The 20 investment lessons listed below aren’t found in the typical textbooks for courses taught to analysts and/or private investors. I am using Life Partners Holdings (LPHI), the publicly traded holding company of Life Partners Inc. (LPI), as an example. It is a company I am familiar with and currently hold short in my portfolio.
20 Investment Lessons
1) Always look for Catch-22 situations before shorting a stock: There will always be fraud, misrepresentation and unusual accounting in the marketplace. Regardless, any company doing something that isn’t “Kosher” is not destined to have its stock price permanently drop, providing it can correct prior mistakes without significant adverse consequences.
Some companies are in double-bind/Catch-22 situations because they cannot fix past errors. These are the stocks to short because being right about the reasons to short also means being right about the eventual decline in the stock price. LPHI is in a catch-22 over its (alleged) method of repricing life insurance policies before they are purchased by fractional investors. If the company keeps its exclusive life expectancy provider, who produces LEs appearing to be 50%-75% shorter than mainstream LE providers, an injunctive action will likely be recommended by the SEC. This will also help plaintiff claims in several lawsuits against the company. Should LPHI replace Dr. Cassidy with the standard mortality providers (or Dr. Cassidy suddenly changes his methodology), it will be a de facto admission that its LEs are 50%-75% too short. Therefore, Life Partners is in a catch-22 situation with no way out of its LE mess.
2) Be suspicious of any firm with margins that are far greater than the industry average: Life Partners is earning approximately 12% on fees taken from the life insurance policies it purchases in the secondary market and “flips” to fractional investors. This is approximately 2 1/2 times what many life insurance providers and brokers charge their clients according to Citron Research. I see the firm having no technological advantage that warrants greater margins.
So should investors be suspicious about its profits and margins? It turns out they should! How Life Partners gets its margins is a subject of various articles from the Wall Street Journal, The Life Settlements Report, Citron Research, and Seeking Alpha (including one from this author). The things that give LPHI greater margins are now being exposed and will, in my opinion, be its permanent downfall. Examples were recently posted on the internet which prove how poorly two funds advised by LPI fared. They can be viewed here and here.
3) Be skeptical of any company with officers who holds its shares offshore: Some wealthy people use offshore tax and liability havens, believing they don’t have to play by the same rules as the rest of us. Brian Pardo, CEO of LPHI, keeps the majority of his shares in a family trust domiciled in Gibraltar. Not surprisingly, he doesn’t seem to play by the same rules as other CEOs.
Some examples of not playing by the rules: a) In a recent letter to licensees and fractional investors, Mr. Pardo threatened “to take action” against both his auditor and the SEC. This likely violation of SARBOX resulted in Ernst & Young resigning as the LPI auditor.; b) Mr. Pardo and his chief counsel declined to answer a subpoena from the Texas State Securities Board, who recently sued both gentlemen.; c) Life Partners and the salespeople who represent the fractional investments do not disclose their total fees and commissions, nor do their presentations follow GIPS or any other known performance presentation standard.; d) Life Partners accounts for certain assets in ways that may not conform to GAAP. This resulted in a SEC Wells notice.; e) The company paid out a healthy dividend in the 4th quarter despite net profits being down by 99%. Approximately half the dividend goes to the CEO.; and f) Mr. Pardo pitched the Life Partners fractional investment as having “double digit” and “well above market” returns in public forums, something that now seems highly unlikely for most fractional investors. People playing by the rules usually don’t do these things!
4) Be cautious about investing in the shares of a financial firm with products promising “double digit” and “well above market” returns to customers: Brian Pardo, the CEO of LPHI, can be heard promising “double digit” and “well above market” returns in two Bloomberg Taking Stock interviews with Pimm Fox and during the May 14, 2009 NASDAQ Opening Bell. It is now doubtful that these promised returns will, on average, come close to being realized. No investment can ever compound a return of 10% or more forever, because at some point it will be worth more than all the money in the world.Therefore, be cautious of anyone advertising higher than average returns with no market risk.
