Buffett has famously said that he could make 50% returns per year on investments, but with one catch. He would have to have less than a million dollars to invest. I have written around this topic before. The advantage that small investors have over large investors and mutual funds is more opportunity. Our investing universe is much larger than  Buffett has  today. We can invest in microcaps and other less liquid stocks that wouldn’t move the needle for one of Berkshire Hathaway’s subsidiaries even if they could invest in sufficient quantities.

Before any one jumps in to defend Warren, as though the man needs a defense, I will state that because you have a larger investing universe does not mean you will have outsized returns, just that you have more opportunity to realize them.

Many of the advantages of a small investor are overlapping or intertwined. It is not always clear why a certain investment criteria yields better results over time. For example do small caps stocks perform better because of the liquidity premium or because they are not covered as widely by analysts. Both seem to have evidence supporting them.

Information disparity- Plenty of analysts cover  most large and mid cap stocks. For you to compete in the large cap investing universe you have to assume that either your analysis is better that professional analysts or that you see something they don’t see.  Both are possible, but probably not enough to get extraordinary returns.

Liquidity premium- Many investors avoid stock because they have low volume. But that is not always a problem, and in the case of a small investor, an advantage. For example, if you discover a stock that is $2.00 per share but only trades 1000 shares a day on average. If you need to buy 100,000 shares for it to effect your portfolio, there is a problem. It could take you a while to accumulate a position in the company without effecting the stock price in a way that undermines your investment. But for a small investor, a $1000 investment may be a significant portion of your portfolio so you you are not as effected by the low volume.  The limited liquidity then becomes an advantage since there will likely be a liquidity premium for owning a low volume stock.

Small Cap advantage- Studies have shown that investing in small caps over time can yield larger returns than large caps.

I think the normal response for most value investors to the shorting question is “No.” But is that really true? And if this question is not true then the title question becomes more important to answer in a value investing context. Whitney Tilson of T2 partners and co-founder of the Value Investing Congress uses shorting as a part of his investment tool set. I don’t think anyone would call Tilson a “speculator,” which is the usual label associated with shorting. He uses the value investing techniques of examining the financial statements of companies and setting a value on the company. He currently is shorting a basket of homebuilders. And in his latest letter to investors he discusses his best short position, recently, which is Inter Oil (IOC). The excellent blog Valuehuntr has also taken a short position in the same company. Valuehuntr’s position is based on the premise that IOC may be engaging in fraudulent behavior. If this is true then this could be another company that drops to the floor.  Both Tilson and Valuehuntr’s logic and analysis seem sound. But I am still not going to short. Why?

Because I am risk averse. There are aspects of shorting that concern me. First, what is shorting? The idea of shorting is that sometimes it makes sense to take a negative position in a company. Shorting is where you “borrow” the shares of a company from someone else, say your broker, and then you sell the shares in the market.  The proceeds are deposited to your account. A profit is made when you buy back the same shares at a lower price and return the shares to the entity that lent them to you.

So what are the risks of Short selling?

The first is the potential for extreme losses. The ordinary potential loss when buying the stock of a company is the amount you invested. If you invest $1000 buying 100 shares of XYZ company.  All you can lose is $1000 plus commissions. But when you short a company and the stock price goes up you can keep losing money until you exit the position. It is often referred to as the potential for unlimited losses. It isn’t of course. No company’s stock price continues to rise forever. But the losses can be extreme.

A risk related to this is the risk of margin call. That is when the stock price rises you will be asked to post additional collateral in your account to cover the loses. I never want to be a position for someone else to decide when it is a good time for me to invest more capital into a position. If the price move up is swift you may not have any choice.

The counter argument, of course, is that you can use stops to help prevent just such a scenario. This is true, sort of, but my experience is that stops work poorly in volatile markets like now. If there is an extreme price movement your stop may be triggered but the next price up could we much worse price for you than you would like.  Moreover, the stop could be triggered and then the share price retreats, but you have already covered your short and thus you have baked in your loss.

It is clear to me that short selling can play a role in a value investing strategy. After all no one expects every company to always go up. But is shorting the only way? Or are there better alternatives? In the next installment of this I will explore the world of options. While I have not yet fully developed a shorting strategy using options I will discuss some of the possibilities in the second part of this article.

