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What investors can learn from the Madoff scandal

The lesson to be learned from one of the biggest frauds in history is simple, says this U.S. advisory — understand what you’re investing in.

Don’t talk to strangers. That’s a piece of advice most of us learn at a very young age.

And then forget altogether when it comes to investing.

But it’s one lesson that should be driven home by the antics of Mr. Bernard Madoff, says Mr. Max Bowser. A specialist in microcap stocks, the editor and publisher of The Bowser Report says investors need never be caught short of information.

Small investors were not Mr. Madoff’s prey, of course, but you don’t have to be a high roller to learn from the scandal that made some very wealthy people look like rubes at a travelling medicine show.

Mr. Bowser extracts several lessons from the Madoff story. Then he turns to a completely different topic — keeping a clean iPod. That’s the job of his Featured Company of the Month.

A classic Ponzi scheme

In case you haven’t seen a single financial news outlet over the past five weeks, $50 billion has gone missing since the exposure of Mr. Madoff’s hedge fund as a fraud — and a long-running one, at that.

It appears that little, if any of the money placed with the fund was actually invested in securities. Rather, money from new investors was used to pay double-digit returns to the earlier investors. A classic Ponzi, or pyramid scheme.

Of course not all the investors were talking to a stranger. A number were close friends of Mr. Madoff. Many other investors in the fund, including charitable organizations, thought they knew enough about Mr. Madoff to trust him.

But all broke one golden rule of belief. They failed to see that the promises made were far too good to be true. The returns trumpeted by the fund were unrealistically high — and now they’re gone for good.

They broke another golden rule, as well. They invested in something they didn’t really understand.

“If we had $1 billion to invest, we might have been tempted to go with Bernard Madoff,” says Mr. Bowser. We have only thousands, he adds. But you can still get in trouble with smaller amounts.

Smart with our bucks

We all want to be smart with our bucks, says the editor. “What can we learn from Bernie? (1) Don’t trust strangers. (2) Diversify.”

The most obvious case of dealing with strangers, in Mr. Bowser’s opinion, is the act of buying mutual funds.

“It turns out they make money in bull markets and lose it in bear markets,” he says rather dryly. “You can do that and avoid the manager’s fees.”

Nor is Mr. Madoff alone in running a Ponzi scheme. A certain Mr. Roy Fluker Jr. went to churches in the Chicago area promising them 25 per cent returns. A few actually got 25 per cent. “Most of the money went into Roy’s pockets, according to the prosecutor,” reports Mr. Bowser.

Promoting microcaps is “our racket,” says the editor, and “we think we can make a powerful case for them.” Other than the subscription fee, he tells his readers, “none of your dough will go through our fingers.”

Plenty of information

With $5,000, you can buy 10 different microcap stocks — 200 shares each of $2.50 stocks. And you know exactly what you’re buying.

“Transparency is the catchword today,” says Mr. Bowser. “There is plenty of information available on penny stocks, regardless of some say.”

True, unless the broker is your brother-in-law, you may be dealing with a stranger. But armed with your own knowledge of the stocks and the insuring of deposits and securities by the federal government (in Canada it’s down to provincial governments), you should be amply protected.

Recent surveys have shown that investors still opt for common stocks over other investments. And one of the advantages of common stocks, says the editor, is that you can get a handle on them.

Why are people reluctant to devote time to studying their investments? “So you have this situation, you spend your life making money, but you can’t devote two hours a week to safeguarding your kitty.”

Don’t be a stranger to your own portfolio, he insists.

Helicopter blades to iPods

Mr. Bowser’s featured stock is one whose science you may not fully grasp, but whose appeal is easy to understand.

Zagg Inc. (OTC-ZAGG) makes an invisible shield for handheld devices developed from protective film used on the blades of military helicopters. This film can be configured to fit the surface of electronic devices to protect them from wear and tear.

The film also allows touch sensitivity, so it can used for touchscreens. Unlike competing cases that take months to get to market, this shield can be configured and packaged for new devices quickly. Zagg doesn’t manufacture the shield itself, but has plenty of companies that turn them out at the rate of 59,000 a month.

The fastest-growing market for the shield is the iPod customer. The shield fits the device much easier than bulky traditional protectors. The patent on the shield is still pending, but that’s not holding up sales.

Zagg continues to expand its product line, the editor tells us, building up its business with Apple retailers. The company has a very clean balance sheet, with no debt. It is estimated that sales will reach $35 million in 2009, earning the firm 20¢ a share. The stock is currently trading at $0.99.

No matter how big or small the stock may be, investors are far better off knowing exactly what they’re buying. But lately it seems that those with enormous sums to invest will take any kind of candy from strangers, and pay the most ridiculous prices for it.