Escaping with an intact wallet
By Daniel M. Ryan
web posted February 25, 2008
Through a fortuitous coincidence, I saw the February 21st episode of Jim Cramer's show Mad Money, in which he spent the entire episode arguing for his viewers to stay in the stock market. His first means to avoid bailing out, fighting boredom through speculating, was supplemented by two others, but it was the technique that Mr. Cramer devoted the most time to.
Just to make things clear, the following tale is not about the kind of speculating that Mr. Cramer was advocating. He explicitly advised his viewers to avoid the market that I took a flyer in, the penny-stock market. To borrow his cogent phrase, penny stocks are "too expensive" when measured against the fundamentals. I want to emphasize this warning because, despite its cogency, it's a cautionary point that's likely to be forgotten. The penny stock market is still full of the same old dreams, some of which do not even tie in with the fortunes of the associated companies. Keep this in mind.
On November 7, 2007, I bought $1000 worth of a stock whose financials and prospects have to be seen to be believed. As of the time of this writing, its entire market cap is a little more than half a million Canadian dollars. That's right: if you have the price of an expensive Toronto house, and could persuade the current owners to sell at about the current market price, you could pick up the entire company and take it private. Yes, the entire company. Through a $1000 play, I owned almost 0.1% of the entire company at the price I paid. (Those with calculator acumen will figure out that the share price has declined subsequently. If I could plunk down $1000 in its shares at the Feb. 22nd bid price, I would end up owning 0.2% of the company. )
This company is listed on a relatively new creation of the TSX Venture Exchange, the "NEX Board." The NEX is earmarked for companies that have failed to meet the minimum requirements of the TSX Venture exchange, or occasionally the TSX itself. (Inflazyme Pharmaceuticals is one of the few companies that got shot down from the TSX straight to the NEX Board.) Typically, the reason why companies end up being listed there are because they no longer have any source of revenue other than interest on any money in their treasury. In Exchange jargon, they're "inactive companies."
They also provide mute confirmation of Mr. Cramer's epigram. Small losses per share are the norm, as maintenance expenses are no longer balanced by revenues. Many of the issues listed on the NEX "feature" a fundamental weak point that's all-but-impossible to find on any other exchange: negative book value. I've read quite a few interim quarterlies of NEX-listed issues with liabilities greater than assets, with accumulated deficits greater than the paid-up capital. The company whose shares I bought was one of them.
It doesn't show an encouraging picture, does it? Based on the above, it would seem almost a certainty that I would walk away with a huge loss. I can confirm this first impression by disclosing that, for most of the time I held the stock, I was in the hole. Excluding commissions, I had a 25%-50% loss for most of the time I held it. In addition, I hobbled my own performance by making a couple of mistakes: ignoring seasonal patterns and the more obvious mistake that Mr. Cramer warned against near the end of that episode – using a market order to buy in.
The first mistake is one that a naïve trader can almost be expected to make. When we buy things in the regular marketplace, we expect to get something in exchange immediately –the good or service itself, or a receipt for it. This Main Street habituation leads to a bad habit when punting: paying the asking price in order to get your hands on the stock with the same immediacy. This kind of impatience is a classic neophyte's mistake, and often hooks experienced market players. In fact, it's a mistake that neophyte participants that are also long-time observers are especially prone to; mistakes such as this one explain why a trading consultant is often better at third-party advice than at running his or her own account. The skill of self-control is different from the skill of market reading.
For a thinly-traded stock, there's a further temptation that inclines the newbie plunger towards buying at the ask, perhaps after a test bid at a cheaper price: the hope that hitting the ask will goose the stock into an uptrend. I have to admit that my own trader's vanity was sufficiently bloated to entertain the delusion that my own (small) order would have the effect of sparking an uptrend. Needless to say, it didn't.
In fact, had I substituted patience for vanity, I would have gotten a lot more shares for the same amount of money, and shaved the time I had spent holding a loss position. Accordingly, I offer this lesson to punters: Even in an illiquid market in a very small stock, your order will not affect the stock's price unless it's a very big one relative to its liquidity. If so, then the effect is likely to be temporary, and will be to your detriment. A huge buy order means a huge increase in demand, which pushes up the price you'll have to pay. A huge sell order means a supply bloat, which pushes your proceeds down. These implications of one of the most basic laws of economics will never vanish. When buying or selling stocks, pushiness costs. It's patience that's rewarded.
