My recent mistakes at value investing

Value investing

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I’ve caught myself violating one of main tenets by ignoring his “margin of safety” principle. Here are the gory details on the two transactions:

    Ergo Science Corp (ERGO or ERGO.OB)

    Summary: This stock appeared in the Special Situations Investing site as a going-private transaction via a reverse/forward stock split. At the time, ERGO was trading for 0.80 and under the terms of the agreement, shareholders with less than 200 shares would be paid $2.10 per share after the split or a straight 162.5% gain (e.g. not annualized) and before transactions costs.

    My moves: I purchased 199 shares at $0.80 too early, before the pre-14A filing was released saying that the transaction would apply to shareholders of record only, meaning the shares had to be in my name. Schwab charges a $50 fee to register stock shares in my name, and it was unclear to me how I would go about mailing or otherwise transferring these certificates to the company (potential additional transactions costs), so I decided the best course of action was to dispose of my shares. I sold 199 shares a day or two later at $0.70 for a net $39.80 loss.

    Hyperfeed Technologies Inc (HYPR or HYPR.OB)

    Summary: This stock appeared in the Special Situations Investing site as a merger. At the time, HYPR was trading for $0.80 and under the terms of a somewhat more complicated agreement, a parent company was planning on supplying the funds to merge HYPR with one of its subsidiaries and pay $1 per share to close the transaction.

    My moves: After my limit order went unfilled for several days, I decided to purchase the bid offering of 2,500 shares at $0.80, seeing only a straighforward $500 return. Then I asked others at Contributor’s corner if they saw anything amiss (thereby violating another investing rule: research before you buy, not after!) at which point someone pointed out that the proxy never listed an expected closing date. I’d jumped in with blinders on, thinking that even if the transaction took a year to close, a 25% return was still decent. But really, being an unlimited merger, there was no reason I had to buy 2,500 shares rather than 100 or 1,000. Yesterday night, I received an alert that stating, among other things, the following:

    By letter dated November 7, 2006, Exegy Incorporated (“Exegy”) informed HyperFeed Technologies, Inc. (“HyperFeed”) that it was terminating the Contribution Agreement among Exegy, HyperFeed and PICO Holdings, Inc. … At this time, HyperFeed disputes Exegy’s right to terminate the Contribution Agreement and plans to vigorously defend its rights thereunder through all available legal means. … The Company currently believes that, as a result of Exegy’s actions to terminate the Contribution Agreement and the short-form merger, existing and anticipated capital resources, including cash and cash equivalents, accounts receivable, assets related to discontinued operations, and financing from PICO, which is currently the company’s only source of financing, will not be sufficient to fund its operations on a going concern basis.

    It’s possible that the merger will be completed, but I decided the risk was too great to bear, especially given the last sentence above. I sold my position this morning at the market open at $0.60 for a total loss of $519.90. Update (Nov. 9, 2006 @ 3:30P PST): The company just filed another 8-K saying “HyperFeed’s Board of Directors today approved a resolution authorizing the immediate filing of a voluntary petition for bankruptcy under Chapter 7, Title 11, United States Code. In connection with the planned Chapter 7 Bankruptcy filing, HyperFeed will cease all business activity and operations.”)

So what happened? It’s pretty simple. In both cases, I didn’t look before I leaped and saw only attractive potential returns, ignoring the risks involved. With ERGO, I made what can only be described as a completely avoidable and dumb mistake by not checking the company’s filing stage. With HYPR I simply got greedy. In both cases, I could (and should) have waited until the companies had filed a Definitive Proxy statement (the safest stage for investing in special situations) before deciding to put my money in. Even though by waiting to this stage, returns may diminish, risk is also diminished as well. I should also have listened to some veteran investors at Contributor’s Corner to understand the risks involved in merger transactions because it was a completely new area to me.

Even though I don’t invest large amounts of money in my special situations portfolio just due to the nature of the transactions, that’s really no excuse for throwing caution to the wind, and my special situations investing portfolio is now down for the year.

I don’t want my decisions and experiences here to reflect poorly on the Contributor’s Corner, which remains a very good tool and the only one of its kind, to my knowledge. (In fact, I just renewed my subscription there for another year.) In most car crashes, it’s the driver’s fault that the crash happens rather than the car itself, and I’m certainly the one driving with blinders on in these cases.

