Small Cap Stocks

One of the main lessons of the financial crisis is simply that the best way to make a lot of money is to lose piles of it.

The big banks, of course, are masters of this strategy, and the recent mortgage debacle is only a recent example of their prowess. Nearly every five years or so, banks devise some new method of losing obscene piles of money, and then demand government funds to stay afloat. Though, I haven’t added up all the numbers, it’s probably safe to say that a large part of the profits of banks during the boom years, are really simply the “amortized” gains from prior bailouts. Surely during this latest financial crisis, many of the big banks simply ended up with record profits following government intervention.

But, the “lose money” strategy is not confined to big banks. Internet start-ups amazingly still play the game quite convincingly, as do all the biotechs. And small investors too can profit from this strategy, as well.

Developing an Investment Strategy Around Money-Losing Companies
For nearly a decade, I’ve theorized, and put into practice a simple investment philosophy, whose returns blow away nearly all hedge funds (even those with insider information). The strategy: Buy companies that are losing money.

Of course, it’s not that simple, but, in general, the most profitable investments by far, are in those companies that are currently losing tons of money. The devil, as always, is in the details (and the timing), but there are strong logical justifications for this approach, which I hope to get to in future posts.

A Quick Case Study: NAVI
In case you’re itching for a recent investment example, look no further than NAVI (though BAC and host of other bankrupt financials are perhaps better case studies).

Today, NAVI came out with their 10-K and my favorite line is:
“We have a history of losses and may never achieve or sustain profitability. We have never been profitable and may never become profitable. As of July 31, 2009, we had incurred losses since our incorporation resulting in an accumulated deficit of approximately $519.6 million.”

Does this bother me? Not in the least bit. NAVI is up some 200% since I entered a position in this perennial money-loser and I expect the stock to finish the year strongly, as well, as the company proceeds to announce some key asset sales.

I’ll have more to come on the “lose money” investment strategy in the future, but for now, I draw your attention to this recent article about Twitter, the money-guzzling Internet phenom that is now worth $1 billion.

http://blogs.wsj.com/deals/2009/09/24/breaking-news-twitter-to-raise-100-million-from-insight-t-rowe-price-other-investors/

The current plea by government officials for banks to increase lending, will likely fall on deaf ears, since it is diametrically opposed to the government’s other policy of subsidizing these banks with enormous gifts of risk-free profits.

Two Contradictory Measures: Government Subsidized Profits for Private Banks and a Call for Lending
On the hand, the Treasury/Fed want to continue to hide bank losses and avoid a much needed restructuring of the banking industry. Instead the aim is to recapitalize the banking system, and maintain the status quo, by ensuring guaranteed risk-free profits to banks via via zero interest rates policies, subsidies, and other money-printing schemes.

Nevertheless, at the same time as the Fed implements the above guaranteed profit scheme for banks, the government wants the same banks to increase lending to businesses in order to revive the production economy. We can’t have it both ways.

Lending is a Difficult Way to Make Money, Playing the Fed Shell Game is Much Easier
But, if I’m a bank, why would I want to make money by lending money, if I can make it by taking risk-free capital from the government? Lending is a terribly tedious way to generate profits. It requires alot of legwork and due diligence, and is quite risky given the state of the production economy. Basically, it’s a pain in the butt. The alternative to lending, of course, is to participate in the Fed’s shell game, whereby banks borrow from the government at zero percent, and then lend the same money back to the government at 4%. There is obviously no contest. If I’m a bank, and I want to generate profits, I’m not going to lend out money. I’m going to simply play the Fed shell game.

Either We Eliminate the Banking Subsidies or the Banks Should Be Taken Over by the Government
So in essence, the current financial system remains a contradiction. We can’t have non-government owned banks subsidized by the government to guarantee enormous profits, and yet at the same time ask these subsidized banks to increase lending.

Obviously, if we want to increase lending, we need to either remove from the system the option of risk-free profits for banks and let them try to make money the old fashioned, by lending it. Alternatively, we can keep the risk-free, money-printing option, and in that case the government should take over the banks and lend directly to businesses, to ensure satisfactory credit flow to the economy.

A Two-Tiered Banking System Makes the Most Sense
Ironically, it makes no sense why we need banks to be middleman in the extension of simple credit in our economy, in the first place. There is really no value add service provided by non-government banks for basic lending products, such as mortgages. These banks simply skim off huge amounts of capital from the system as middleman, and create enormous economic problems by inventing complicated financial products in an attempt to make simple bank products, like mortgages, more profitable.

