Small Cap Stocks

In 2009 it was very profitable to invest in garbage securities, including those of companies that are bankrupt. One of the best performers of the year was General Growth Properties (symbol: GGWPQ.PK), which has skyrocketed 1,000%+ on the back of investment hype propagated by long hedge fund managers, such as Ackman. Interestingly, in recent weeks other hedge fund managers, such as Hovde, have been publishing negative reports on General Growth, suggesting that the stock is most likely worthless post-bankruptcy.

The General Growth story had me looking for other bankrupt real estate related companies that could also ignite some interest with hedge funds. This has led me to CALC a residential home builder operating out of CA, and currently in bankruptcy proceedings. What caught my eye was that Hovde, the same fund that is short General Growth, and whose analyses of General Growth are downright negative in terms of real estate value, has been buying CALC stock in the open market. In addition, today the company was granted approval to continue to trade on Nasdaq, despite the bankruptcy proceedings. The outcome of the Nasdaq ruling suggests an emergence from bankruptcy late in the 1st quarter of 2010.

Needless to say, investing in bankrupt entities, like CALC, is extremely risky, so please do your own due diligence and don’t gamble what you can’t afford to lose. Incidentally, what has probably attracted Hovde to the shares of CALC is simply three things:
1. Unlike General Growth, CALC’s balance sheet and operating business are not in the least bit complex. The company is negotiating a mere $182 million in debt.
2. The company’s tangible book value at 9/30/09 stood at $3.75.
3. The company’s sales seemed to have bottomed. In fact during the last quarter the company saw a: “significant increase in sales orders during the last five weeks of the third quarter.”

The above three points suggest that it’s conceivable that CALC can (as many other real estate entities have recently done) negotiate a restructuring of the debt without much damage to equity shareholders. Importantly, investors (or should I say gamblers) in CALC’s stock should hear news in early 2010. If it’s positive, the stock could easily double.

Disclosure: Affiliates of Envoy Global Research, and its principals, own shares in CALC. All ideas, opinions, and/or forecasts, expressed or implied herein, are for informational purposes only and should not be construed as a recommendation to invest, trade, and/or speculate in the markets. Any investments, trades, and/or speculations made in light of the ideas, opinions, and/or forecasts, expressed or implied herein, are committed at your own risk, financial or otherwise.

Just want to wish all my readers a Happy Holiday and New Year.

2009 started out in a scary fashion. But, as Bernanke revved up the printing presses, the stock market took off.

If you’ve followed the picks on the site, you should have been up close to 100% this year, even if you are as risk-averse as me.

Risk-averse? Yes. Most people confuse investing in supposed speculative stocks of companies that are losing money with risky behavior. I hope I am slowly proving to you why this is a ridiculous notion. With solid research, a diversified portfolio of “speculative” stocks that are mostly losing money, are ignored by Wall Street, and are trading at multi-year lows are the least riskiest investments you can find anywhere. The devil, of course, is in the details. In 2010, I hope to spend some more posts on why investing in perceived garbage companies is really the only way you can really make alot of money in the Market. I’ll also devote more space to the topic of Loss Analysis (as opposed to Profit Analysis, which is the focus of nearly all funds). From my perspective, Loss Analysis is the key analytical tool for those looking to increase wealth via stock market investing.

As for 2010′s Stock Market, I don’t really have a clue. However, since I like to bet on reversals, as opposed to continuations of trends, I’d hazard to guess that unlike 2009, 2010 will start out strong and then the Market will succumb to a major correction.

The culprit? The Free Fed Money Train will slowly come to a halt. As zero risk financing for all sorts of real junk ceases, those with capital will hoard it for dear life, as there now remain few opportunities for investment that meet any sort of rational investment criteria.

The trick to winning in 2010, is the same as in prior years: Sell when you can, not when you have to. If you are constantly building up cash, you’ll have the capital to take advantage of the inevitable correction to bet again on turnarounds. And there always is a correction, usually when you least expect it.

If you’ve read my former post on healthcare, Health Insurance is a Misnomer you are sure to conclude that the current healthcare reform bill will reform nothing. In fact, it ensures a near certain escalation of health care costs in the coming years.

The reason is because by increasing the premiums to health insurance companies via subsidized health “insurance” for the uninsured (as opposed to a true public plan which sadly has been shelved), the overall financing available for health care will increase dramatically. As I mentioned, the availability of “financing” to private entities always increases prices of the underlying products/assets being financed. This is an economic law.

So, if you’re not afraid about inflation yet, you should now be very afraid. The government does a good job of keeping inflation in check for everything we don’t need to live, such as electronic gadgets. However, when it comes to things we all need to actually live, e.g. food, energy, health care, the sole intent of a government-controlled by big corporations and finance is to encourage inflation. Ironically, the government removes some of these critical items from the CPI! How this inflation is accomplished is subject for another post, but suffice to say, it is done thru the Fantasy of Finance.