5) Never trust an investment manager or analyst to be diligent: In a recent The Life Settlements Report page one article, a portfolio manager/analyst was quoted as being unaware of a recent Wells notice sent to the company by SEC staffers. The Wells notice is a very serious matter, suggesting that the SEC staffers intend to recommend the Commission seek civil action(s) against the company. It is inexcusable for an analyst to be oblivious to a Wells letter sent to a company whose shares are in her portfolio, even if the portfolio has been selling shares of the stock. Several large institutions and mutual funds held this stock during its biggest decline, unaware of various irregularities. Always do your own research before buying or selling a security, and never completely trust outside research.
6) One-trick-pony stocks fall hard when few will pay to see the trick: Almost all of the Life Partners revenue comes from purchasing life insurance in the secondary market and taking a large fee when accredited investors take fractional ownership of the same policies. With the multitude of lawsuits filed against the company, along with the negative press from the Wall Street Journal and The Life Settlements Review, fractional investors have gotten wet feet and sales have dramatically slowed. Now that a 99% decline in quarterly net income is expected, the stock price has plummeted. It seems few investors want to pay the price to see this pony’s trick. Note: The 10-K is delayed and the company is now facing a potential NASDAQ delisting unless the newly hired auditor, a regional two-office firm, can complete the work on time.
7) Ask yourself, “Would I buy this product?” and “Could I sell this product?” when analyzing one-trick-pony stocks: When a product is easy to sell (buyers want it), revenue will follow. When a product becomes difficult to sell (buyers don’t want it), revenue will fall. Salespeople, called “licensees,” market Life Partners’ fractional investments. When licensees could sell fractional investments by flaunting double digit return potential with safety, LPI’s revenues looked promising. Now that these same licensees have to disclose the SEC Wells letters (one was amended), the Colorado fraud suit settlement and a myriad of other legal issues, revenues have collapsed. The LPI product is not something I would want to buy, and it certainly isn’t something I would find easy to sell or recommend.
8) Never base an investment decision solely upon the last reported balance sheet of a company: LPHI’s most recent 10-Q shows approximately $29,000,000 in cash with no long-term debt. Approximately $3,600,000 was used paying the latest dividend, and another $700,000 in a special dividend. Unfortunately, the remainder of its entire holdings in cash could be spent in paying restitution should it lose one of a multitude of lawsuits recently filed against the firm. LPHI’s cash could also be completely used reserving for mounting premium forwarding costs. Understanding the balance sheet of a company is important. Knowing a company’s off balance sheet and future liabilities is of equal importance.
9) Beware of investing in companies with a business plan based upon false assumptions: Life Partners' business plan is built upon several assumptions that short sellers believe are false and perhaps fraudulent: (a) LPI assumed it was acceptable to purchase an insurance policy priced with at least two industry accepted life expectancy (LE) estimates that are not disclosed to the fractional investors. It is alleged LPI further assumed it was acceptable for fractional investors to purchase shares of the same policy based upon a much shorter LE industry calculated by Dr. Donald Cassidy. Dr. Cassidy is a cardiologist who produces life expectancies part time. He has no actuarial training and does not monitor his results. (b) LPI assumed it was acceptable to promise double digit returns to fractional investors despite the 12% in commissions taken by the marketing force and approximately 12% in fees taken by LPI. (c) LPI assumed the SEC had no authority to regulate its activity because of a previous case won in US District Court. (d) LPI assumed it was acceptable to sell “double digit” and “well above market returns” using data that does not conform to GIPS or any known performance presentation standard. I believe each of the above assumptions has failed or will shortly fail for Life Partners.
10) Beware of any financial firm selling investments that are not registered: Life Partners sells unregistered investments through licensees. The company assumes these licensees are not required to have securities licensure. “Full disclosure” comes with registered securities that fall under the Securities Act of 1933. Investors should usually avoid any company with a business dependent upon avoiding SEC regulation since the Commission and various states might mandate regulation at a later date. Indeed, the material asked for in a subpoena issued by the Texas State Securities Board indicates that the TSSB may have an interest in seeing that the fractional investments sold by LPI become subject to registration.
