoring either zero or one saw their stock rise by only about 8% annually. On the other hand, those companies with scores of either eight or nine saw their stocks rise by on average 32% per year. For comparison, over the study time period (1976 – 1996) the stock market as a whole gained about 20% annually.

These results are incredible, but Piotroski does a good job of making them more credible. A priori, it would be reasonable to believe that fundamental analysis would be most beneficial for those stocks that were not well followed (e.g., stocks with small market caps). That is exactly what Piotroski shows in table 4 in his paper. While the strategy does outperform the market for all sizes of companies, it is much more effective with small companies. As table 5 shows, companies with no analyst following and high rank scores outperform the market by 18% per year.

What is perhaps most exciting about this paper is that the strategy of using fundamental analysis to find the strongest value stocks works with many different measures of fundamental strength. As shown by table 8 in the paper, a measure of financial distress or decreasing earnings or decreasing profitability can also discriminate between better and worse investments among low P/B stocks.

I cannot say with surety why this strategy works (ie, why investors do not take this information into account already). However, I think that the reason does not matter. Consider this analogy: you are the manager of a professional baseball team. Your goal is to find and hire the best baseball players you can for the least amount of money. You scout out all the lowest earning free agents in professional baseball. You then hire four or five of the most talented of those. In the long-run, you’ll be able to build a fairly solid baseball team for relatively little money. Assuming that you have a good eye for talent, you’ll be able to pick up many players for much less than they are worth. Why are they available for so little? It doesn’t really matter to you. Perhaps certain among them have been known to have a temper, perhaps others are perceived in the league as being injury prone and you judge that perception to be wrong. Perhaps other teams just overlooked certain players. It doesn’t matter much to you as long as you can get good players without paying too much.

It is much the same with finding value stocks: maybe some good companies are in boring industries, maybe they have suffered from some bad publicity, or maybe they are in a difficult industry. As long as you look for the best of the cheap stocks you’ll likely do well. Piotroski’s strategy ensures that this is what you are doing, by using quantitative variables such as profitability, asset turnover, cash flow from operations, and other variables that are correlated with future profitability and future earnings.

This is probably a good point to remind you of the unpredictability of future earnings. David Dreman as well as others have shown repeatedly that it is very hard to predict future earnings. I have previously mentioned the dangers of regression to the mean in trying to buy stocks based on projections of future growth that are unreliable. So, in buying cheap stocks (stocks with low price to book ratios) we ensure that we are not paying too much for growth that may never occur. Also importantly, we reduce our risk by buying stocks with improving fundamentals. As Piotroski points out, low P/B stocks with high rankings are less likely to go bankrupt or to fall drastically in price than are those with low rankings.

In a world where mutual fund managers only rarely can beat the market by one or two percentage points over 10 or 15 years, such performance is astounding. However, one problem with this or with any similar research is that these returns were not actually obtained. Anytime an investment strategy is tested on past data, there is the risk of optimizing the strategy for that past data and by doing so changing the strategy in such a way that it will be worthless in the future. An example is certainly an order: let’s say I have developed a technical trading system that simply buys stocks that are at their 52-week lows. I test this system over market data from the past 10 years and I find that the system leads to an annualized 5% return. This is not good, so I try to improve the system. I add information on stock’s P/E ratios, their market cap, and analyst ratings for those stocks. I retest the system and find that over the past 10 years it would have given me an annual return of 10%. That is better but still not great. So I try to improve the system even more. At this point, I have run out of ideas so I try plugging in random things to see if they improve the system. I find that only buying on certain days of the week and selling on other days improves the system. Also, I find that buying stocks only after a Chicago sports team has won a game almost doubles returns.

After all this work, my system yields theoretical annual returns of 30%. Confident, I try out my system and lose half of my money in one year. What went wrong? By testing factors that are almost certainly of no relation to stock returns, I over-optimized the trading system. While the system worked well in the past, the system was developed for that past. There is thus no reason that it should work well in the future.

