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.

The first order of business will be to find a good discount online broker. The good news is that a few of the big name brokers have lowered their fees or commissions recently, making them more competitive, and enlarging the pool of potential brokers. The bad news is that it is a cumbersome process to wade through all the detail of a broker’s website to discover if they have hidden fees or surcharges. I have created a comparison chart called Best Online Broker for Small Investors and Penny stocks, which you can download or see below. This is not a comprehensive list of all brokers. Any company with a commission of greater than $10/trade was eliminated.

In the spirit of Buffett, who is said to look at the risk of an investment first,  I want to mention, briefly, the notion of capital risk because a brokerage companies goes bankrupt or pulls a Madoff. We all know that in a traditional bank account the Federal Deposit Insurance Corporation (FDIC) insures our accounts up to $250,000 per depositor, per bank.  This is not a permanent state of affairs, and is set to reset to $100,000 per depositor per bank in 2014. As the FDIC says on their website,  the “FDIC insurance is backed by the full faith and credit of the United States government. Since the FDIC began operation in 1934, no depositor has ever lost a penny of FDIC-insured deposits.” Of course, those in Nassim Taleb camp might argue, the FDIC does not make bank deposits risk free, but the guarantee does minimize the risk. The situation with securities is not quite as clear cut.

For stocks, the Securities Investor Protection Corporation (SIPC) is in charge. They have a brochure which you can download called SIPC English 2009. I suggest you read this or go to their website to truly understand what your capital risk is with regard to a broker failing.  The high school student version of it is this: the SIPC doesn’t insure an investor against loss. This should be self evident. If you are investing in the stock market you know that you could lose your money, that you have an expectation of risk. The SIPC doesn’t help you avoid the risk. If your stocks decline in value, you will not get a check from the SIPC. But here is what the SIPC does say, “…(the) SIPC replaces missing stocks and other securities where it is possible to do so … even when the investments have increased in value.

SIPC does not cover individuals who are sold worthless stocks and other securities. SIPC helps individuals whose money, stocks and other securities are stolen by a broker or put at risk when a brokerage fails for other reasons.” The SIPC guarantees up to $500,000 per customer, including $100,000 in cash. But the broker MUST be a SIPC member for the investor to be protected. For the small investor we are covered for the time being. But this raises concerns for person’s nearing retirement with large IRA’s. The viability of a firm is vital. As with diversifing bank deposits with different banks to mitigate risk, this suggests that over the long term one should have more than one retirement account if possible and at different brokerage firms. This is a subject for a future post. As of this posting I have confirmed that all brokers listed are members of SIPC. Before you open an account you should check and ensure they still are.

Let me spell out my criteria for best online broker. This will differ, perhaps significantly, from other blogs or websites. What may be right for you, if you have a larger portfolio  or if you eschew penny stocks, could look completely different. This is by no means a definitive list, but it should suffice for the Chroma Investing Small Investor Portfolio. You will note that I go into some detail here, because the brokers are quite adept at hiding some fees behind a cute little asterisk. Also, commissions and fees change often. I was surprised how different some companies are since last year at this time when I went through a similar process. My apologies in advance if I missed your favorite broker. Some I eliminated for price, others for minimum deposit requirements.

1) I looked primarily for value in stock trading commissions. The intention is to have little or no mutual funds, ETF’s or bonds traded in this portfolio. That does not mean they are not worth investing, simply that that is not the focus of this investing account. Consequently, factors that effect those type of investments have been  ignored.

2) The total brokerage costs including commission & fees will need to be low, under $10/trade especially for Penny Stocks. There will need to be no or additional charges for buying penny  or OTC stocks. There are lots of companies with value hiding in 99 cent store of investing, I would hate to miss them because my broker charged too much to trade them.

3) No inactivity or maintenance fees.

4) unlimited shares in a trade without additional fees. This is another way that brokers attempt to limit penny stock  purchases. A stock trading at .25/share will require 4000 shares to invest $1000.

5) I will not include a comparison of margin account rates because I intend not to employ leverage of any kind.  This means  I will also not factor in options or contract prices.

6) I am assuming we will be placing all our orders online directly, with no broker assisted trades.