I took an unexpected hiatus from writing my blog. If you emailed me in the last few weeks, my apologies for not responding, I will strive to resume my prompt reponses in the future.

First, the most important reason I have been absent: my wife gave birth to our first son on May 16th. The time that I would usually spend on my blog has been in part spent with my new child.

The second reason is that after six seasons “Lost” has finally come to an end. As some of you may know, I have had the great pleasure of working as a Producer on the show. The second reason I dropped off the face of the earth is that I was completing the finale. Until now, I did not feel it was appropriate to discuss what exactly my day job was, now that it is over I feel that I can. This will not be a forum for discussing “Lost,” it remains a place to explore investment ideas.

And we are living in interesting times for investors.

But for people like me, it brought a smile to my face.

Uh, What?

In the sea of red, I thought, wow, there are almost certainly some stocks that have dipped into the value terroritory again. Many small caps got punished way out of proportion to the overall market. That is one of the great things about investing in small cap stocks. Opportunity number 1 is the pool of possible investments just went up.

If you are scared about the long term prospect of a stock you own, don’t blame the market, perhaps you shouldn’t own it. Opportunity number 2 is re-evaluating your portfolio. We all make mistakes. The question is whether you would buy more of stocks that you own at a lower price. If not, again, it is a time to reexamine the choices you have made. Perhaps you have been too hasty in making stock selections. I have certainly done that.  I am reviewing all my positions. If I don’t think they are still great opportunities, and if they are below the price I purchased them, then I probably made a mistake. If I confirm that I like the investment, perhaps I should add to my position.

Market Drops are opportunities for finding value and reevaluating your positions. If you look you will find value. Happy hunting.

I will be posting irregularly for the next couple of weeks. I am working on the series finale  of a television series of I have been working on for years. Think of it as tax season for an accountant. I am slammed, but still looking for value.

Today as the market dropped over 2%, HAST dropped over 17% to exactly the price sold at last week. Regret comes and goes. I have moved on to other  investment prospects.

I do not recommend purchasing this stock anymore, since it has appreciated so much in the past two weeks. In fact it has come very close to my selling point. I did not get my order filled or I would have sold it today.

Here is why I purchased this stock

1. Piotroski F-score of 9 (out of a possible 9)

2. Net Current Asset Value of approximately $4.54/share (so, price was just under Net Current Asset Value.

3. Negative Asset Growth.

4. Altman Z score for non-Manufacturing companies 3.77

5. Price to Book .59

Strategy: Put in a limit order when it crosses 50% gain again, which it did earlier today, but my sell order did not get filled.

Disclosure: As of this posting I own 110 shares of HAST. I do not recommending buying them right now.

The first account I set up was the  Small Investor Portfolio. I started it with $2000. I will add $200/month to the account. It is meant to replicate what a beginning value investor or a value investor with a small amount of capital might be able to do on his own.  You can see the three stocks I have purchased for this portfolio already by looking at IFON, DUCK and ORXE.

This fund will be  primarily an asset valued portfolio relying heavily on Net Net stocks and other asset valuation strategies in the vein of Benjamin Graham. The stocks should have at least a 33% discount to Net Current Asset Value or some other Margin of Safety from intrinsic value.   I will create a spreadsheet to track the financial information that I glean from a companies financial statements. I will also read the latest 10k and 10Q’s looking for trouble or problems. Finally, I will do a little scuttlebutt research to see if I can see if there is a sig alert (for non Los Angelinos, that is when one or more lanes get shut down on a freeway) for the company. The Small Investor Portfolio will rely  heavily on analysis both quantitative and qualitative. I will take my cue mostly from asset valuation focused investors like Ben Graham and not from future earnings oriented investors like Warren Buffett. I will not be doing any Discounted Cash Flow analysis or looking for Owner’s Earnings growth. The strategy will be to identify these cigar butt, stocks that are discounted from their Intrinsic value and purchase them with a Margin of Safety. Unlike some other value investors I will include ADR (foreign stocks listed on an American exchange) and Penny stocks that trade on the Pink sheets or over the counter. The stocks should have a positive net income. The exceptions will be companies with positive operating income, with one time charges offs or discontinued operations. The other exception to positive Net Income will be biotech or pharma stocks with huge upside potential.  I will hold the stocks until I have reached the stocks intrinsic value or the circumstances surrounding the company change significantly enough to warrant a reevaluation of the company. If my estimation of the company’s value changes significantly in a negative manner, then I will sell the stock. In some cases I will utilize some special situation stocks in the manner outlined by Joel Greenblatt in his book You Can be a Stock Market Genius. I will explore these situations as they come up. And although ORXE was a NCAV stock, I consider it a special situation stock. With only $2000 to start, the small investor portfolio will be a Focused portfolio containing initially no more than 4 stocks. As the account grows with profits or the monthly capital additions I will expand this to at most 8 positions, and begin to increase the dollar amounts as the account grows. If the opportunity is there I will try to remain 80% invested at all times, retaining 20% in cash for new opportunities that come up, particularly if the market declines. If the Net Net and special situations dry up, I will stay in cash or reevaluate the investment strategy. This will be a long only portfolio. I will avoid financial stocks because I do not know how to evaluate their assets in a meaningful way.

