Posts Tagged ‘alternative investments’

Are Penny Stocks a Serious Investment?

One of my favorite pastimes is thumbing through the financials of public companies. Hidden gems do exist, but they are rare with the myriad analysts using serious computing power to scrub large firms daily. This is one of the reasons investing in an index fund makes so much sense.

There are good investments in the large company world. As I write, Apple Inc. has around $50 per share in cash in the checkbook. When you subtract cash the enterprise value is in the low teens. This is a good value from most perspectives. However, there are risks associated with Apple. First, it’s hard to move the needle on such a large company. Second, they manufacture a large part of their product in China. A quick glance at recent news and it becomes clear the risk involved. Third, each product launch needs to keep growing larger at a rapid pace to stay on top the pack. The one thing Apple has going for it is a large margin of safety.

The Wide Open World or the Wild West (You Decide)

Large international public corporations aren’t the only game in town. There is another world fraught with many risks and the promise of undiscovered gems worth many multiples of its listed price.

These quasi-public companies are followed by virtually no one. Worse, audited financial data is hard to find if available at all. And the biggest problem of all: insider trading.

People commonly call these unique animals penny stocks. They don’t always trade for pennies, but frequently trade under $5 per share.

These companies are listed on what is called the Pink Sheets, a throwback to the days when their quotes were printed daily on pink sheets of paper. Quotes were hard to come by in the past. Today, most of these companies can be pulled up from most online trading platforms (E*Trade, et cetera). One thing to remember, pink sheets is a quotation service only. Online brokers get their quotes for these stocks from that source.

The reasons for listing on the pink sheets are varied. A large number are outright scams. Others are companies who have fallen on hard times. Large international firms outside the U.S. sometimes opt to list on the pink sheets so they don’t have as heavy a reporting burden. Nestle is a prime example.

The world of small stocks isn’t littered with pump-and-dump scams only. Many small banks also list on the pink sheets. A small, one-branch bank in a small town in rural America has no chance of selling shares on the broader exchanges. The reporting requirements alone would be disruptive to their business model. The small bank can instead opt to list on the pink sheets. They will still report to the banking regulators and provide some financial statements on which to make an investment decision. Find a small one-branch bank near where you live and pay them a visit. Ask if they have stock you can buy. You might be surprised. They sometimes pay an attractive dividend.

A Round of Golf, Anyone?

Your favorite accountant has some experience buying stocks from the pink sheets. It doesn’t happen often because there is far more garbage then gemstone in the detritus. The smell tends to get on your hands and it doesn’t wash off worth a darn.

Outside tax season I like to waste an afternoon several times a year scouring the pink sheets based on geographical location of the listed company. The screener I linked also has OTC listings in addition to the pink sheets. I’ll let you play around with it on your own.

For our discussion we will focus on one stock I did buy in the early 2000s. I set the screen to list U.S. companies only. I started scrolling down the list looking for all listings in Wisconsin, my home state. I made a note of each Wisconsin listing.

My hopes weren’t high I would find anything of value. Even if a gemstone rose to the surface I may never recognize it. Remember, information is hard to come by on many of the companies.

One name jumped out. A golf course less than a two hour drive from my home caught my eye. I was vaguely familiar with the establishment and didn’t know they were listed.

This is where it gets risky legally. The golf course on my radar was interesting so I started a pet project of researching the company. They hadn’t published any financial information in quite a while. Intrigued, I decided to go one step further.

My first reaction to any pink sheet listing is to stand clear. Our friendly golf course just hit me right. Wanting to know more I took a day trip. I can’t golf worth a crap, but I do get more value than the average golfer because I get to swing more often than they do. The trip was all in the name of research.

The golf course was well kept when I arrived. The parking lot was full; the golf course teaming with old guys wasting their day; and the clubhouse was doing brisk business. I was excited!

My research to his point was similar to analysts using satellite data of Wal-Mart parking lots during the Christmas shopping season. There is nothing illegal about visiting a company whose stock you are considering for purchase. Having a drink and playing a round of golf (I did) is also acceptable behavior. No security laws have been broken.