Therefore, one of the keys to developing a trading or investment system is to ensure that it is both relatively simple and that it is theoretically derived. If the system is derived from theory then it is not vulnerable to the problems of data mining. One way to ensure that a strategy has not been over optimized is to test it on data that was not used to form the strategy. This has been done with Piotroski’s strategy and the results are impressive. Paul Sturm of SmartMoney.com wrote about the strategy three times in 2001, 2002, and 2004. Over that period of time, the stocks he chose using Piotroski’s strategy rose 50%, whereas the S&P 500 lost over 10%.

Another concern in developing a quantitative investment strategy is that it should be robust. A robust system will tend to work even if you use unreliable data or if circumstances change. An example of a non-robust system would be DCF analysis. In DCF analysis, if your estimate of future growth is even slightly off your estimate of a company’s true value will be way off.

Piotroski’s strategy is quite robust because it involves weighting each of nine variables equally. So if two of those nine variables turn out not to be related to a stock’s performance, the strategy will perform worse but will still likely outperform the market. Or, if there is an error in our database and a number is off by an order of magnitude, it will only slightly reduce the performance of the strategy.

Harry Domash has written an article at MSN Money about implementing this strategy. While he describes how you can implement a similar strategy using MSN’s stock screener, that stock screener does not contain all the necessary information to fully implement Piotroski’s strategy. (Also, MSN’s advanced stock screener only works with Internet Explorer. Other than that, however, it is one of the most powerful free stock screeners available).

Lighting Science Group: Yet Another Overvalued, Overhyped OTC BB Company

Lighting Science Group (OTC BB: LSCG) is a step above the everyday vermin that inhabit the OTC BB. It has two real businesses, one of which manufactures and distributes LEDs, and the other of which installs LED and other lighting systems. The one problem with Lighting Science is that its value as a real company is dwarfed by its market cap. In this way it resembles some other companies I have criticized in the past, including Continental Fuels (OTC BB: CFUL) and Noble Roman’s (OTC BB: NROM).

First, the market cap: with a total of 26.524 million shares (fully diluted) outstanding after its recent 1-for-20 reverse split, and a recent price of $9.90, Lighting Science has a fully diluted market cap of $263 million. The company has some sales and is a real business, but the thing it is best at selling is its shares: its share count has doubled in the past year alone (see the 10Q on page F-3 for details; this calculation excludes the 1-for-20 reverse split).

Book Value

Book value is something that cannot easily be faked. While different industries have different capital requirements, book value is a very good way to compare the size and intrinsic value of different companies in the same industry. As of September 30, 2007 (still according to the company’s 10Q), the company had a book value of $3.5 million. However, after a recent reverse merger with a private company, LED Holdings, the combined company has much greater book value of $24 million, including $16 million in cash (see the pro-forma financial statements).

Sales

The combined company (which will keep the name Lighting Science) had $5.7 million in sales for the first eight months of 2007. This is equal to an $8.5 million annual revenue run rate. This leaves the company with a stratospheric price to sales ratio (P/S) of 31, as compared to a P/S of just about 2 for GE [[ge]], one of the best and most consistent manufacturers, and a P/S of 6.5 for CREE [[cree]], a much larger manufacturer of LEDs.

I should note that LED Holdings has had a poor 2007 in terms of sales. Sales for all of 2006 were $8.9 million, but they fell to $3.7 million (a run rate of $7.4 million) in the first half of 2007.

Losses

While quickly increasing revenues is normally a good thing, it is not good to increase revenues and at the same time increase losses. Lighting Science’s (not including LED Holdings) loss over the first nine months of 2007 ($8.1 million) was 4.8 times greater than the loss over the same nine months in 2006. The third quarter 2007 loss of $4.8 million was 3.7 times larger than the 3rd quarter 2006 loss. LED Holdings, while being profitable over the last few years (with a profit of just over $1 million in 2006), has seen much slower growth in sales, and its profits in 2007 will be a lot lower than in 2006. The combined company would have had a pro-forma loss of $5 million over the first eight months of 2007.