7) Since short term interest rates are effectively zero, I will not bother comparing interest rates, if any, that cash earns in a sweep account (although I may reconsider and update later, if this factor changes)

You may also want to include a No-IRA fee in your criteria. For the purposes of this blog I will not. But for me personally, in my IRA’s I include this as important screen to minimize expenses.

I will discuss size of positions in another post. But one of the tricks in investing with a small portfolio is not getting killed by the fees. If you expect to have a total of 3-4 positions in the portfolio, at least in the beginning, each $500 invested will have a 1% purchase fee with a $5.00 commission and 1% exit fee. The result is that you must make 2% just to break even. That is not an onerous hurdle. Let’s say we changed that to just $10/trade. Our total is then 4% to buy and sell a stock. That is, I think in the new normal era, perhaps too high a price to saddle yourself with. Of course, we have to balance commissions with other fees, particularly extra charges for Penny  or OTC stocks.

So let’s jump in and evaluate. First, I will screen out companies for various criteria, then discuss all that passing companies. Later I will give a quick comment on each company.

From this chart I can eliminate a few companies right away simply based on price. E*Trade, TD Ameritrade, & ThinkorSwim all charge $9.95. Think or swim had other negative  factors which I detail below.

OptionsHouse, Scott Trade, SogoTrade & Tradeking (my favorite broker) are eliminated because they have Penny stock charges.

That leaves Charles Schwab, Choice Trade, Fidelity, Just2Trade, TradeMonster & Zecco. Fidelity and Just2Trade have too large a minimum balance requirement, so they are out. For investors, starting with larger sum in their investment portfolio, this arbitrary cut off may not apply. Of the remaining four companies two had IRA fees, Choice Trade, and Zecco, so if that is an important factor to you. Think twice. For the Chroma Investing Small Investor Portfolio it is not.

On an absolute price perspective you would have to narrow the choice down to ChoiceTrade or Zecco, at $5.00 and $4.50 per trade respectively. But finding the best broker isn’t only about price.

O.k. so what I haven’t mentioned, because it is so hard to judge, is what is offered for this price and how customer service is when things don’t work out as expected. This is qualitative area where stats don’t tell the whole story. Before I decide between these two brokers, I would like to hear from you. Do you have any experience with either ChoiceTrade or Zecco? Tomorrow I will call both and get a sense of their customer service. Then I will make a decision. I will post soon where I decide to open the account. Maybe I will open accounts at both and see what the process is like, before I fund the account.

Below are my thoughts on the companies on the  comparison chart.

Charles Schwab- The original discount broker. In recent years their prices have not been competitive with other online discount brokers, that seems to have changed this year. They are a surprise late addition, because they have recently (Jan. 2010) lowered their per trade fee form$12.95, eliminated the number of shares that would be allowed per trade without additional fees. Schwab has banking options, including checking accounts.

Choice Trade- I had not heard of them until I started my research on discount brokers.  Two things intrigued me. First, their overall good price and Second, they are offering a $50 bonus if you add a margin account and open your account for $2000. That is a quick 2.5% gain on my money.  They are not a good choice if this was an IRA account because of the IRA fee.

E*Trade- I was surprised they made the initial cut, that is under $10. But ultimately they would be to costly for our tiny trading account.

Fidelity- Last year trades cost over $10. This is perhaps the biggest surprise. I have read about some complaints with their trading tools, but are supposed to have a lot of free research available on more than 4500 corporations.

Just2Trade- Their low, low per commission rate would be partially offset by their IRA fee for some investors. Their reputation, however, sucks. The longest complaint I read on any forum about any broker was about Just2Trade. If you believe that poster, they could not get anything right. Two things concerned me most. First, their customer service is not great. Second their cash balances are often inaccurate.

OptionsHouse- Another low priced commission house, seemed initially promising with their $2.95 commission, but their Penny stock surcharge begins below $2.00 and is $0.005/share. Moreover, anything over 50,000 share requires a separate over and brokerage commission.

Scott Trade- I have spoken to several investors who have been happy with Scott Trade and their moderately price $7.00 trade. Their commercials at least garner attention. But Scott Trade is a terrible choice for Penny stock investors. They charge 0.5% of the value of the purchase for Penny stocks. Even on a $500 investment that adds $2.50 and makes them uncompetitive.

