The Tycoon Report

Stock Pricing, Financial Newsletters, and Pump-and-Dump Schemes

I just finished reading Ken Fischer’s latest book entitled, “The only three questions that matter”. In case you don’t know who Fischer is, go the Forbes 400 list of the wealthiest individuals in America. This is not a reason to recommend the book in itself as Jim Cramer so enthusiastic does. Instead, the reason the book is so refreshing is Ken is that rare investor who thinks for himself and tries to teach his Forbes column reader to do likewise. It’s the old adage, “give a man a fish and he’ll be right back at you for another fish, but teach him to fish, and you’ll get a little snooze time”, or something like that! You might not like Jim Cramer but he is right when he opins that “reading this book might be the very best thing you can do to improve as an investor”. (I personally find Jim to be both very funny and have a lot of good investment ideas-he’s definitely manic when it comes to stocks!)

Ken Fischer’s book explodes many market myths such as high trade or governmental deficits are bad for capital markets, that high P/E stocks are less likely to increase in price than low “value” stocks etc. In the future, I’ll blog on my thoughts on some of these topics and how they affect my investment style and current investment hypothesis, but now I just want to discuss the most burning issue for neophyte investors: why do stocks increase or decrease in value and what is a fair value for a stock?

Here’s the answer: supply and demand (for stocks, of course!) Now you know in theory how to price stocks and evaluate claims of newsletter writers regarding the relative merits of a stock they may be “pumping”. Just construct the supply and demand curves and where they intersect is the current, fair market price of the stock. I know what you’re probably thinking, this is utterly true and completely worthless information. But stay with me here and maybe you’ll learn something new.

What influences the price of a stock? Simple, like any commodity its just how many sellers there are on a given day compared to how many buyers. More sellers than buyers, the price goes down, vice-versa and it goes up. (A lot simpler, more boring and true than headlines that read, “market down on credit crunch fears”, or “market rallies on positive unemployment figures”)

Consider a simple analogy: Let’s say you bake and sell bread. One day there’s a line going around the block at your bakery and you only made the usual amount of bread. So, you decide to raise the price of your bread 10%. So, you’ve made a nice extra 10% profit. If you were selling shares in your bakery you could also charge more for these shares (about 10%) and your stock price (the derivative in this case) would increase with the underlying commodity (the bread). You’ve raised your bread price and literally made more bread (O.K., bad pun).

The next day, you decide to make a lot more bread since making both more bread and charging more for it really helps your bottom line. Unfortunately, some of the people who bought bread the previous day are tired of your bread and the others have enough for a few days. So, you hire a newsletter writer to advertise how your bread is now the hottest (fresh out of the oven) bread in town. You’re pumping up the price of your bread as well as the derivative (the stock). And for you sophisticates, the secondary derivative, an option to buy your bread stock in the future. Also you’ve pumped the price of the tertiary-an option on an option to buy your stock on the future. O.K. this fictional “financial instrument” doesn’t yet exist, but it will in the future if there’s a buck to be made by investment banks, and there probably is.

Unfortunately, your success has now encouraged other bread producers to ramp up their supply and lower their prices, so your bread stock goes down. Its simple, too many sellers and not enough buyers. You respond by diversifying into rolls or buying out your competitors using your now higher priced stock. Etc., Ad Naseum.

So, now you, gentle reader, completely understand how to evaluate a stock price: it’s what the market is willing to pay on a given day! So-called technical or fundamental analysis are often after-the-fact rationalizations of a stock price, not the reason for the stock price! This is very important to understand, so you don’t take umbrage when your favorite holding is decreasing in value. Also, it will help you understand why news headlines such as “Mr. Market is fickle today and doesn’t like metals, utilities, etc. you name it” are very silly, even foolish statements.

What are some of the things driving stock supply?

1) Investor psychology or “market sentiment”. Think things like the market fears a credit crunch which causes borrowing to build more ovens (for your bread) to be more costly.

2)The amount of stock you issue. If you give all your employees lots of free options you’re diluting the share price. If some other bread producer does the same or does an IPO to raise capital there suddenly is an excess supply in the “bread sector” stock on the market. (This is why there was too much “supply” of dot.com stocks circa 2000 and thus the price crashed) If you issue more stock to raise funds since you couldn’t borrow using debt (those damn greedy thoughtless mortgage lenders (and borrowers!) have ruined it for us honest bread makers!), you’ve also dampened demand and thus what the buyers will be willing to pay for your stock. After all, with all this new bread stock floating around why should they pay 10% premium?

