The Poor Investor – Investigatory Value Investing

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The Paradox of Penny Stock Investing

A lot of investors keep a portion of their portfolios for speculating in the stock market, often referred to as “fun money” by many.  This percentage generally ranges from 1-5% of an investor’s portfolio.  This is the portion of a portfolio that you’d use to bet on stocks that usually have more potential than actual substance; this often times means betting on penny stocks or stocks trading on the OTC market or pink sheets.  Keeping a portion of your portfolio dedicated to this endeavor is like having a release valve for your portfolio.  Many investors may find it to be quite cathartic.  It should be noted, however, that this is not for everyone.  You still have to remain extremely disciplined and, in a sense, compartmentalize the speculative portion of your portfolio to some extent.

Now, you’re not going to read about how to invest speculatively in “The Intelligent Investor” or “One Up on Wall Street,” two of my favorite books, as you might recall from this post.  However, this does not mean that speculative investing shouldn’t be part of your portfolio and shouldn’t be taken just as seriously as your overall investing philosophy.  A sound philosophy should be developed for the “fun money” portion as well.  The goal, just as with the larger portion of the portfolio, should be to minimize risk.  Just because you are speculating with this small part of your portfolio doesn’t mean you want to lose the money any more than you normally would.

There are many types of ways to speculate in the stock market but generally I tend to think of this as focusing on stocks at the low range of the micro cap world, or penny stocks (those interested in options trading, commodities, currency speculation, and other activities such as these should look elsewhere).  These are companies usually trading for a market cap less than $100 million.  Although these stocks should be analyzed just like other stocks in your portfolio there are several particular areas you really need to go over using a fine-toothed comb:

  • Legitimacy
  • Management
  • Growth

The first portion is business legitimacy.  This means that you should be scouring the SEC (or other) filings of the company and looking for any red flags.  It means that you should be evaluating the company as if you were going to start working there the next day.  If you wouldn’t work there, you wouldn’t want to buy the company, surely.  This means you should be asking questions like:

  • Has this company been around for at least 3 years?
  • Does the product/technology/business make sense?
  • Does the company keep issuing shares only to line executives’ pockets and dilute existing shareholders?
  • Is there an inordinate amount of outstanding shares?
  • How is the company financing itself?
  • Does the company carry too much debt?
  • Do insiders own a large portion of the company?
  • How does the company treat its employees?
  • Is the company hiring a lot of new employees?
  • Does the company have reputable partners or do business with those of high repute?
  • Does the company provide sufficient information/transparency to its shareholders?
  • Are the small shareholders valued?

This is by no means an exhaustive list.  But questions along these lines should be asked and the answers you get to them should make you feel comfortable.  If you don’t find an answer you like, find out why and see if it makes sense.  If you find too many red flags in this portion of the process, don’t even move on to next examination step, just move on to the next company.

The next portion is management.  Many times with small companies it’s good to see management that has been around since the company’s inception.  It’s not necessarily a red flag if they haven’t, or the green light if they have, but as a general rule of thumb this should be the case.  Lots of times, with small companies, you can actually call the management and ask questions that concern you.  When speaking to the management try to get a sense of whether or not these are people you can trust.  You should ask yourself several questions after speaking to management:

  • Are they open to honest inquiry?
  • Do they evade or avoid certain questions?
  • Do the answers they give make sense?
  • Do the answers correlate with what you’ve read about the company?
  • Does what they say actually pan out? (wait a bit and see if what is said comes to fruition)

Other factors to consider when looking into the management of such companies are:

  • Have they invested their time, money, blood, sweat, and tears into the company?
  • Do they own a lot of the stock so that they eat their own cooking?
  • What are their credentials?
  • Are they accountable to anyone?
  • What is the track record of management, especially the CEO?
  • Is there sufficient diversity on the management team and BOD?

Again, this is not an exhaustive list, but gets you thinking along the lines you need to be thinking when looking into more speculative companies.  Act like you are a detective looking for any signs or hints of fraud and steer clear when things start to smell funny.

In the back of your head, you should have already considered the growth prospects of the company in question or it wouldn’t have even be worth looking into in the first place.  However, it should be noted that many micro cap or penny stock companies might look like good growth opportunities but the growth could actually be very limited.  For instance, the company could be in an extremely high growth market such as biotech or pharmaceuticals, but markets such as these mean that competition is going to make it very difficult for the company to actually succeed.  This means that the growth prospects should be tremendous (if you’re going to speculate, don’t speculate with a company that’s going to hit a home-run,  instead, think multiple grand slams).  Some aspects of growth you might want to look into are:

  • What are the odds of market penetration?
  • Are the competitive advantages big enough and sustainable?
  • Does the company have multiple patents? How solid are the patents?
  • Are there large partners aiding the company’s growth/penetration?
  • Does the company operate in a niche market within the growing market?
  • How does the company plan on funding growth?
  • Does the company have an expansion plan in place so that it can grow successfully?
  • If growth/market penetration has been proven already, how likely is it to continue?