Sogotrade- I heard negative things about Sogotrade even before I decided to include them in the comparison. But their price of $2.95 begged inclusion. Unfortunately, they also have 0.5% charge on Penny stocks, and frequent complaints about their their online trading platform.

TDAmeritrade- Another large brokerage company that recently dropped their commission to $9.95/trade. Much better deal are possible with you are frequent trader. Eliminated for price.

Think or Swim – I have used Thinkorswim for more than a year. They are eliminated for two reasons, First they limit their $9.95/trade fixed rate to 5000 shares, above that you pay a per share fee, and Second, I hate their web based interface. It is the least intuitive I have seen. It is shocking to me anyone likes it. I feel like I am transported back to the days of early DOS, where nothing made sense.

TradeKing- A solid company, with great customer service and good reasonable $4.95 commission. Unfortunately, for the purposes of the small investor portfolio the Penny Stock Charges forces their elimination.

TradeMonster- The most promising of all the brokers I never heard of. While their $7.50 commission is higher than I like, it has no Penny stock charges, shifting the balance in its favor. The interface allows all tools to be used in Paper Trading, making this a very interesting choice for a small investor who is also a beginner. The ideal Chroma Investing reader.

Zecco- The price you can’t deny. $4.50/trade. If you are a frequent trader or have $25,000 in assets you get 10 free trades/month. On the plus side Zecco has virtual trading and FOREX trading. On the negative side they have a yearly IRA fee and on some forums some complaints about customer service. Perhaps the service is getting better.

Disclosure: I currently have accounts with TradeKing and ThinkorSwim, but do not have a financial relationship with any brokerage company including any not listed in my comparison. Although based on my research I intend to move my thinkorswim account.

It is my intention to start an investing account with just $2000. The reason for this is that it is an amount of money that one could save in a year with less than $200/month. I will add $200/month to the account to mirror what a small investor might be able to do. $2000 is also an amount that you may have on hand, saved from not buying a Starbucks latte every day for a couple of years. O.k., lets not get that extreme. Like all the investments detailed on this website, all trades will be real money, so all gains or losses will be actual and reported on this blog. I will call this the Chroma Investing Small Investor Portfolio.

An account of this size will allow you to hold 3 or 4 equity positions and thus to have a focused value oriented portfolio. Starting with a small amount will also force a certain amount of discipline in buying. Knowing in advance that you will initially only be able to hold 3-4 positions will focus our attention on the quality of the investments to make sure that we are making only the best investment decisions.

The investing philosophy will be straight forward: value investing with an emphasis on NCAV and other deeply discounted asset plays, special situation investments, or other empirically supported value investing approaches, all with an emphasis on maintaining a margin of safety and keeping an eye on understanding the investment risks inherent to each company. I will concentrate on small and micro cap companies, where the smallness of our portfolio is actually an advantage over big money investors. I will look for the best value, and not shy away from Penny Stocks, if that is where the value leads. My intention is to avoid leverage, and any investment involving margins, including options and futures. It is possible in the future that I will develop a value approach that looks at investing against the market or an individual company if I can satisfy myself that such a strategy can be made in a beneficial risk/reward scenario. As with every other investment on this blog, the research will be self directed and no investment will be made with out checking the financials and analysis myself. You should do no less with your investments.

I do not intend to invest in mutual funds, ETF’s or bonds. Nor will their be any speculation on commodities, currency or other other bets outside of my ken.

Tomorrow I will begin the search for the best online broker for this account.

I think he gets investment risk better than any one. I will quote two passages, the first lays it out, “Modern risk management is a farce; it is pseudoscience of the worst kind. The idea that the risk of an investment, or indeed, a portfolio of investments can be reduced to a single number is utter madness. In essence, the problem with risk management is that is assumes that volatility equals risk. Nothing could be further from the truth.”

The second is where he talks about his trinty of risk which I would like to devote a whole post to in the near future, “…I don’t think of risk as a number, but rather as a permanent impairment of capital (as Ben Graham put it). Now that permanent impairment can be generated by three potential sources (which aren’t mutually exclusive). Firstly, there is valuation risk – you can simply overpay for an asset. Secondly, there is fundamental or business risk – something goes wrong with the underlying economics of the asset. Thirdly, financing risk or leverage (which no matter how hard you try can’t make a bad investment good, but can make a good investment bad).