The second mistake I made was ignoring seasonality. The company in question is a would-be gold explorer. Like many shares of this type, it tends to be dormant during winter. As exploration becomes more internationalized, of course, the underlying reason for this seasonality becomes less and less relevant. Nevertheless, the pattern is still there. I ignored it, and ended up buying in several months before any credible rally emerged.
Of course, many industries have no seasonal pattern – or, if they do, the time element is profoundly irregular and thus unpredictable. The only way to cope with missing seasonality is to plunk down less than your total stash in the hope of buying more later, at a cheaper price. This technique is known as "averaging down."
It's a risky technique, and one that will likely induce a lot of anxiety. The stock market is ruled by expectations, and it's one of the most efficient discounting mechanisms around. Consequently, a stock whose price has dropped significantly can be warning of future trouble to come for the underlying company. Averaging down basically assumes the opposite: that the price will bounce back. Hence its riskiness.
Had I averaged down, I would have shaved the cost per share on that stock – significantly. In my case, the dollar amount I had at my disposal was so small as to make this decision a non-issue. In addition to the $1000, I had to put out $43 in commission. My splitting up the purchase into two allotments of $500 would have meant paying two $43 commissions. So, averaging down was impracticable for me at that point, as it is for any punter with a very small amount to deploy.
Based upon the above, I would seem to be quite the hapless fellow. Buying with a market order, having my hands tied by putting my entire savings into a single high-risk stock, not getting a grip on my emotions – I would seem to be a sure loser in search of a drubbing. All of my monthly statements until I sold the shares did show me in a loss position.
Nevertheless, I have on my desk a confirmation which shows a $1207 credit for the same shares that I bought at $1043. My profit, factoring in commissions, was $164. Annualized for the fourteen weeks and a day between purchase and sale, the yearly rate profit looks mightily impressive. (Less so is the fact that the dollar amount is less than I paid for food during that period – and I eat cheap.) Despite my neophytic haplessness, how did I do it?
Here's what I did right:
- Sizing up the stock and underlying company correctly. This was not a speculative stock. For an inactive company, what passes for "speculation" is Hopes & Dreams. This kind of company is too risky for speculation. It's actually a trader's stock.
- Designing a strategy that fits the stock. If it's a trading stock, then there's only one kind of relevant information: how it's trading. The appropriate research for this one was its trades. By "trades," I mean raw trading data: the number of shares and the price of each share for each trade. For a trading stock, the charts are too diffuse – too obscurative.
- Ignoring the irrelevant, after sizing up what is "irrelevant" for the stock in question. With a stock like the one I bought and sold, speculative anticipations about the company (no matter how exciting) were irrelevant. The only relevant fundamentals-related data would have been hard news about the company – the announcement of a deal or its bankruptcy, for example. Common sense said that most of its boosters are people who already hold it, and the detractors are those who have lost as a result of them holding it. I found it interesting to read the associated opinions, but I ignored them as forecasting or assessment tools.
- Committing to sell, through an explicit sell order at a specified price, long before the sell date. This step requires a certain control over your emotions, as well as keeping quiet. An unexecuted sell order costs you nothing if it expires; the only associated disutility is disappointment. The best way to minimize that disutility is to keep quiet about the order, leaving you with no crow to eat should your order expire worthless. Such a technique comes into its own with a thinly-traded stock because all of the sells at a certain price are executed on a "first come, first served" basis. Even if you jump to the phone or your computer when the rally you expect has developed, you're still at the back of the line once your order's been placed. Exciting stocks generate long line-ups on the sell side as well as on the buy side. The only way to "jump the queue" is to lower the price – and even then, it's a hop from one queue to another.
- Being comfortable with "panicking at a profit" when selling. I could count this as a mistake, as I managed to more than halve my profit through lowering my sell price just before the sale. Had I been patient as a seller, I would have made more than $400. Nevertheless, the riskiness of the stock all-but-mandated a quick exit. Had I not jumped from one sellers' queue to another, I may have not sold it at all. At the time, I had sensed that the rally was brittle – and it was: had I not sold, I'd still be riding a big loss. Shaving the profit through panic selling into a rally is also useful for later emotional control – fighting the "pig within." I left a profit for the other fellow. Doing so was good for my regret control.
The above rules are derived from trading a trader's stock, one that's far below the standards for a reasonable speculation. Thus, they're largely trader's rules, and might not transfer very well to more reasonable plunges. Nevertheless, they encapsulate a largely undiscussed part of speculation: trading technique. They should provide a subsidiary benefit for more reasonable speculators, ones who really cannot descend to the low-level technique of reading trading records. 
Daniel M. Ryan is a regular columnist for LewRockwell.com, and has an undamaged mail address here.