However, I had to be careful! Since financial reports were not published in a while I couldn’t jawbone with the golf course’s accountant to glean information. It would have been risky to even jawbone with bartenders or anyone connected to the club. Trading on non-public information is called insider trading a very illegal!

The stock of the golf course traded around $3. Based upon their location (close to my home) and how busy they were when I visited, I decided to buy. I bought all my shares from slightly under $3 up to $4. Because of the risk I would hear something I shouldn’t I never visited again. I bought $30,000 of their stock over several months and sat on it. There was no dividend so it was one of those things I collected on the back shelf and didn’t think about for a long time.

Surprise!

A few years later I checked on the stock to discover it started climbing at a slow and steady pace. My $30,000 was worth six figures. I was happy! I also knew if I tried to dump my shares I would probably not get the current listed price.

I tucked the stock on the back shelf again. Intrigued, I periodically checked the price. It kept slowly climbing. About six years after my purchase the stock was in the mid 20s when it disappeared. Oh-oh!

My dreams were shattered. There were still no financial reports and a quick drive to the golf course showed they were still open. Was it a scam?

Nope! A few weeks later a check came in the mail. They were bought by another golf course for cash. My reward for six years of holding the stock was a 14x gain.

Before you run out and try to replicate my experience, know lightening has only struck once in my field. I got lucky. My luck was weighted in my favor by verifying the company was really there and viable. (They had customers!) I bought with a lot of blind faith. Every other pink sheet investment (there have only been a few) produced less than respectable returns.

The golf course was my biggest venture into the pink sheets. It was also a bet (you decide if I invested or gambled) I was willing to take because it looked like a nice place. All public information legal to trade on.

My other investments from the pink sheets and OTC markets usually involved banks. Returns were less than spectacular. In some cases I even lost money. In my defense I never took a flyer buying a true penny stock.

Where is the Respect?

Penny stocks in rare cases can be a respectable investment as my experience has shown. I do NOT encourage such investments! They are very risky and only for those willing to do some extra legwork without crossing the boundary between legal and insider trading. You also must be willing to lose 100% of your investment.

For some reason a few penny stock journals follow this blog and republish articles from time to time (always with permission). I wanted to share my one positive example so these guys have an article that will resonate with their readers.

For regulars around here, I still recommend the bulk of your money finding a home in a broad-based index fund. This is the best place for most people to invest long-term. If you have an itch to scratch digging for buried treasure the pink sheets and OTC markets have possibilities.

One caveat. You will spend a lot of time digging before any morsel reveals itself. It’s just the nature of the game. The good news is that Wall Street isn’t watching. You don’t have to compete with large hedge funds and the super-wealthy. The value of all pink sheet companies combine is around $1 billion. Too small for mainstream investments bankers to waste their time on.

Now, if we’re done here, I know a clean golf course where we can knock a couple balls around.

The Real Reason the Stock Market is Going Up

After nine years of steady growth in the economy and stock market both indicators have taken a sharp turn north. Economic stimulus in the form of tax cuts in an already good economy holds the possibility of destabilizing the whole economic structure.

There is ample concern over the staying power of the advancing stock market. Valuations are at or near record highs in all measures. All news seems to be good news. Predictions for future gains have reached nosebleed territory.

Investors need to know why the market is climbing so fast to protect their ass-ets. Those close to or in retirement need to take special precautions.

To accomplish the goal of explaining why the market is climbing I need to get technical. Numbers and charts have to be part of this discussion to understand why the economy and markets are behaving the way they are.

In the Beginning

A long time ago in a country close by there once was a housing bubble. The savings rate dropped to record lows while debt levels were growing more difficult to service. In 2007 the first cracks appeared under our feet and accelerated quickly.

Housing prices collapsed and the economy ground to a halt. There was real fear in the air. Many investors today have no idea what market fear means. Fortunes will be lost when the inexperienced get their first taste.