I’m not sure that any of them is easier or trickier to monitor. I think you to consider all three aspects in order to gain a holistic view.”

Enjoy the first part of the interview.

Where did I go wrong?

1) TGAL was losing money. For some reason I ignored this factor. I have made exceptions in the past, but that was for start up bio tech or Pharma companies that were Net Net stocks and had a chance to turn profitable, but also where the upside was much larger. TGAL didn’t fit even my exception.

2) Watch the quality of the assets. Jae Jun at Old School was kind of enough to remind in a comment on my VOXX posting. While Accounts Receivable have been declining, so has cash. And Inventories have been rising, not a good sign when your losses are edging up.

3) Too many purchases too quickly. I am a small time investor. I work a full time job and do this in my spare time. I can not afford to make mistakes that I made on TGAL. Better not to trade than buy in haste. This is something I practice with regularity, but failed at on TGAL.

Do you have any investing mistakes you would like to share? Post in the comments, particularly what you learned from them.

MNDO is an Israeli company that, “a leading provider of convergent end-to-end billing and customer care product based solutions for service providers as well as telecom expense management (call management) solutions.”

As usual I went to Morningstar  TTM and latest year information including 3rd Quarter (Q3) Balance sheet info. Mind had $34.6 million in current assets and just $6.9 million in total liabilities for a Net Asset Value of $27.7 Million. MNDO has a little over 19 million shares making per share NCAV value (unadjusted) of approximately $1.45/share. So far, so good.

Then I went to the latest 6k, which is a form used for “reports by foreign issuers.” MNDO has just issued a special dividend of $.80/share in December. So the NCAV value isn’t $1.45/share it is closer to $.62/share. MNDO is no longer a Net Net company. Does that mean it is not worth investing in? I can’t tell you. But this example points out why you must read the SEC paperwork yourself. In this case Morningstar Q3 balance sheet was accurate, but no longer current. In MNDO’s case it made a very big difference and it is clear why it recently appearted on the screener I was using.

Mind C.T.I. needs further evaluation to see if it is worthwhile on either Discounted Cash flow basis or Low price to book basis. Both of these require more research, which I will try to do this week.

Disclaimer: I obviously did not purchase shares of MNDO, because it has not met my investing criteria so far. That does not mean it won’t in the future. Make sure you always do your own research and don’t make investment decisions based on something someone else tells you.

The recent Great Recession, has shown that diversification across asset classes did not help prevent losses. You only need one false example to prove a theory false. So, I have taken a distrust for diversification across asset classes to a new level, I am now officially against it.  The point of diversification is theoretically to hedge losses by investing in assets that are uncorrelated. In other words, if your stock investments fall in value, bonds rise, or if gold falls, real estate doesn’t. I won’t get into the specifics of which asset classes are supposedly uncorrelated. I am definitely treading on thin ice, in the investment world, with this notion. But last year we had real estate falling, stock prices falling, bond prices falling, and commodity prices falling all at the same time. The theory is clearly wrong.

The flip side to the theoretical minimizing loss, is that, even if were correct, you are also restricting profit. You are in essence betting against yourself. To protect yourself from the volatility of the stock market you might invest in bonds. But if Treasuries are essentially at slightly above zero, you are better keeping your money in your safe at home. At least that way you can throw yourself a big party if you feel like it.

But back to the smell test. If it smells rotten why buy it? Very few professional investment persons can claim expertise in multiple fields of investments (asset classes), and as a result would be unlikely to perform as well across these asset classes. If professionals cannot master so many different pieces of the pie, how can a beginning or part time investor hope to compete? That was a rhetorical question. We can’t. Let’s get back to using our skills to our advantage. If you are skilled at bong trading, then perhaps you should  stick with that arena. If you have a strategy to make money in the stock market that gives you an edge, go for it. Why would any rational person invest in areas in which they have absolutely no competence or understanding? They shouldn’t. I have stressed over and over, find your edge and stick to it.

But I still haven’t answered the title question.  The answer for me is yes.  Diversification is prudent, but not among different asset classes, but within the areas that you can claim competence. Let me get into specifics. I am a value investor at heart. Despite anything else I try, I understand value investing; it makes sense to me. Finding Net Net stocks not just in the United States but internationally, puts in a sphere that I am confident in, but diversifies me in ways that help mitigate against what I don’t know. I own stock in a Mexican company, A Chinese company, A Canadian Company as well US companies.