Of course, I don’t have a clue how to best combat this inflation, especially in healthcare, since unfortunately it’s now clear that Obama and his team are hell bent on keeping the status quo for every damaging aspect of our economy. First it was the big bank casinos, and now the healthcare insurance clan. Both industries are totally broken and damaging to society, yet everything is being done to uphold and increase the power of these socially reprehensible institutions, while simultaneously richly (beyond imagination) rewarding the managers who run these companies.

OK enough politics. Now back to speculating in stocks, which incidentally remain the best way of increasing your capital above the rate of inflation.

If you cannot sustain big short-term losses, there is really no way to ever make money investing.

Markets are Unpredictable and Impossible to Time

The reason why you must sustain losses at first, is because both the Market and Business are entirely unpredictable. Even if you are completely correct right now in your evaluation of a business, unforeseen outside events, and bad luck are always conspiring to turn currently attractive investments into duds.

At the same time, when it comes to the Market, if you’re trying to make money, by definition, you must anticipate the Market. You cannot react to the Market. However, it’s impossible to know when the Market will pile into an investment driving up the price. In other words, despite the fact that your investment thesis is correct, it make take quite awhile for the Market to agree with your view, especially if you are somewhat of a noncomformist, which I consider a prerequisite character trait for any successful investor.

A Recent Example in PWER: Stock Falls 80% After I Recommend It, Only to Rebound 1,000% Thereafter
PWER provides an excellent example of the above investment advice. When I first wrote about PWER back in September 2008, the stock price was around $2. I correctly called attention to the company’s growing inverter business for the renewable energy industry, underlying cash-flow, and to a recent acquisition of a competitor. All three points, suggested that PWER was a solid investment. Nevertheless, despite the fact that I called the fundamentals of the company correctly, the stock price proceeded to plummet 80% after my recommendation, as the financial crisis unfolded.

Amazingly, however, a little over a year later, PWER’s shares have soared to $4.50, and analysts have falling over themselves to upgrade the shares, based on the company’s growing inverter business. Of course, I have no idea how PWER will perform going forward, but I find it fascinating that it took over a year for others to recognize the company’s potential. In case you are wondering, I didn’t have the fortitude to handle the steep decline in PWER’s price after my recommendation and I no longer hold the stock, having sold at a small loss. A combination of “Recency Bias” and Cognitive Dissonance, has kept me from getting back into the shares at much lower prices. Incidentally, my original write up, posited a $6.50 per share price target based on a relative valuation to Xantrex, a Canadian company that was acquired by Schneider Electric.

The Correct Strategy: Sell Winners and Buy Losers
I can provide many more examples like PWER from my investment life, but the important point remains, that if you are investing correctly you need to expect losses, sometimes large ones, before you make money. The key is to understand that if you are investing in situations that have low downside risk and high upside reward, in the long run, good luck will produce a few very big winners. However, in the short run anything can happen and does happen. You need to have deep pockets, patience, and alot of luck.

When you understand the above, it is clear that the advice given in many popular investment books, to cut losses quickly, set stop losses etc., is completely false and mainly sends money to your broker by inducing overtrading. In fact, I’d hazard to recommend that the best investment policy, assuming you’ve done your research carefully, is to sell your winners and double down on your losers. But, again, buying losers will only make sense if you’ve carefully considered all aspects of the company, especially the balance sheet, and you have some intellectual understanding for calculating the risk/reward of investments.

Following up on my last post concerning the relationship of the availability of financing and prices, I thought it would be a good idea to quickly review what finance is in the first place.

From my perspective all of finance, from the simple mortgage loan to the complex derivative, can be summarized in one simple sentence: Finance is the creation of capital today based upon the expectation of some future event(s).

In essence, in both personal and business situations, certain purchases are not currently affordable. Finance, however, makes these purchases possible by creating new capital out of nothing simply by reference to a future event. So for example, if the new factory can’t be paid for today, it’s not a problem. We will still create capital for it, on the assumption that future profits from the factory will cover today’s expense. The actual form of the capital, i.e. equity or debt, is not so important, and it could consist of any currency that has value in the eyes of the economic players.

The crucial discovery of modern-day financial capitalism is simply that this financial alchemy can be further enhanced by securitization, which simply means that the entity which originally creates the capital can sell it to another party, and that party to another, ad infinitum. Moreover, the original capital can even be split up between various parties. It is obvious that securities also must derive their current prices from future events, since the original contract which created the capital is completely based upon future expectations, so that any new buyer of this contract, must also have some future expectation if they are to pay to assume ownership of the contract.

Once one accepts the vital role that future expectations play in finance, two key ideas become evident.

Finance is Fantasy
Since future expectations are vital to finance, there is a fantasy aspect to finance. Finance does not deal in realities. It can’t because the future is unknown and virtually anything can and does happen in the future. As such, finance is completely reliant on creating believeable stories of the future. Basically whatever you can imagine and convincingly present as possible can be financed. Finance is infinite! This is why the Fed can create capital endlessly. If I owe $1 trillion, I just need to convincingly present a future scenario that justifies borrowing another $1 trillion. By simply hiring a bunch of clever bankers, it shouldn’t be too difficult. Bankers excel at creating new fantasies about the future. They are dreamers.