Congress passed several bills to protect failing banks. If not for these efforts we could have looked at an economic catastrophe similar to the early 1930s.

Fed’s Balance Sheet

Saving insurance companies, banks and car companies wasn’t enough to turn the economy around.

The Federal Reserve and central banks around the world dropped interest rates to zero or close to it without the intended results. The economy didn’t want to respond.

Some central banks experimented with negative interest rates. In the United States it came close. With exception for a few T-bills issued interest rates stayed a whisker above zero.

Draconian problems require draconian policies. The Federal Reserve started buying massive quantities of Treasuries (government debt). Normally the Fed buys and sells very short-dated T-bills in their effort to keep prices stable, employment full and adequate liquidity to keep the economy functioning smoothly.

Due to the high levels of purchases the Fed was making the purchases started to extend to longer-dated securities and mortgage backed securities.

The Fed’s balance sheet held $869 billion in assets on August 8, 2007. The balance now stands around $4.5 trillion. Yes, with a “T”.

Surprising Results

The Fed creates money as part of the debt process. When Congress spends more money than comes in from taxes the Fed can come in and buy some of those bonds and make a notation in their ledgers. This and the literal printing and coining of currency are how money is created. (I’ve greatly oversimplified the process of money creation. There are plenty of YouTube videos on the subject.)

Adding trillions to the Fed’s balance sheet (see Fed’s balance sheet chart) should have more than jump started the economy. Instead, all we got was an eventual crawl out of the Great Recession with modest, yet steady, economic growth.

Predictions were everywhere inflation would run rampant due to all this so-called money printing around the world. There was ample reason for the inflation fears. History is filled with instances where the money supply is increased significantly only to destroy the economy involved with uncontrollable increasing prices.

Why was this time different? There are no examples I can think of where this level of money creation didn’t cause an inflation shock.

Where Did All the Money Go?

With nearly $4 trillion added to the Fed’s balance sheet the economy should have boomed. In a way it did, but in a stealthy way.

Asset prices have been climbing. Housing in many parts of the country are at record highs. The stock market has added trillions to the net worth of investors.

Alternative investments sopped up some of the excess cash. Bitcoin is a good example.

But it wasn’t enough to account for all the “money creation”.

To understand what “should” have happened we need to look at some charts and explain some terminology.

There are different kinds of money in a way. The Fed tracks these types of money as M0, M1, M2 . . .

M0 is the currency and coins you hold in your wallet. M1 includes cash and checking accounts. M2 includes all of M1 plus bank CDs, money market accounts, mutual funds and bank savings accounts. Each higher level of “M” includes all of the previous categories of M plus increasingly less liquid assets. For our discussion we can stop at M2.

We also need to understand something called the velocity of money. Basically, the velocity of money is how many times money changes hands within a certain timeframe. Example: If all M0 changes hands eight times in the last year we say the velocity on this money was eight for M0.

There is also a multiplier effect when the Fed “creates” money. Banks are required to keep only a fraction of their deposits on hand while lending out the rest. This is called fractional banking and many people hate it with a passion declaring the downfall of Western civilization if it isn’t stopped.

Now that we have a few terms under our belt we can ask our original questions intelligently. Where did all the money go?

The short answer is all the extra money created by the Fed and central banks around the world stayed in bank vaults and at the central banks!

The necessity for increasing the money supply was to bail out faltering financial institutions! Banks had so many bad loans on their books they had to shore up their balance sheets so the Fed used various vehicles to get money onto their balance sheets so they appeared solvent.

Central banks around the planet also loaded up on sovereign debt, both domestic and foreign. Today, trillions of U.S debt is held by the central banks of foreign countries.

Who Moved My Money

The real reason the economic liftoff from the Great Recession was so slow was because the economic stimulus wasn’t as stimulating as it should have been.

With more money available than ever it sat quietly in bank vaults. Economic growth wasn’t fast enough to justify increased lending so banks kept their powder dry so the money never hit the broad economy. The slow trickle of funds into the “real” economy provided modest, yet steady, growth.