PIPE Dreams

Longtime readers know of my disdain for PIPEs, or private investments in public equity. With penny stocks, these usually mean that a well-heeled investor gets shares at a deep discount to the market price and as soon as a six-month or year-long lockup period is over that investor will flip the shares onto the public for a tidy profit, even if the stock price of the company decreases.

Note 11 in the 10Q details a PIPE from a year ago in which the shares were placed for $0.30 ($6 per share, post-split). In addition to 0.667 million post-split shares, the investors also received (for free) 0.5 million post-split Class A Warrants and 0.667 million post-split Class B Warrants. The Class A Warrants give the holders the right to by the post-split stock at $7 per share. The Class B Warrants give the holder one full share and the right to buy 3/4 of a share at $6 (post-split) per share. Given a stock price of $9 (below the current $9.90), the the “PIPE-fitters” would have garnered themselves $8.5 million on an investment of $3.6 million ($9 per share times 0.667 million shares plus $2 per share times 0.5 million Class A Warrants plus $3 per share times 0.500 million Class B Warrants).

When PIPE investors do so well (more than doubling their investment in under a year), the company and its public shareholders do poorly. In return for a measly $3.6 million in cash (plus an extra $6.5 million when the warrants are exercised), shareholders were diluted by 1.667 million post-split shares with a market value of $15 million. If Lighting Science’s business were truly doing well, it surely could have found more advantageous funding sources.

La Revanche de David Gelbaum

Perhaps a good investment strategy would be to short sell any stock in which David Gelbaum invests. His Quercus Trust showed up as a large holder in Octillion (OTC BB: OCTL) and he is a large holder of Lighting Science.

[Edit 3/31/08: upon further review, I think it is more accurate to state that Gelbaum invests fairly indiscriminately in ‘green’ companies. So his investment does not mean much of anything, good or bad.]

Comparables

Perhaps the most comparable company to Lighting Science is CREE [[cree]]. It manufacturers LEDs and has some good technologies and patents. It trades at a P/S of 6.5 and a price to book ratio (P/B) of 2.7. If CREE is fairly valued and both it and Lighting Science deserve similar multiples, Lighting Science is overvalued by 500% according to the P/S ratio and by 430% according to P/B ratio. Being generous to Lighting Science, I would call it 400% overvalued and give my fair value estimate as $2.35 per share, one quarter the current price of $9.40. Of course, because Lighting Science is not profitable (unlike CREE) and is much less established, it deserves to trade at a significant discount to CREE. A 50% discount would be reasonable and would result in a fair value of around $1.20 per share (88% below the current market price).

A Bit of Positive Press

Perhaps you caught Jeff Bishop’s positive review of the company on SeekingAlpha. His article is entirely fluff. Furthermore, his company, Beacon Equity Research, has a nasty habit of covering a ton of OTC and Pink Sheets stocks and rating them “speculative buy” or “outperform”. I looked at over half of their reports, and all of the companies that were rated (one was not rated) were rated either “speculative buy” or “outperform”. Highly rated companies included such utter dreck as Rocket City Automotive and Universal Property Development and Acquisition Corp. Beacon is paid to cover most of the companies it covers, either directly by the companies or indirectly by large shareholders. That explains why Beacon is so overwhelmingly positive about the companies it covers.

Reverse Stock Split

Lighting Science recently completed a 20 for 1 reverse stock split, increasing the market price from around $0.48 to around $9.60. Academic research (pdf) has consistently found that companies that undergo reverse stock splits underperform the stock market drastically.

Conclusion

Lighting Science Group Co. is at best a halfway decent company that could eventually become profitable. At worst, it will continue to lose money for the foreseeable future. Either way, it is way overvalued. While LEDs will be a great market, there is little reason to believe that Lighting Science will be a leader in that market. It has too many competitors with more resources. If anything, my target price of $1.20 for Lighting Science is too high. I would argue that the comparable I used for the valuation, CREE, is overvalued as well. In fact, CREE is one of the most highly shorted companies on the NASDAQ.