The concept for the 80-20 investing portfolio is simple. Set up a few simple established value investing principles, make them stringent and then buy every stock that passes the criteria. So while the value investing criteria may be similar to the Small Investor Porfolio the strategy is not.  Some of these criteria  are concepts I have not yet covered in this blog, but I will post about them in the ensuing weeks. The criteria will include a combination of the following:

1. Price to Book ratio in the bottom 20% of stocks screened.

2. a Piotroski F score of 7 or better.

3. The annual growth in total assets should be in the lowest 20% of companies screened (currently negative double digit asset growth).

4. A passing score on the appropriate Altman Z score.That means above 3.o for Manufacturing companies and 2.6 for other companies.

5. Net Current Asset value equal to or greater than market cap.

6. Ratio of current P/E to 7-10 year P/E is less than 1.

7. Price to Sales ratio  less than 1.

There is no margin of safety per se. I think that by combing the different criteria that have been tested over the long term and then adding criteria that should minimize the down risk suck as Altman Z score, I am hoping that I have built in a margin of safety into the criteria itself.

In the future I will introduce a system for Hedging downside risk by using LEAPs or long term Asset Protected securities. This is the flip side to long positions. More about this in a future post. Thus this will be a long and short (although only using options) portfolio.

The strategy is buy as many of these positions as you can.  If I run out of cash, I will only replace a position in the portfolio with a better position. Since intrinsic value will be more difficult to calculate, I will hold the stock until the stock appreciates 50% and sell. If it declines or fails to meet my sell price I will sell at two years.

All the analysis has gone into the set-up. I will not be doing heavy analysis for this portfolio. In fact, apart from verifying that the company passes the criterias, I will do NO analysis. I will make sure that a company passes all the quantitative criteria and that is it. This will be a mechanical trading system in a similar to the magic formula investing strategy. Because I am expecting that more stocks will need to be purchased for this system to function, I have established the 80-20 Account with $5000. I will add $300/month to this account.

You might ask why I am not combining both criteria. It is simple. I am experimenting. There is some research that suggests that we are our own worst enemies in investing, that emotion, and poor decision processes will hinder our investment performance. I want to test these theories in a real and concrete way.  With 80-20 Investing I want to remove ego and emotion and see if it is possible to make money in a more simple way. Some of the Net Net companies don’t pass the risk thresholds I have set. But I am not sure that means that they are statistically worse investments. I am attempting to discover for myself what really works.

What is Duckwall – Alco? They are, what was originally called, a “dime” store. The first store was established in 1901 in Abilene, Kansas by A.L. Duckwall. The Alco stores began in 1968. From their fiscal 2009 10K, ” The Company’s overall business strategy involves identifying and opening stores in towns that will provide the Company with the highest return on investment.  This strategy includes opening ALCO stores. As of February 1, 2009, the Company operates 258 stores located in the central United States, consisting of 208 ALCO stores and 50 Duckwall stores.”

As always lets start with the risks of purchasing DUCK. This is NOT a list of all possible risks, just a list that struck me as significant. If you see risks that I have not mentioned, please post a comment.