But even modest growth for long periods of time starts to add up. Unemployment dropped from double digits to four and change. Greed and distant memories of fear from the Great recession emboldened lawmakers.

Unsatisfied with modest growth they got greedy and wanted it all NOW! Tax rates were cut massively and the market was off to the races.

But there is an unspoken problem in the room. Remember all that money? To get it into the economy the Fed had to lower interest rates to zero for a very long time. If that money were to ever be unleashed into the marketplace bedlam could ensue!

And now banks for the first time in a long time see plenty of reasons to open the vaults and start pouring out the money. Fractional banking will do the rest.

Take a look at the charts for M1 and M2 money supply. M1 (currency and coins in your pocket) has climbed steeply from $1.4 trillion in late 2009 to over $3.6 trillion today. Cash and coins (literal money printing) more than doubled in eight years! The fractional banking system can convert this physical money into about five times as much additional digital money! M1 seems to be the main driver of the steady economic growth over the past decade.

Now look at the M2 money supply chart. The money supply rarely declines in the U.S. so don’t be alarmed by the upward sloping curve. M2 also grew rapidly since the Great Depression with just under a doubling in supply.

The money supply charts in and of themselves mean nothing. (Okay, they mean a lot. Just play with me a bit longer.)

Money supply is only one facet of the equation. How fast that money percolates through the economy also makes a difference.

Look at the M1 velocity of money chart. The number of times currency changed hands in a year declined heavily since the Great Recession. Some readers will find comfort we are back to numbers similar to the 1970s. Don’t be.

Part of the reason the M1 velocity of money changed over time is due to how we spend. We spend with our debit and credit cards so cash starts to move less leading the Fed to print less currency as a percentage of the total money supply.

As less actual currency exists it tends to move faster as we saw in the economic boom of the 1990s. M1 velocity declined since the Great Recession due to additional supply, potential hording and reluctance to spend over fear of returning economic hard times.

More current data suggest M1 velocity is starting to increase. (Sorry, no chart.)

Finally, look at the M2 velocity of money chart. When you look at CDs, mutual funds and other bank deposits the velocity of money (M2) hit lows since records were kept.

Now think of this. If all the money tucked away safe and sound is unleashed on the economy what do you think will happen? Regardless what you think the unleashing has begun!

The only way for the Fed to sop the excess money out of the system is to keep raising interest rates. It could take equally high rates to equalize the supply and demand of money as it took for low rates to kick-start the economy.

With unemployment near 4% it will be hard to fill positions created by the rapidly expanding economy. This will require wages to increase (a good thing) while forcing prices to climb in tandem (not as good as wage increases).

Higher inflation requires higher interest rates. The good old days of zero percent rates is about to disappear.

What Does This Mean for the Stock Market?

Equities are on a sugar high right now. Low interest rates and inflation coupled with growing profits is the perfect recipe for substantially higher stock prices. But we have a problem.

The stock market had a few hiccups this week as interest rates on the long end of the curve are rising sharply in anticipation of what I explained above. The Fed will have a hard time controlling the long dated Treasuries. Investors will sell until rates increase to a level commensurate with the inflation risk of their income stream.

The stock market is in for a rude awakening as well. The Goldilocks economy has been over-stimulated. And as with any drug overdose the other side is filled with pain.

Interest rates and inflation are still low. That can change fast. As the massive quantities of money finds its way into the general economy from bank vaults and as fractional banking multiples the effects, the economy is sure to grow in at least nominal terms. Inflation is sure to follow unless you think this time is different.

A mere 3% or so growth rate the President promises isn’t enough to deal with all the excess money. I played with the numbers (back of the envelope) calculating what would happen if money started to move like it did in the early 2000s and the banks started lending all the extra money they’ve been holding in reserve. I come up with a U.S. economy at least double the size it is now (~$20 trillion) to as much as $64 trillion.

These are staggering numbers requiring massive growth in the economy coupled with significant inflation. The Fed may have no choice soon to raise rates faster or risk losing control on prices.