Once again, this is not an exhaustive list, but how you should be thinking about the growth of the company.  Also, you should be comfortable with the answers to these questions and any other questions you decide are pertinent.  Above all, don’t make excuses for the company!  If you get answers that don’t jive with you, move on.

Last but not least, try to attend at least one shareholder meeting of the company.  This will give you a chance to get up-close and personal with management as well as bounce questions off of other shareholders.

A good example of an interesting speculation from my portfolio is Natcore Technology, a solar company headquartered in New Jersey.  While I won’t go into laborious detail about the company and how it fits the criteria mentioned above, I will mention some highlights.   The company was founded in 2009 when it bought out a company of the same name— thus clearing my 3-year hurdle.  The company trades on the TSX Venture exchange, a very well-regulated exchange, in Canada and the company reports regularly.  The company is headed by Chuck Provini, a former US Marine and graduate from the US Naval Academy.  He has at least 19 military decorations, was a captain in the Vietnam War, and has lived his whole life in the United States.  The rest of his bio can be found here.  The CEO has been very forthright with shareholders and encourages shareholders to call him if they have any questions.  He even issues regular statements via the Natcore website.  And, although he is surrounded by several other individuals with pretty extended resumes, the one that stands out the most is Dennis Flood.  Dennis Flood is the CTO of the company and has worked in the solar industry for over 30 years.  He worked at NASA where he developed photovoltaic power systems for space and planetary missions.  A more extensive bio is seen below:

“He received two Special Act or Service Awards from NASA for his pioneering work on advanced solar cells for space applications and for research that established the feasibility of powering a human outpost on the surface of Mars with solar energy.

Flood also served as chair of the IEEE Electron Device Society’s (EDS) photovoltaic device technical committee for seven years and as a member of the IEEE EDS education committee. He also participated in the EDS’s Distinguished Lecturer Series, a position he held for more than a decade.
He is a member of the international advisory committees of the European, the U.S, the Japan/Asia and the World Photovoltaic Conference organizing committees.

He is an inventor or co-inventor on several patents or patent applications in photovoltaics and nanotechnology and has over 100 peer-reviewed publications and presentations in solar energy, electron devices and materials science.”

Source: PV-Tech.org

Natcore has several patents.  It has also been granted a license to use the Department of Energy’s black silicon technology.  This allows more light to be absorbed so that solar cells are more efficient.  However, the patent which holds the most promise is the company’s Liquid Phase Deposition technology.  You can read more about this technology and the benefits here, but in a nutshell, this technology allows the company to manufacture solar cells at a much lower cost than they are currently being manufactured.  Combine that with the company’s latest selective emitter technology and the cost is further reduced.

The CEO explains the company’s technology here.

The company’s technology is breakthrough, to say the least.  It could completely change the solar industry.  If you research the company some more you’ll see a myriad of great accomplishments.  So, you might be wondering, with so many “great things” going on, why is this company speculative?   Well, the company has yet to generate any revenue.  It is still working on commercializing the technology and proving the cost benefits of the technology.  The company has reached several milestones and has been making forward progress but it has nothing to sell as of yet.  Although it is working on what it calls the “AR-BOX” as its first commercialization effort, it is not ready for commercialization yet.  So questions remain.  Will the company prove that its product is commercially viable?  When will it be ready?  Will the company produce significant enough revenue with large enough margins if/when the product is ready?  Will the market adopt the product even if the company does prove it?  Several more questions like this remain.  That’s why this is speculative.  There is nothing to go off of except for future hopes and dreams of revenue.  Although the company has been marching towards that territory, there is nothing to sink your teeth into as an investor to figure out what the margin of safety is here.  This is why a small percentage of my portfolio is dedicated to this type of investing.

At the end of the day, many investors should avoid speculating.  It can be tempting to get carried away and not keep the speculative portion of the portfolio below 1-5% and sell when the speculate portion rises well above this point (assuming you adopt the 1-5% strategy).  Investors often ride a speculative investment up just to ride it back down again.  There is often times more discipline involved in speculation than there is with regular investing and many investors have enough trouble maintaining discipline with their regular strategies.  So, this is only for the bold, disciplined, and cautious investor.  It almost sounds like a paradox, being disciplined to be speculative, but it’s impossible to be successful at speculation without the discipline.  Otherwise, your “fun money” will be “dumb money,” which defeats the whole purpose of allocating a portion of your portfolio to speculation in the first place.  You might as well just cash out 1-5% of your portfolio a year and burn the money if you aren’t going to follow a disciplined approach.