Lighting Science Group Corp. is overvalued by any means. Smart investors should head for the exits and watch this company’s stock collapse from the sidelines.

For More Information

3rd Quarter 2007 10Q
Pro-Forma Financial Statements
LED Holdings Financials (and those of its predecessor company, LED Effects)

Disclosure: I am short LSCG. I have a full-disclosure policy.

Paye Tes Dettes!

The title of this post comes from the Charles Trenet song about the importance of paying off one’s debts (full lyrics).

In the search of good value we must be willing to take necessary risks. We must be willing to bet on struggling companies, sometimes with bad management, sometimes in struggling industries. We must never combine those three, however. Most important of all, we must shun excessive debt like the plague. While I prefer to avoid companies with significant debt, in cases in which the company has consistent earnings and the ability to maintain those earnings (because of strong brands or monopoly status), debt is forgivable.

For companies with tough competition and little competitive advantage, debt is a very, very bad idea. Two great cases in point are Movie Gallery (MOVI) and General Motors (GM). Both companies have historically strong brands and decent business models. They are both extraordinarily cheap. If they had less debt they would be great companies to buy. Saddled with debt, however, they lack the ability to survive their cut-throat industries.

Movie Gallery is a great example of stupid management harming a company. The company’s stock traded as high as $30 in 2005; it now trades at $4. Movie Gallery runs a chain of video rental stores. They have historically been profitable. However, early in 2005 the company took on much debt to buy Hollywood Video. The company now has a market cap of $130 million and debt of $1.1 billion.

I would argue that the movie rental business is one of the best businesses to be in. People like watching movies, new movies cost a lot to see at movie theaters, and the competition (satellite and cable movies on demand) are not that great. While Netflix (NFLX) has made it harder for bricks and mortar stores, I feel its impact has been drastically over-rated. I subscribe to the Netflix service, but there are plenty of people who do not. A bricks and mortar store can do good business because those that rent less frequently will not subscribe to Netflix.

Therefore, I think that Movie Gallery’s two chains, Movie Gallery and Hollywood Video, will still be around in one form or another fifteen years from now. The problem is that the debt of the current company will likely result in bankruptcy and leave the stock worthless.

General Motors faces much the same problem. Unfortunately for the careless investor, their full debt his hidden in details in their financial statements about their union contracts and the number of retirees for whom they provide pensions. Some have estimated that GM will have to pay out over $70 billion in pensions and health care benefits to its current and future retirees. For a company that has consistently lost a few billion dollars per year over the last few years, this is a problem.

In addition to its debt, GM has too many brands, too much production capacity, an unfavorable union contract, and shrinking sales. Without such a sizable debt, GM would stand a chance of restructuring and saving its stockholders. As it stands, it has no room to maneuver. Unless it can become highly profitable within a year or at most two years, it will go bankrupt.

So does debt matter for stock returns? Yes, at least according to “Predictability of UK Stock Returns by Using Debt Ratios” by Muradoglu and Whittington (scroll down on the page to which I link to download the PDF). While the data are from the UK, the results are logical and should apply in the USA as well. While the correlation of debt ratio with stock returns is lower than the correlation of P/E with stock returns, there is still a definite negative correlation: the stock of those companies with the least debt did the best. The 30% of companies with the lowest debt showed a consistent advantage over those with higher debt. Those companies had gearing ratios (leverage ratios for you Americans) of under 20%, meaning that total debt represented less than 20% of enterprise value. There are other ways of reporting leverage but I like this one. For comparison, MOVI has a gearing ratio of 89%, while GM has a gearing ratio of 96%.

Disclosure: I have no position in any company mentioned. This was originally written two years ago and published elsewhere. Movie Gallery has since declared bankruptcy. I have a disclosure policy.