But I can also look for value stocks in different industries that may not react to the macroeconomics in the same way. Biotech will often rise and fall at different times than Industrials. If I am looking for bargains, I don’t care where they arise, just that I can buy them at a great deal. Look for the best deals, and only invest in great opportunities. Hopefully, this will translate into better long term profits. I am not alone in my ideas. Peter Lynch did advocate against Deworseifying, or having so much diversification that it hurt your returns.

Disclaimer: The usual for me. I am not an investment professional, so my often unorthodox views don’t hurt me in my career aspirations. As always, don’t trust anything on the internet without doing your own research, including this site. I may be right, but if you don’t understand why I am, you can still hurt yourself in the investment world.

Yes DCF is a little complicated. First you need to start with  Free Cash Flow (FCF). The idea is to calculate what future cash flows will be in a specified time. The way this is often done is to base it on past free cash flow growth. I look at the last ten years to smooth out inconsistencies to calculate a rate. In my DCF spreadsheet I usually this for the first year or two and then begin to reduce this rate  gradually until I get to ten years. That is when it reaches the terminal rate, or the rate at which you think it will grow indefinitely. The terminal rate is often set at 3% but can be adjusted lower or higher depending on the industry and the circumstances. Finally, when you estimate out as far as you are interested in calculating (20 years or 10 years are common time frames) you need to discount it back to the present. The discount rate more many investors will be the Weighted Average Cost of Capital (WACC). I don’t use it, mostly because it is too complicated and likely to be smaller than desired rate of return . Another way to look at the discount rate is the question how much do I want to make each year on my investment. I always want the classic amount Warren Buffett used to say he wanted from to earn from his investments or 15%.

The DCF is a very common source of instrinsic value for value investors, but it does have some serious limitations that you must be aware of. The success of the equation is dependent on getting the inputs correctly. Fairly modest errors of input can result in catestrophically incorrect valuations. That is why, as with everything, we go back to Ben Graham’s concept of Margin of Safety. Once you have determined the instrinsic value of a company is, you should allow for a margin of saftety that helps offset errors of input. I use 50% for almost every company, but occasionally I will dip down to 33% for a truly blue chip stock, but not often.

It did not occur that others were in my boat until I got a couple of requests to get a copy of my valuation spreadsheet in response to my mentioning it in my post about Checking Data before Investing. These requests  prompted me to thinking about it more seriously, and I thought I would offer up a couple of items before I complete the revision of the spreadsheet.

First, there is the caveat that you will need to input ALL of your own data. None of the cool cheats that you can get in the PC world thanks to Microsoft.

Second, because this is my spreadsheet, these are my valuation techniques, including my formulas or adaptations for calculating value, that may differ from other more standard ideas. In general that will make my valuations more conservative. Instead of using a classic DCF, I use a Net Present value of the growth of Free Cash Flow (FCF) over ten years with assumptions about my discount rate, which is never less than 15%. I have stated on this blog a lot, I want to find great investments, not just pretty good ones.

Third, I don’t include any calculation for Weighted Average cost of Capital for many good reasons. The first of which is that it is too complicated to calculate with any real accuracy. The second is that I am always looking for a fairly high return on my investment so my DCF is based on my desired return not an arbitrary calculation that is a better theory than practical tool, at least according to Charlie Munger.

Finally, if you are interested in a DCF spreadsheet for Mac drop me a comment on any post or email me at chroma at  ChromaInvesting dot com. I should a version completed for release by the end of the week.

If you decide having some extra help is worth some money, I encourage you to try out the service first. I am trying the Morningstar Opportunistic Investor premium service. You get 30 day trial to test out the program to see if it fits your system. Opportunistic Investor describes itself as a service that ” seeks to uncover investment opportunities in no-moat stocks, deep cyclicals, arbitrage opportunities, spin-offs, bankruptcy reorganizations, and other special situations. We typically look for upside potential that is many times the downside risk, and prefer stocks with identifiable catalysts to unlock value. We will constantly adjust our portfolio to maintain the best possible risk-reward ratio.” Part of my investing strategy includes looking at spin offs, arbitrage other special situations. I will post when I decide whether or not to keep the service.