Finance Always Exaggerates the Future
Since the amount of capital that can be created is entirely based on the future, and since bankers/traders etc. are compensated based on the amount of capital they create today, finance incentivizes everyone in society to exaggerate the future to secure the largest amount of capital today. The bigger the story, the more money can be raised. It is not important whether the future is sufficiently probable or not, as long as it is believable.

Just in case, you didn’t think the above had anything to do with investing in the stock market, I’ll just throw this one idea out.

Companies that currently Lose Money are no less valuable, all things considered, than Those that Make Money.
Since Finance is about the future and consists in fantasies about the future, the present money-making capacity of a company remains irrelevant. It’s always the future profits of the business that determine the present value. Whether a company is making or losing money at the present time is completely meaningless. What is important is simply: What will the company do in the future? So a company losing $500 million a year, can in theory be worth more than a company than is earning $500 million a year, if future expectations of the money-losing business are such that it will generate larger profits in the future than the company that is already massively profitable.

Given the above, the game of investing in stocks is actually quite simple: Determine a believable story about future profits, and bet whether that story will gain traction with other investors. The extent of your profit in investing is simply based upon the credibility of your fantasy of future profits coupled with the amount of believers you are able to convert. In other words, investing profit is always a function of hype and timing.

Like nearly everyone else, I’ve been following the health insurance debate closely, even though I fear that the ultimate outcome is sure to be depressing for those with a moral conscience.

Health Care Insurance is Not Insurance

One thing that hit me today, though, is that health insurance is really a misnomer, since the intent of the vast majority of health insurance has really nothing to do with insurance.

The point of buying insurance is generally to protect yourself financially from a catastrophic event. But, health insurance is now nearly completely removed from the catastrophic angle, even though part of health insurance is surely still catastrophic in nature. Basically, because medical costs have risen dramatically, one buys health insurance simply so that one can afford essential medical services, that are not even in the least bit catastrophic. So, in reality health insurance is not insurance at all, but a method of financing the purchase of highly expensive (or better yet, highly inflated) medical services. It should really be called Health Financing, instead of health insurance.

When framed in this manner, one can clearly see how absurd the healthcare insurance industry really is. Why are we paying insurance companies up-front to finance basic medical services that we will surely need in the future? Health insurance should only be for catastrophic events. If it was purchased for catastrophic events, then undoubtedly health care insurance costs would drop dramatically. In no other area of finance are consumers or businesses forced to pay exorbitant up-front fees just for the right to get financing. Usually financing costs are equal to 1% of the transaction, if the transaction actually proceeds.

Why Are Health Care Costs Rising? Answer: Finance Disguised as Insurance

How then will one pay for basic medical services if health insurance is only purchased for catastrophic? This is a complicated question, but obviously there can be a much better financing mechanism, as there is for every other high-expense item in society.

More importantly, the financing of basic medical services begs the question of why medical service costs are escalating so rapidly in the first place that we need to finance these costs?

This again is a complex topic, but I’d hazard to say that health care costs are rising precisely because of the ridiculous nature of health insurance. In other words, health care premiums are not rising because health care costs are rising, but health care costs are rising because health care insurance premiums are rising. This may sound crazy, but if you’ve followed financial markets long enough, you’ve surely come to realize that prices are simply a function of the availability of financing. As financing becomes readily available, especially fraudulent financing as typified by certain mortgages and as exemplified by health care “insurance”, the underlying cost of the asset or product being financed ultimately rises dramatically for reasons that are too detailed to get into here. This is a basic law of finance that few will readily admit to, but is evident for all to see. For example, why have stock markets around the world risen 60%+ since March? The answer of course has nothing to do with the corporate earnings outlook, and everything to do with the availability of 0% financing from governments to large banks.

Eliminating the Financing Mechanism from Health Care Insurance Would Cut Costs Immediately

In considering the above, the obvious solution to spiraling health care costs is to immediately force insurance companies to offer only catastrophic insurance. This will eliminate the financing of basic medical services, which would in turn dramatically reduce the costs of basic medical services. This may sound simplistic, but I believe it to be accurate. With diminished financing, healthcare costs for basic services are bound to drop significantly. For those honest individuals who may be hurt by such a price drop, the government could step in to help during the transition.

Is this Solution Realistic? Not in a World Controlled by Finance
Of course, I realize that the solution above is not realistic, simply because our entire government is held hostage by big business and Finance. The sole intent of these parties is to increase prices as quickly and as steeply as possible. Sadly, therefore, any economic solution that attempts to decreases prices and increase affordability is bound to be dead on arrival. Always inflation, never deflation, is the mantra of our government and economic leaders. So a simple prediction can be formulated: As health care insurance companies continue to drink from the fountains of fraudulent finance, health care costs will continue to skyrocket with or without health care reform. Expect a doubling or more of health care premiums in the next decade, even though incomes will basically stay flat.

At some point, health care costs will bankrupt a majority of families in this country since it’s inconceivable to spend such a large percentage of pre-tax income on health care premiums and still have money to pay for other real living expenses. Of course, the bankruptcy of the population is quite beneficial for the government and for big business, since as the mortgage debacle shows, as economic troubles deepen the government redoubles its efforts to hand out free money to big business and big banks.