The next few years are going to be interesting. The grand experiment undertaken during and after the Great Recession has another side, a side we are about to enter.

 

Why Does the Stock Market Tend to Struggle in High Interest/Inflation Environments?

Before we finish I want to outline why the market tends to have an initial upward thrust before falling sharply in environments similar to the one we are currently in.

There are two reason markets struggle with high inflation and interest rates. The first deals with value. Remember the definition of value creation:

ROIC – COC = V

where the return on invested capital exceeding the cost of capital equals value creation.

As the cost of capital increases fewer deals get done because they are less profitable than parking the money in a risk-free investment, generally Treasuries. Fewer deals mean less economic growth eventually until the economy cools and we wait until another generation of uninitiated makes their debut.

The second reason stocks suffer in high interest/high inflation environments is the quality of earnings. When inflation is low interest rates tend to be the same.

If a company is generating 10% profit growth steadily with zero inflation and increases their growth rate to 15% with say 7% inflation, the earnings are worth less.

Either way equities suffer. With the amount of money we know exists out there, what it takes to suck it out of the economy and with the likelihood the velocity of money returns to traditional levels, inflation issues are probable.

Any readers remember the 1970s and stagflation? I do. I was a wee tyke, but I remember.

 

There is a lot of money out there looking for a home, kind readers. When a portion settles into your account the only question will be: How much will it be worth?

 

Signs It Is Time to Sell an Investment: The Unfolding Lending Club Fiasco

23b65f55-97d0-408b-9215-14e47abb86fbI started investing in Prosper, the micro-lending platform where you can invest as little as $25 on a loan, back in June 2012. By investing a small portion in a large number of loans risk is spread out; no one loan going bad has an outsized effect on performance. I started withdrawing money after the returns plummeted after changes were made to the platform. Because it takes time to collect payments from loans held, it is an illiquid investment. My original investment of $13,400 is still worth $979 after withdrawing $15,430. Not great, but not bad either.

Before investing I did my research. I wanted to invest in Lending Club, but was unable to at the time because Wisconsin residents were not allowed. Prosper was my second choice so I took the plunge. Eventually I was able to invest in Lending Club, but because the rules were so easy to change (as I saw at Prosper) and the investment is illiquid I only added $5,000 to my Lending Club account.

When Lending Club went public I was allowed 200 shares of the IPO (I think, whatever the max was) at the IPO price. I sold within a day or so after it went public for a tidy profit. My opinion (and review of the financials) was investing in loans was better than the stock. My instinct served me well in hindsight.

I continued withdrawing money from Prosper, but did not continue adding to the Lending Club platform because I don’t like the way taxes are handled on these types of accounts. There were plans to have a post on The Wealthy Accountant promoting Lending Club as a viable alternative investment. Something in my gut held me back. I reviewed the financials of the company and tried to figure out how money ran through the system. Something did not make sense to me.

Then on May 6, 2016, Renaud Laplanche, Lending Club’s CEO, was forced to resign due to ethical issues. I did not need to see any more. My auto reinvesting of funds was discontinued and I started pulling my small investment from Lending Club too. So far I have suffered no lose of funds. I only withdrew $1,324 so far and my account value according to Lending Club is still worth around $5,190. Time will tell if I am made whole.

Where There Is Smoke There Is Fire

Rarely does one incident end the bloodletting. Laplanche is the face of the micro-lending industry and Lending Club. Some of the ethical issues reported did not pass the sniff test. There had to be more problems lurking below the surface. Bloomberg over the weekend had this report. You can read the lengthy details on your own. My worries were confirmed: where there is smoke there is fire. The stock price is down 80% from its IPO price and the possibility of the company failing is real.

Lending Club has always been a risky alternative investment best used by wealthy investors for a small portion of their portfolio. My maximum investment was $18,400 in micro-lending companies, plus the IPO stock investment I sold quickly after the stock started trading. I could afford to invest more, but I like to invest cautiously. I was always worried by the idea of super high interest rates charged borrowers, plus a loan origination fee. There had to be better alternatives for borrowers.