1. Broad macro economic risk. This is really a risk for most businesses right now. I think it goes without saying, unless you are a firm believer we are already climbing out of a “V” shaped recession the economy faces some serious headwinds. I do not subscribe to the “V” shaped view. Another downturn could have adverse effects on the companies bottom line. I do not think we are out of the woods with regards to the housing crisis and unemployment is still very high and unlikely to drop significantly very soon. If you agree, then you should make sure you have an overall hedging strategy. But that is the subject of another posting.

2. The bulk of DUCK’s current assets are Inventory and the Inventory’s have been increasing while Sales have been stagnant for the past couple of years. While this does not mean they are in trouble it is certainly worth watching.

3. While the stock is a NCAV stock it does not have my usual 33% margin of safety. At my purchase price there is only  approximately a 25% discount to intrinsic net current asset value. This was my fault. When I filled out my initial spreadsheet for DUCK I used data from Morningstar. I always check the data and correct based on the latest 10k and 10Q before I buy a stock, because Morningstar’s data is so often wrong. I have posted about this problem previously. I thought I had taken this step. But I did not. So my calculation was based on the morningstar data of 3 million shares not the 3.798 million shares they actually have. Quite a rounding error on their part. But the ultimate responsibility of my mistake was mine. Now that I own the stock, I do not think the mistake was signigicant enough to warrant selling the stock immediately. But I will need to keep a close eye on the results they post on 4/16/10.

4. Liquidity. The average daily volume is only 3000 shares. I don’t consider this a great risk for small investors because the share price will keep the number of shares low enough to not move the price needle.

5. Management- Duckwall – Alco has recently hired a new CEO. I do not yet know if that is good, bad, or neutral.

Why invest in Duckwall – Alco?

1. Net Net stock. So with my mistake out in the open, let me run through the real numbers. I am estimating that their Net Current Asset Value is about $18.18/share. I purchased at $13.75/share which is about a 24.4% discount to intrinsic value.

2. No value is given to the company apart from its assets. But Duckwall – Alco  is a profitable, 100 year old business.

3. Growth Strategy. They plan  on opening new stores in smaller towns where there is no competition seems sound given the size of their average store which is approximately 26,000 square feet. It seems like niche without competition. Eventually this could translate to better margins.

4. Year over year increase in sales- This is not a very strong positive given that the comparison of last March was of a country jumping off a cliff. It would have been scary had they not posted better results.

5. Investing guru Michael Price owns 6.97% of the company. At least I am going against him in a short position.

What is my strategy?

This will depend. If Earnings have declined or their asset position has deteriorated I will sell and take my loss. If the company’s position is neutral or positive, I will hold to see if the company appreciates in value.

Disclosures: I am long DUCK. As with any investment decision you should do your own homework. I am not an investment advisor, but a film business Producer.

Here is what IFON says about themselves from their latest 10k

“We are one of the premier distributors and providers of wireless handsets and accessories in Central and South America. We provide end-to-end handset and wireless terminal solutions for carriers in those markets. We distribute products of original equipment manufacturers (OEMs), including Samsung and others. We are also involved in the designing, sourcing and distributing of a proprietary line of products under our own verykool® brand, which includes entry-level, mid-tier and high-end products.”

What that statement doesn’t say is that Infosonic, halted distribution in the United States and Mexico and that now it derives approximately 87% of their revenue from Argentina. That seems like a good segue to what could scare you away from making this investment.

So what are some of the risks of an investment in IFON? These are not all the risks. You may in your own risk assessment discover some that are more important to you. These are ones that I think are important to note.

1. A 30% tariff in Argentina targeting imported headsets could decimate IFON’s business there. Or as IFON says, “…we expect it will reduce significantly the overall OEM sales volume in Argentina. We believe that this tariff will have a material adverse effect on our sales, results of operations and prospects for our OEM products in Argentina. ” Given the proportion of overall business, this could have catastrophic results for  Infosonics. In fact the tariff has already begun to effect its business. “Our three largest customers in 2009, all carriers in South America, represented 28%, 28% and 18% of our net sales in fiscal 2009. In 2010, a customer accounting for 28%, has begun significantly reducing its purchases from us as a result of the newly enacted Argentina tariff on wireless handsets, among other electronic devices. ” This will certainly effect Infosonic’s margins. It does seem that much of this fear is baked into the current price of the stock given the drop from over $1.00 just a little more than two weeks ago. If you are interested, you may want to wait and see if the stock dips back into the low .60′s again before buying in.