However, I created this site in order to learn more about investing and since I believe strongly in transparency, I’m sharing the good with the bad. Hopefully others will be able to learn from my mistakes.

Bottom line: I’ve realized it’s time to get control over my discipline again, and my “real-world tuition” of $559.70 will serve as an effective reminder of what happens when I throw caution to the wind!

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8 Feedbacks on "My recent mistakes at value investing"

Ralph

I don’t do much (any) trading of this kind as it seems too much work for small rewards – I just stick to a long term asset accumulation and investment plan with sensible diversification, asset allocation, and reasonable levels of gearing.

Having said all that, I find your trading activities interesting to read about – although it seems to be an aweful lot of work in order to make a maximum potential ($258.70 – fees) or ($500 – fees). Especially given that, in the normal course of events, a few of these trades wouldn’t work out as planned, so you should be planning on an expected return of, say, half of the maximum possible return (on average – you’ve had a couple of bad picks there). So, it’s a lot of work for a potential $300 or so.

A final thought – a special situation with a potential gain of 162.5% (!) suggests that either a) the risk of it not working out is VERY high (as you found out), b) the return isn’t really that high (as you discovered, the maximum potential gain for the 199 share lot was less when you allowed for the extra $50 fee required), or c) if the situation was really as you had first thought, many others would have also worked this out and bid the price up from $0.80 to closer to the $2.10 level (say $1.50).

I know that such special situations are supposed to exist because the “big boys” don’t bother dealing with such piddling amounts in very small companies, but, in this day of internet day traders there are LOTS of people such as yourself looking out for these, so even a mildly efficient market will mean that the share price reflects the actual risks involved.

The nearest thing to a “free lunch” I’ve encountered is when a DRP for a company offers a discount to the current share price (usually 2-5%) AND the DRP formula rounds UP all “odd lots” to the nearest whole share. This can boost your dividend yield significantly if you have a small holding. However, the discounts offered on DRPs in Australia have dropped a lot in recent years (now generally 0%-2%), and there is a tendancy to round DOWN DRP share allocations, and either retain the residual dividend in a DRP account, retain the rounded amounts, or donate them to charity. So this “free lunch” also seems to be on the way out now that there are a lot more small shareholders due to cheaper online brokerage being available to the masses.

Regards
http://enoughwealth.blogspot.com



Ricemutt

Ralph – thanks for your comments. I think you’re spot on with some of your observations: there’s no such thing as easy money, and even small mergers are hard for individual investors to profit from.

The bulk of my investments follows the straightforward “dollar-cost-average, focus on indices (ETFs) and long-term investment” approach, so I see my special situations dabbling as more of the “enterprising” side of the value investing equation, and it comprises only a tiny portion of my investment portfolio.

For now, I still find the opportunities interesting enough to pursue both in terms of learning opportunities, though I realize there are many others out there who would agree that the time and effort involved aren’t worth the smaller amounts. Of course, the benefit of the smaller transactions is that when you screw up like I did, the impact is smaller, too!



antler

Why are you messing around with penny stocks? They are illiquid, non-transparent, and frequently fraudulent.

You cannot call anything to do with these toxic issues “value investing” — its rank speculation, nothing more, nothing less.

You don’t find it the least bit telling that both of these predictable anecdotes begin with, “This stock appeared in the Special Situations Investing site…”

I don’t have to know what ‘Special Situations’ site is, I can take a guess though — it’s some dubious penny stock tout site that probably gets paid for their carefully-worded alerts.

Well, live and learn.



Ricemutt

@antler: Heh — actually, I expected to get this sort of question/comment sooner about the two stocks in question. I suppose you can call them penny stocks, but I feel pretty confident that the nature of the investments in question falls squarely into value investing. What I’m calling “special situations investing” is also known as “workouts” — companies going private or involved in certain transactions that offer small arbitrage opportunities — and is mentioned by Benjamin Graham in The Intelligent Investor as very viable opportunities for enterprising value investors. (I don’t have the book in front of me right now, but I’ll pinpoint the pages where Graham mentions these when I get back home.)

That I didn’t do my homework doesn’t change the fact that there are real opportunities out there, though maybe they’re not to everyone’s tastes. Is this stuff more speculative? Yes, but not in the sense that I’m buying penny stocks in an unfounded anticipation of a three-digit appreciation rate. These companies were offered a figure per share in a reverse/forward split or merger, so the number wasn’t pulled out of thin air. Of course, there’s always a chance that the transaction won’t complete (as in the case of HYPR, but not ERGO), but they work out as well, as in the case of ANII (which I wrote about a couple months ago).