Greed caused me to invest in Lending Club as a lender. I justified my decision with the knowledge risk would be spread over hundreds of loans and that my investment was very small. I considered Lending Club as part of my mad money investment portfolio.*

Where to From Here?

The damage has been done to the tainted nascent industry. The stock probably continues down and I would not be surprised to see business failures in the industry. Adding money to a Lending Club investment account at this time is a bad idea in my opinion. (But what would I know; I’m only a wealthy accountant.) I encourage my clients to explore a different avenue for their alternative investment money. I am not bashful about telling clients I am withdrawing from Lending Club and Prosper and will continue until the accounts are depleted. I will not return to the industry for a very long time, if ever.

Lending Club is damaged goods. Too many ethical issues have cropped up for me to ever consider Lending Club again. My guess is this all ends badly for investors of the company stock. It is already down ~80%. How much more can it go down? All the way to zero, another 100% decline. No one knows what will really happen. We have seen this story play out before in the stock market. Those who leave the dance early fare best with rare exception.

Lenders on the platform also have risk. You can sell some of the loans you own, but I am not sure how good the secondary market operates since I never used it. The recent news probably has prices lower there too. The loans are illiquid. You only get money back as borrowers make payments. My feeling is lender accounts are secure from the company’s woes. I am personally withdrawing money as borrowers make payments, but will not sell notes. My risk is rather small at this time since I have been running for the door quickly since the first signs of smoke. If you have a large investment it might be worth considering some sales in the secondary market platform offered by Lending Club and Prosper.

Lessons Learned

The first lesson is to cut and run whenever there are ethics violations involving the CEO or CFO. It is the rare company that comes clean with all the ethical dirt in one disclosure; the board of directors probably doesn’t even know all the dirt and therefore can’t disclose it. Keep in mind this is different than non-ethical violations. An OWI/DWI charged against the CEO is different than an ethical violation. Ethical violations take a lot of digging to get the whole story. When you see smoke, cut tail and leave. You will save yourself a lot of pain and suffering later.

Lending Club, and Prosper to a lesser extent, was too good to be true. These companies offered double digit rates of interest in a negative interest rate world. This is distinctly different from investing in a business where returns on invested capital create value. Borrowing money to people paying 20% or more for personal spending is never a healthy investment. Readers here understand how important it is to spend less than you earn and saving half your income is the norm. I invested in people who spend well beyond their means and now it is time to pay the price for such a stupid decision. I was supporting bad financial decisions and I know better. It is only luck (or the grace of god) that will bail my ass out. I was lucky to start divesting early. Not everyone is as lucky.

Another lesson is always keeping the bulk of your money in broad based index funds. Index funds invest in the biggest and most successful enterprises on the planet. One or two companies might get in trouble, but the group as a whole will weather the storm better than most and do better in the long run. I understand each person needs a tailored investment plan. Traditional investments should comprise the bulk of your portfolio.

Excess risk means exactly that: excess risk. Lending Club was never a low risk venture. The stock’s continual decline after the initial jump after the IPO was a damning sign. Prosper’s declining opportunities and investor returns proved to be the canary in the mine. Don’t be surprised if Prosper and other companies in the industry also air out laundry. I am not accusing Prosper or any other micro-lender of malfeasance. What I am saying is some industry practices will come under greater scrutiny and probably will affect the industry adversely.

We can learn a lot from the currently unfolding Lending Club fiasco. If we learn our lesson and do not repeat the same mistakes we are all the better for it.

Special thanks to Pete at Mr. Money Mustache for tweeting the Bloomberg article, informing me of the latest issues at Lending Club. Pete is updating previous posts or providing a Lending Club update on his blog later this week.

 

* I keep around $100,000 in alternative investments as my mad money account. Sometimes I buy individual stocks I like after serious research. Currently my mad money account has a lot of cash. I said it was a mad money account, not a crazy money account. It is hard to find solid investments at current price levels. I still plow excess cash into index funds knowing full well the day will come when a correction arrives. However, cash never hurt anyone.