3)You can lower the supply of stock (and likely increase its price) by buying it back. You use your excess cash flow to buy up your stock, lowering the float, which yields a nice return of E/P% at the current P/E. You further decrease retail stock supply by encouraging more of your insiders to buy their company stock and they do. Taking your firm private is the ultimate way to lower stock supply and if a lot of companies do this guess which way the market or sector will move? Shipping is a good example, most of this sector is entirely private companies. So, knowing this, do you think the few public shippers will go up relative to the market? Shippers also have some other nice supply/demand ratios in their control.

4)Hedge funds and other large institutional investors recently got a lot of redemption requests and pending lawsuits as a result of some bad, highly leveraged bets on collateralized debt obligations (CDOs). These CDOs, upon closer examination, turned out to have some bad collateral (subprime loans) and they can’t dump these since there are no buyers (there is no market!). So, they have to “dump” a lot of “good” stocks with excellent cash flow and good margins to get liquid. (An excellent buying opportunity for those investors like myself who wisely remained somewhat liquid during the recent “boom”. This subsequent buying ramps these babies up to pre-fire-sale levels in a few weeks-very predictable and profitable)

What are some of the things driving stock demand?

1)Your bread uses only “organic ingredients” not available to other bread makers, a rumor, (your may have started), suggests your bread is blessed by the pope, and so is priced at a premium (think Apple Iphone, Ipod), so your margins and profits are larger. Your competitors have lousy bread that’s always crashing and is constantly being recalled (think Microsoft).

2)Your bread stock is considered a “premium” stock and people like Paul Newman have revealed recently they have large holdings, so a high P/E is more than justified, thinks Mr Market. (Gurus like Warren Buffet, George Soros, Renaissance Hedge fund have just revealed they now love bread stocks and the railroads which will have to ship all this new bread)

3)People have noticed your bread stock has been going up steadily and want to join the trend for “unlimited profits”. So, these “momentum” investors, who can read a chart and understand a 50 day moving average as well as anyone, hop on the bandwagon, further increasing demand and pushing the price up.

4) A lot of foolish people decided to borrow shares of your bread stock from their broker and with the stock moving up in price due to your buyback program the cost of their purchasing the shares to return to the broker keeps going up and they’re starting to panic as margin calls start coming in from their worried broker. This “short squeeze” leads to more demand and buying of your stock moving the price up further, squeezing out even the “calm” short sellers.

Dump and Pump Schemes:

Anyone who has signed up for a “free” newsletter and given their email has been inundated with advertisements for the latest revolutionary “hot stock”. These are usually lighted traded over-the-counter or pink sheet stocks priced in the $1-5 range to encourage buying by retail investors. (Notice how companies like GE and Microsoft never seem to get pumped?) Typical “suggested” gains are in the hundreds to thousands of % in some very short time frame.

Continuing our analogy with this scheme. Your bread stock has a small float (number of outstanding shares) and isn’t very liquid (you might have trouble “dumping” it for a tidy profit), but this is the reason you’ve hired a newsletter and started an email and print ad campaign to encourage suckers/investors to buy this equity right now (so you don’t miss out on potential 1000% profits). As the company founder you hold a lot of this worthless enterprise that you started (you actually don’t own any ovens since you used your free cash flow to pay for the pump and dump scheme advertising cost). Your “business plan” consists of unloading your stock, (and you can always issue more), on unsuspecting investors who didn’t do elementary due diligence.

These paid advertisers are so considerate to inform you of this huge profit possibility since your financial well being is paramount to them even though they don’t know you from Jack, along with their obvious concerns which include elimination of world hunger and that nice Mediterranean villa they’ve wanted to buy.

How to check out these flim-flam schemes and select the useful, educational services (like this one) from the detritus flooding your inbox? Go to say, Yahoo finance, and bring up the data on the equity being pumped. Look at the capitalization, free cash flow, debt to equity ratio, revenue, price/sales ratio, and the chart (see charts are useful for back testing). If it fluctuates up and down madly with no real trend and their claims of outrageous 300% on previous picks cited by the newsletter don’t match (or only match in a miraculous 30 day period requiring insider information for correct market timing), relegate these newsletter to your Spam box, since you’ve got better things to do with your time. Every once in a while you’ll discover a service that seeks both to educate and entertain. Stick with it.