2. This almost goes without saying, but the wireless communication business is a brutally competitive industry and IFON is a no-moat business. For some investor’s this is enough to scare you away. But most cigar butt type, Net Net stocks, are no, or thin moat companies.

3. IFON had a net loss in 2009 of $1.5 million. Ordinarily, this would get the company tossed to watchlist only pile, but since InfoSonics had positive income from continuing operations, I made an exception. This is probably also the other reason the stock price got flushed almost 40% in less than three weeks.

4. Stock Price Volatility. From their 10k, “the closing price of our common stock has fluctuated between $2.51 and $0.10 from January 1, 2009 through March 19, 2010, and we anticipate significant volatility in such price to continue for the foreseeable future.” This is not actually a risk to me. I expect and hope to capitalize on it. So, I obviously bought shares too early, but I bought on a day that in which the price dropped 20%. As the saying goes, it is hard to time the bottom of a market.

5. Margin pressure. I touched on this briefly in Risk #1, but IFON’s margin pressure is not limited to the Argentine tariff issues. As Infosonics says of its own performance, “… in 2008, although we had higher sales, we were not profitable due to lower gross margins, as well as, among other things, higher operating expenses.” In such a competitive industry, margin pressure is not a risk, it is a certainty. But that does not mean they will succumb.

6. Potential De-listing from NASDAQ. Obviously, the price of IFON is currently trading below the required $1.00/share price. If this persists then IFON could be delisted, which will almost certainly result in a drop in the share price, at least in the short run. Again, I don’t necessarily view this as a long term risk, since this would actually provide an opportunity to buy additional shares at an even better discount.

So after all these risks, why would anyone in their right mind buy this stock? Let’s turn next to the case for investment.

1. IFON is a NCAV stock. Their current assets are $66 million with total liabilities of $41.6 million. This means they have $24.4 of Net Current Asset Value. Divide that by the 14.577 million shares and you get a per share value of $1.67. Because I use the old school, as in Ben Graham depression era, margin of safety of 33%, that reduces my buy in price to anything under $1.10. Or if you like to use another, more conservative version of Net Net Valuation that I learned from Jae Jun at OldSchoolValue, you still have a buy price of approximately $.79/share. We could also assume that the company will lose another $1.5 million for 2010, but, even this would only reduce the buy price to $1.03/share from $1.10/share. There is a margin of safety on the margin of safety.

2. The Altman Z- non manufacturing score is over 2.6, which suggests that the likelihood of bankruptcy in the next two years is very unlikely. So while the company is certain to face some turbulence, I don’t think, in my suggested holding period of two years,  that the stock price will go to zero.

3. The CEO has a large stake in the company. As of the latest 10k, Joseph Ram, the CEO, owned 30% of the outstanding shares. While this is no guarantee of his interests aligning with shareholders, it often is.  I like to see large ownership stakes by management.

4. Continuing operations were positive. While IFON had a net loss the company was slightly profitable in continuing operations. This is a reverse from the past few years. I don’t put a lot of faith in this.

5. The company has recently completed a stock buy back program. While the amount $500,000 was not huge, the average purchase price of $.63/share (below its current share price) shows that management understand when it is a good time to buy its own shares. Often share buy backs are extremely negative to me. When the buyback is done at peak share price, the shareholders value is depleted. This buy back was positive for shareholders.

Investing Strategy

I don’t believe in making up a story of how IFON’s share price will rise. Stories often get in the way of proper valuation of a company.  There is not any immediate catalyst to drive the price up. But my overall strategy is borrowed from Ben Graham: Hold until it appreciates to fair value or 50% or 2 years, whichever happens first. In other words, if this stock has not appreciated within two years I will sell it. If it appreciates to fair value, I will sell it. The only other factor that may effect this is if I need to sell this stock because another better deal comes along.

Disclosures: I own 650 shares of IFON as mentioned earlier. If the price drops further I intend to purchase more shares, I may or may not post about this additional purchase, if it should happen. Remember only a fool would invest based on someone else’s advice without checking it out first. Please verify all information for yourself and do your own analysis before investing in any security.