Disclosure: Long NXT.V

The Investing Book You Haven’t Read

As a do-it-yourself investor, I love to read investing books. However, there are only a few books that have really had great educational value, the rest were merely entertainment.

Here are the books which have helped me the most:

  1. One Up on Wall Street, by Peter Lynch
  2. The Intelligent Investor, by Benjamin Graham
  3. Poor Charlie’s Almanack, by Charles Munger
  4. Common Stocks and Uncommon Profits, by Phil Fisher
  5. What Works on Wall Street, by James O’Shaughnessy
  6. See below.

Most of these books you’ve probably heard of or read yourself. If you haven’t read them, I suggest you do if you plan on investing on your own. However, there’s one more book (6) that also goes on this list that most people haven’t read. This book, in my opinion, is essential to the go-it-alone investor. The book is called “100 to 1 in the Stock Market,” by Thomas Phelps. The only problem is the book is out of print and hard to find. Your best bet is borrowing it from your local library.

Thomas Phelps offers some good advice as to what to look for when trying to find a 100- to-1 investment:

  1. Inventions that enable us to do things we have always wanted to do but could never do before. 
  2. New methods or new equipment that helps people do commonplace things easier, faster or at less cost than ever before.
  3. Processes or equipment to improve or maintain the quality of a service while reducing or eliminating the labor required.
  4. New and cheaper sources of energy.
  5. New methods of doing essential jobs with less or no ecological damage.
  6. Improved methods or equipment for recycling the materials used by civilized man instead of making mountains of waste and oceans of sewage.
  7. New methods for delivering the morning newspaper without carriers or waste.
  8. New methods or equipment for transporting people and goods on land without wheels.

He even gives 365 examples of 100-to-1 stocks (from 1932-1971) which could have turned $10,000 into $1,000,000 if bought right and held tight.  Some of  the more familiar of these include:

  • J.C. Penney Co.
  • Deere & Co.
  • Abbott Laboratories
  • Dr. Pepper
  • Lockheed
  • Greyhound Corp.
  • Philip Morris
  • Merck & Co.
  • Goodyear Tire & Rubber
  • Motorola
  • International Business Machines
  • Johnson & Johnson

These stocks all gained at least 100x their original value and some obviously much more.

Let’s say you decided to invest using Mr. Phelps’ method using $10,000 (+any additional money for fees).  Furthermore, say you decide to devote a year to trying to uncover 25 stocks which you thought fit the bill as 100-to-1 type companies.  After this, you divide your money equally into the 25, buying $400 of each company, and hold them for 20 years.  If you only identified 3 out of 25 stocks that went 100-to-1, and say the rest went to zero, even factoring in that year you were looking for the stock, you would have a compound annual growth rate of 12.56%, and $120,000.

Here is the CAGR for identifying 1 out of 25 to 10 out of 25:

  1. 6.82%
  2. 10.41%
  3. 12.56%
  4. 14.11%
  5. 15.33%
  6. 16.34%
  7. 17.20%
  8. 17.94%
  9. 18.61%
  10. 19.20%

Even identifying 2 out of 25 is nothing to scoff at, which beats the average S&P 500 return, including dividends, by ~1%.  Not to mention, this method does not include the dividends you might gain from the companies you invest in.

This method, just like any other, is not fool-proof—and although I don’t know the odds, common sense tells me that they are heavily stacked against you in trying to find 100-to-1 type companies.  Keeping that in mind, I leave you with a parable Mr. Phelps shares with us in the beginning of his book:

“Ask and It Shall Be Given to You”

Five poor Arabs slept on the sand. A bright light woke them. Out of it came an angel.
“Each of you can have one wish,” the angel said.
“Praise be to Allah,” exulted the first Arab to catch his breath. “Give me a donkey.”
Instantly a donkey stood at his side.
“Fool,” thought the second Arab. “He should have asked for more.”
“Give me 10 donkeys,” the second Arab begged.
No sooner said than done. He had ten donkeys.
The third Arab had heard and seen how the first two had fared.
“To Allah all things are possible,” he said. “Give me a caravan with a hundred camels, a hundred donkeys, tents, rugs, food, wine, and servants.”
They came so fast that the third Arab was ashamed to be seen in his rags before such an entourage. But his shame did not last long. Deftly his servants dressed him in robes befitting his new status.
The fourth Arab was more than ready when his turn came.
“Make me a king,” he commanded.
So quickly did the crown appear on his head that he bruised his knuckles from scratching where an instant before there had been nothing but an itch. The palace gardens stretched out before him almost as far as the eye could see, and the palace turrets reached so high their pennants were lost in the desert haze.
Having seen his companions in misery ask too little, the fifth Arab resolved to make no such mistake.
“Make me Allah!” he ordered.
In a flash he found himself in sand, covered with leprous sores.

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