E-mail this article Printer-Friendly

Three simple questions for the average investor

No matter how complicated insiders try to make the market seem, says this U.S. advisory, the average investor can still outsmart them.

Today we find an editor who thinks he’s falling in love. The object of his affection is a writer, or at least that writer’s ideas. Because she’s sticking up for the average investor.

Mr. Max Bowser, editor of The Bowser Report, is a small cap specialist who writes for small investors. “We get so emotional when we discover anyone saying anything good about Mr. Six Pack buying stocks himself.” In this case, Ms. Janet Paskin, writing in Smart Money, has very good things to say.

Individuals can do well buying stocks for themselves, she says. They have become a lot savvier. The investment community must respond to the average investor, whose knowledge of the markets is distinctly above average these days.

Mr. Bowser runs with her argument. He breaks it down into a few simple questions for individuals — and a few howling mistakes that the pros have been making. Mr. and Ms. Six Pack, he suggests, are well aware that the market is not as complicated as many insiders make it out to be.

They call it financial engineering

“The investment industry seems to be intent upon making the business of buying and selling stocks a very complicated affair,” he says. “They’re trying to make it a profession akin to medicine, chemistry, the law, etc. They call it financial engineering.”

Yet investing in the stock market is quite simple. When you’re looking at a stock, there are just three questions you need to ask:

1) Is the company profitable?
2) If it hasn’t made money in the past, why hasn’t it?
3) Is the firm a business that has the prospect for growth?

There is also an obsession with risk, says Mr. Bowser, “with the result that the industry goes into distortions trying to eliminate that aspect.” But there is always risk when you buy a stock, he reasons. The company may make bad decisions. Management may not keep up with changes in the industry.

A theory that doesn’t work

The problem is that the pros’ attempts to deal with risk haven’t been all that brilliant. He cites the Black-Scholes theory of portfolio insurance developed by two University of California at Berkeley professors, Dr. Fischer Black and Dr. Myron Scholes (who’s from Timmins, Ontario by the way). It hasn’t worked yet. Mr. Bowser quotes Mr. Michael Lewis, writing in Portfolio magazine:

“Put simply, Black-Scholes is based on the assumption that a trader can suck all of the risk out of a market by taking a short position as the market falls, thus protecting against losses, no matter how steep.

“In every financial disaster where it has been tested, including the current subprime mortgage mess, Black-Scholes has not worked since it was put into practice in the 1980s … When a market is crashing and no one is willing to buy, it’s impossible to sell short. If too many investors are trying to unload stocks as the market falls, they create the very disaster they are trying to avoid.”

This in turn means that all those fancy instruments created to defer risk — CDOs, SIVs, interest rate swaps and the like — are worthless in times of crisis, the very time they’re supposed to come to the rescue.

He adds one more example. This one comes from an actual case where interest-rate swaps went wrong. Interest-rate swaps are a derivative of bonds, says the editor, and this is how they fouled things up in Jefferson County, Alabama, where the city of Birmingham is located.

Bankruptcy and kickbacks

County officials raised $5 billion in municipal bonds for improvements. When they were issued, interest rates hovered between 3 and 4 per cent and the rate swap (really a form of insurance) was supposed to keep rates from going higher than those levels.

But the credit crisis triggered by the subprime mortgage drained all the financial backing from the interest-rate swaps. The result: the county is now paying 6 to 10 per cent on its bonds. It also owes $200 million it can’t pay, taxpayers are paying more for water and sewage, and the county may face bankruptcy. Just for good measure, the mayor is being investigated for a little matter of kickbacks in the interest-rate swaps.

In short, the derivatives didn’t do the job they were supposed to do, but they sure opened up opportunities for inside dealing. Unhappily, the same epitaph can be written for many, many derivatives.

Bangles and beads

We’ll conclude with a look at a small stock that average investors can make up their own minds about. Mr. Bowser’s Company of the Month has a rather unique function. It supplies equipment to the decorated apparel industry. If you see clothes with beads or other such embellishments on them, he says, chances that it was done on a machine from Hirsch International Corp. (NASDQ-HRSH).

The company is 40 years old and has been selling equipment made by one Japanese company for 30 years. Now it is branching out and making additional arrangements with other firms, like an Austrian group that makes screen-printing equipment and an Italian company that specializes in laser application equipment.

In addition to a steady stream of machines, parts and accessories, Hirsch distributes software that simplifies the work of embriodery.

Mr. Bowser has one reservation about Hirsch. Unlike most of the stocks he likes, it pays what he believes is excessive compensation to its executives. But he admits “it can be argued that they have earned the money by turning the company around.” They have built “a profitable marketing machine in a rather mundane industry.”

Sales were down a little last year, but income exploded, increasing by an astonishing 1,694 per cent from the year before! Obviously, says Mr. Bowser, this company concentrates on profits. It trades at $2.09.

A small American stock like this may or may not be your cup of tea (or six-pack). But the moral of this editor’s story is that you’re better off making up your own mind, instead of relying on the help of higher-ups in the industry. In fact, the more tangled up they get in their derivatives, the smarter it looks to do your own thinking.