I probably won’t change your mind, but I invite you to take a look at the special situations site I mentioned (http://www.fatpitchfinancials.com/contributors). And, no, I don’t benefit at all from mentioning the site. You’ll find it’s not a get-rich-quick-by-buying-penny-stocks but based solidly in Graham’s methodology.



George

One thing to also note is that not all special situation opportunities involve penny stocks. Some going private transactions have actually involved some mid cap and larger stocks. We are also avoiding stocks that are not filing with the SEC, the most dangerous of penny stocks. Warren Buffett has even been involved in at least one of these deals in the past. (I wish I had the reference right now, but I’m sure it is hiding somewhere on my site. I believe this is one of the investment options he would choose when he stated he could earn 50 percent returns consistently if he was only investing $1 million instead of the billions he has to allocate now.)

I think the main problem that Ricemutt, as well as myself, are facing is a major slow down in the number of reverse split going private transactions. I think the slim pickings in current opportunities have made us less cautious. The good opportunities are being gobbled up by private equity (dam those smart hedge funds) since they are flush with capital right now. I can assure you that they are not afraid of “penny” stocks.

One thing I am doing is piggy backing on all this hedge fund activity and taking advantage of the spinoffs they are encouraging. Dutch tender offer buybacks also offer up good opportunities for small investors, and they often involve large cap stocks.

Still, nothing beats the risk reward ratio for many of the reverse split going private transactions that have been available in the past. The trouble with these opportunities is that you can only invest a small amount and they are not always available. Really, they are only something to invest your excess cash in when the market is generally overvalued and you are trying to pass the time until the next fat pitch.

PS – I really need to find a way to reward Contributor’s Corner fans like Ricemutt, but for now you can rest assured that their reviews and comments are unbiased.



Live Financial Services » Blog Archive » Bursting Another Sort of Bubble

[…] My Recent Mistakes at Value Investing By Experiments in FinanceThe author discusses two recent mistakes, Ergo Science (ERGO) and Hyperfeed Technologies (HYPR). He attributes both mistakes to his failure to stick to Benjamin Graham’s “margin of safety” principle.Stocks: ERGO, HYPR […]



Steve Selengut

When All Stocks Are Value Stocks – Think QDI

Value stocks are those that tend to trade at lower prices relative to their fundamental characteristics than their more speculative cousins, the growth stocks; they have higher than usual dividend yields and lower P/E and P/B ratios. So when all stock prices are down significantly, have they all become value stocks? Or, based on the panicky fear that tends to overwhelm media and financial experts alike, haven’t they all taken on the speculative characteristics of growth stocks?

Well, to a certain extent they have, because the lower value stock prices go, the more likely it is that they will eventually experience the 15% ROE that typifies the classic growth stock. Interestingly, by definition, growth stocks are expected to be associated with profitable companies, a fact that speculators often lose site of. There are three features that separate value stocks from growth stocks and two that separate Investment Grade Value (IGV) stocks from the average, run-of-the-mill, variety.

Value stocks pay dividends, and have lower ratios than growth stocks. IGV stock companies also have long-term histories of profitability and an S & P rating of B+ or higher. Would you be surprised to learn that neither the DJIA nor the S & P 500 contains particularly high numbers of IGV stocks? Still, since 1982, value stocks have outperformed growth stocks 62% of the time. So when an ugly correction has a makeover, it’s likely that all value stocks transform themselves into growth stocks, at least temporarily.

Will Rogers summed up the stock selection quandary nicely with: “Only buy stocks that go up. If they aren’t going to go up, don’t buy them.” Many have misunderstood this tongue-in-cheek observation and joined the buy-anything-high investment club. You need dig no further than the current lists (June ’08) of “most advancing issues” to see how investors are buying commodity companies and financial futures at the highest prices in the history of mankind.

This while they are shunning IGVSI (Investment Grade Value Stock Index) companies that have plummeted to their most attractive price levels in three to five years. Many of the very best multinational companies in the world are at historically low prices. Wall Street smiles knowingly (and greedily) as Main Street hucksters tout gold, currencies, and oil futures as retirement plan safety nets. Regulatory agencies look the other way as speculations worm their way into qualified plans of all varieties. Surely those markets will be regulated some day— after the next Bazooka-pink, gooey mess becomes history.