Essentially, there is nothing all that complicated about extending simple credit, such a loan to buy a house. Surely the same people who deliver our mail reliably every day, could also click the mouse a few times, to run some program that checks credit scores, analyzes tax filings, and then approves or denies a loan.

Interestingly, the trillions of dollars that have been used to bail out the current banking cartel, could have already been used to create an entirely new banking system, whose sole purpose, via a government fiat, would be to extend credit for transactions that are essential to the functioning of our economy. As for more complicated credit products, privately-owned banks can take up this business, but without any government guarantees or subsidies.

As the political apparatus in this country continues to extol the virtues of the financial bailout, I think it’s important for thinking investors to remind themselves that the bailout orchestrated by the Fed and the Treasury has in reality been a dismal failure. Therefore, extreme caution is still warranted when venturing into the US financial market, which remains a vast ponzi scheme now supported by taxpayer dollars.

The Brilliant Solution: Print Trillions of Dollars

The truth is that the bailout has merely been a financial bailout, rather than an economic bailout. In order to combat what is ultimately a deep economic crisis, which had really been brewing for nearly a decade, our brilliant economists at the Fed, led by Bernanke, devised a truly creative solution: print trillions upon trillions of dollars and give it to scheming bankers with no strings attached. Surely Bernanke will soon win the Nobel Prize in Economics for this ingenious invention. Simultaneously, in order to appease the common folk, the President ordered the printing of a few hundred billion for some part of the production economy, but for which segment nobody really knows.

The Result: Devaluation of the Currency, More Toxic Assets, and Higher Energy Prices

Ultimately, this massive printing of money has, not surprisingly I might add, accomplished absolutely zero, except to sharply devalue the US currency, which in turn has artificially driven up the prices of financial assets. This has in turn emboldened crooked financial institutions, to completely ignore a restructuring of their toxic real estate assets, and simply pay out the government booty as bonuses.

The US residential real estate industry, remains by far the largest part of our real economy, as opposed to the fantasy economy on Wall Street and the bailout economy in Washington. And yet, despite media reports to the contrary, the real estate industry remains in a dismal state, propped up solely by another silly financial innovation, the first-time homebuyer tax credit.

Of course real estate cannot rebound in any meaningful way, if the people who can actually buy the houses have no money or jobs to pay for the houses. But, shh don’t share this brilliant insight with the geniuses running the Treasury. The banks already understand this simple fact, though, which is why they have made it virtually impossible to get decent credit to buy real estate, as they prepare for an avalanche of new distressed properties.

Finally, to make matters worse, the slosh of money has now contributed, once again, to sharp price increases in necessary commodities, especially the price of oil. Ultimately, rapidly rising energy prices, as recent economic history and logic dictates, will completely destroy the still fragile US economy.

In the end, our real economic problems remain unsolved by the bailout and will keep coming back to haunt us. These grave economic issues are of course:

Unfortunately, though each one of these problems can be addressed simply and quickly by proper legislation, not one intelligent solution has been offered.

As the US stock market continues to race higher, and the value of the dollar continues to plumb lower, it pays to remember that during the Weimer printing press in 1919-1922, the Weimer stock market rose over 89X, from 100 to 8900. The Weimer market seems to have actually peaked at a whopping 21,400 in 1923. Here is a good link, which has the entire history of the Weimer printing spree: http://www.nowandfutures.com/us_weimar.html

The end result of the Weimer printing press wasn’t pretty in the least bit, which makes one wonder how the largest monetary printing press ever unleashed, that of the US Federal Reserve and US Treasury since Oct. 08, will turn out. My guess, as I’ve stated in the past, is that since stock prices now have no theoritical upper limit (i.e. every big bank is now guaranteed by the Fed/Treasury, and is permitted to falsify accounting statements, rendering asset pricing valuation meaningless and putting capitalism to rest), pressure will continue to build for continued staggering price rises in financial la la land. So maybe Dow 20K is not that far off? Then Dow 40K is really just another 100% move.

Eventually, of course, the financial insanity will trickle down into the real economy, with a vengeance, pushing up prices for everything. But, a little partying until the endgame of hyperinflation arrives surely can’t hurt.