How much financial bloodshed is necessary before we realize that there is no safe and easy shortcut to investment success? When do we learn that most of our mistakes involve greed, fear, or unrealistic expectations about what we own? Eventually, successful investors begin to allocate assets in a goal directed manner by adopting a more realistic investment strategy— one with security selection guidelines and realistic performance definitions and expectations.

If you are thinking of trying a strategy for a year to see if it works, you’re being too short-term sighted— the investment markets operate in cycles. If you insist on comparing your performance with indices and averages, you’ll rarely be satisfied. A viable investment strategy will be a three-dimensional decision model, and all three decisions are equally important. Few strategies include a targeted profit taking discipline— dimension two. The first dimension involves the selection of securities. The third?

How should an investor determine what stocks to buy, and when to buy them? We’ve discussed the features of value and growth stocks and seen how any number of companies can qualify as either dependent upon where we are in terms of the market cycle or where they are in terms of their own industry, sector, or business cycles. Value stocks (and the debt securities of value stock companies) tend to be safer than growth stocks. But IGVSI stocks are super-screened by a unique rating system that is based on company survival statistics— very important stuff.

In the late 90’s, it was rumored that a well-known value fund manager was asked why he wasn’t buying dot-coms, IPOs, etc. When he said that they didn’t qualify as value stocks, he was told to change his definition— or else. IGV stocks include a quality element that minimizes the risk of loss and normally smoothes the angles in the market cycle. The market value highs are typically not as high, but the market value lows are most often not as low as they are with either growth or Wall Street definition value stocks. They work best in conjunction with portfolios that have an income allocation of at least 30%— you need to know why.

How do we create a confidence building IGV stock selection universe without getting bogged down in endless research? Here are five filters you can use to come up with a listing of higher quality companies: (1) An S & P rating of B+ or better. Standard & Poor’s combines many fundamental and qualitative factors into a letter ranking that speaks only to the financial viability of the companies. Anything rated lower adds more risk to your portfolio.

(2) A history of profitability. Although it should seem obvious, buying stock in a company that has a history of profitable operations is inherently less risky. Profitable operations adapt more readily to changes in markets, economies, and business growth opportunities. (3) A history of regular, even increasing, dividend payments. Companies will go to great lengths, and endure great hardships, before electing either to cut or to omit a dividend. Dividend changes are important, absolute size is not.

(4) A Reasonable Price Range. Most Investment Grade stocks are priced above $10 per share and only a few trade at levels above $100. An unusually high price may be caused by higher sector or company-specific speculation while an inordinately low price may be a good warning signal. (5) An NYSE listing— just because it’s easier.

Your selection universe will become the backbone of your equity asset allocation, so there is no room for creative adjustments to the rules and guidelines you’ve established— no matter how strongly you feel about recent news or rumor. There are approximately 450 IGV stocks to choose from— and you’ll find the name recognition comforting. Additionally, as these companies gyrate above and below your purchase price (as they absolutely will), you can be more confident that it is merely the nature of the stock market and not an imminent financial disaster.

The QDI? Quality, diversification, and income.

Steve Selengut
http://www.sancoservices.com
http://www.kiawahgolfinvestmentseminars.com/
Author of: “The Brainwashing of the American Investor: The Book that Wall Street Does Not Want YOU to Read”, and “A Millionaire’s Secret Investment Strategy”



Steve Selengut

Value Stock Investing – The November Syndrome On Drugs

Every fall, especially in opportunity rich markets like this, I encourage investors to think about some year-end strategies that make the final calendar quarter a special time in all markets. Several forces are at work, all of which have links to conventional Wall Street wisdom; none of which promote good long-term investment decision-making.

This year, we have the added excitement of anticipating a new, perhaps economically too liberal, administration taking over with an already implanted, and demonstatably inept, congress. The markets are in a truly unprecedented state of “uncertainty overload”. What’s an investor to do— or not to do?

Typically, the November syndrome has features that impact in both directions. It causes weak prices to fall even further and strong prices to climb higher. This year, the strong category requires a microscope for candidate viewing, while the weak seem to have inherited the listings. Money Market funds and Treasury securities are the low yielding, lower-risk, depositories of choice.

At the individual investor level, the mad dash to lose money on equity securities has begun. The idea that this is somehow a good thing is an anomaly created by a counter productive tax code and an industry that has a vested interest in perpetuating the absurdities it (the IRC) creates.

Assuming that we are dealing with investment grade securities, lower prices should most logically be seen as an opportunity to add to positions cheaply— not as an opportunity to reduce one’s tax liability on investment earnings. There is, and never will be, a good loss or a bad —.

Naturally, both you and your CPA feel better with lower tax bills, but why sell a perfectly good security at a loss to produce pennies on the dollar in tax relief? Speculations, sure, valueless securities, why not? But when nearly all IGVSI stocks are at their lowest levels in decades, selling for losses should be the last thing on your mind.

Most IGVS companies remain profitable. Less profitable, for sure, but few have cut dividends and nearly all will survive and prosper when the economy recovers. Would your CPA accept just half his fee to save on his own taxes? Would you barge into your boss’ office and demand a pay cut?

In the old days, when markets moved slowly and buy-and-hold was the investment strategy of choice, the 30-day, buy-it-back, tactic was an effective way of having your tax break cake and maintaining your portfolio as well. But with 1,000-point weekly swings, there are no guarantees that the markets will tread water for your personal tax convenience.

In fact, more often than not, major corrections such as this one produce either a Santa Clause rally or “January Affect” that is far more profitable for November-low buyers than for tax-motivated sellers.

Similarly, “letting your profits run” to push the dreaded taxes into next year is foolishness. Talk to the geniuses that didn’t take profits in 1999, or in the ’87 or ’07 summers. The objective of the equity investing exercise is to take profits— the more quickly and more frequently, the better. This year’s volatility has produced hundreds of profit taking opportunities.

Another popular year-end shell game is the “bond swap”, which preys on the fear most income investors experience when their somewhat guaranteed, income securities, fall in market value. This is the same absurdity that allowed “mark-to-market” accounting rules to crack the foundations of financial institutions around the world.

A contract (from a quality borrower) to pay a fixed rate of interest, and full principal at maturity will vary in price throughout its existence. It’s nothing to be particularly anxious about. Junk bonds are for speculators, not for those of us with gray-templed children.

Bond swaps allow an advisor to pick your pocket by exchanging them at a “nice tax loss” for another bond with “about the same yield”. He gets a double dip (invisible) commission and you get a bond of longer duration or lower quality.

On the same page, the idea of exchanging a steady, much-higher-than-normal-yield, closed-end-fund (CEF) cash flow for an overpriced T-Bill yielding less than 1% is above Emperor’s New Clothes absurdity levels.

But there are even more year-end games going on to take advantage of your confusion. Wall Street gangs up on you with a self-serving strategy blithely referred to by the media as “Institutional Year End Window Dressing”— a euphemism for consumer fraud.

In this annual ritual, mutual fund and other institutional money managers unload stocks (and CEFs) that have been weak and (usually) load up on those that are at their highest prices of the year. This year, they’ll be holding cash and Treasuries.

Always keep in mind that (a) Wall Street has no respect for your intelligence and (b) the media “talking heads” are entertainers, not investors. Institutions must paint a picture of brilliance in their annual glossies. This year, a panic-stricken Main Street is helping them with their annual “sell low” hypocrisy.

It would be an understatement to say that these year-end tax and face saving activities are misguided and unnecessary. But this year’s “November Syndrome” is an unprecedented investment opportunity that most people are too confused to appreciate.

Simply put, get out there and buy the (high quality) November lows, both equity and fixed income. Establish new positions for diversity, and add to old ones without surpassing “working capital model” diversification limits. Keep appendages crossed for a therapeutic dose of “January Affect” elixir, as you reaffirm your understanding of long-term investment strategy.

The media will talk about this New Year phenomenon with wide-eyed amazement. Most of those terrible losers (you just sold?) begin to rise from the ashes, as the professional window dressers repurchase the solid companies they just sold for losses— interesting place Wall Street.

One last thought; if you have taxable profits that you can’t bear the thought of holding on to, just send the profit portion to me. I’ll pay the terrible taxes.

Steve Selengut
http://www.sancoservices.com/
http://www.kiawahgolfinvestmentseminars.com
Professional Investment Management from 1979
Author of: “The Brainwashing of the American Investor: The Book that Wall Street Does Not Want YOU to Read”, and “A Millionaire’s Secret Investment Strategy”



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