11) Beware of any company that has a slew of class action lawsuits filed against it within a short time frame: A bitch in heat never had a more undignified following than a pack of class action lawyers chasing what they believe is a sure thing. When a dozen or more law firms all go in for the kill, there is a good chance at least some of the claims are valid. LPI and its board of directors are currently being sued for a variety of claims including stock fraud, securities fraud, racketeering (RICO) and breach of fiduciary duties.
12) Investors don’t like to admit they are wrong: Some investors will hold onto their investments after bad news is announced, hoping their original thesis on the stock will pan out. Today LPHI is trading at a price close to reported book value suggesting investors expect the company to turn around its declining sales. Short sellers will likely wait to cover at a better price.
13) He who panics first panics best: When news is first disseminated about a stock that places it in a catch-22, it is time to short it or (if you are an owner) quickly sell and find better investments. The time to panic was when the first Citron Research report was published. Most institutional shareholders didn’t panic after that report. They should have.
14) Mosaic information is found in many places, all you have to do is look for it: Life Partners routinely gives out material information on the bottom of press releases regarding the ongoing number of customers and amounts of investments sold. The company once sued a critic who used a Yahoo message board as his podium, an unusually harsh thing to do to a small individual investor who may have hit a raw nerve with his comments. Critics of the company (like me) posting comments on electronic forums have been intimidated by having our real names published by others (it was never proven who did this). The sales presentations used by licensees were easily found on the Internet (most were taken down in the past year) promising double digit returns and using slides showing 14% compounded rates of return. Mosaic information is everywhere and the information is often times material. Unlike most material nonpublic information, it is considered legal to invest utilizing mosaic information.
15) Investors cannot depend upon state regulators to determine if something is wrong: LPI is domiciled in Waco, Texas. The Texas Department of Insurance has seemingly done nothing to stop the Life Partners “double digit” and “well above market” return advertising, and the lack of dependable life expectancies used to price fractional investments. Texas insurance regulators have effectively deferred to the attorney general of Colorado, the SEC, the California Department of Corporations, and over a dozen law firms representing plaintiffs to regulate a firm allegedly involved in fraud, misrepresentation, racketeering (RICO), fiduciary misconduct, and lack of registration. It is easy to see why I formed the opinion that Texas insurance regulators are at best incompetent. Investors should never depend upon state regulators to protect them! Short sellers should not depend upon regulators to harm their targeted stocks.
16) The "cockroach theory" is usually correct: The "cockroach theory" states that when one cockroach is discovered more are hiding nearby. The same thing goes for accounting and legal problems surrounding most stocks. If one problem is found, it is likely more problems will eventually be discovered. LPHI announced a SEC investigation—a material event-- several months after the investigation began. Ever since, more and more bad news about LPHI has been reported and it doesn’t seem to end.
17) Exercise caution whenever an analyst suddenly stops coverage. Life Partners paid a monthly fee to Taglich Brothers to cover LPHI. The company suddenly dropped coverage, writing a final research report giving the company a “neutral” rating. Would a paid research firm abruptly drop coverage without a good reason? A series of negative articles and bad news began shortly after the Taglich Brothers coverage ended.
18) Don’t expect stocks of good or bad companies to go in one direction: Unless there is an unexpected trading halt and delisting, stocks with bad news don’t go straight down. There are several reasons for this: (a) Investors don’t like to admit they are wrong (see # 12 above); (b) Option expiration and the days before option expiration can add to stock volatility; (c) Short sellers with large positions may start covering in a way that provides an orderly exit of large short positions; (d) The stock might get squeezed; and (e) Company management may do everything possible to keep the stock promoted. Bad stocks don’t go straight down.
19) Never expect the board of directors to act in the best interest of the public shareholders: The CEO of Life Partners threatened to “take action” against both the company auditor (likely a SARBOX violation) and the SEC. As a result, Ernst & Young abruptly resigned believing it was no longer independent. More importantly, Ernst & Young and the previous auditor wrote to the Life Partners audit committee stating the financial statements for 2010 and the effectiveness of its internal controls can no longer be relied upon. How is the board of directors acting? The BOD’s silence seemingly backs the CEO. The board seemingly did nothing when the SEC began investigating the firm. It seemingly did nothing when numerous law suits were filed, and it seemingly did nothing when the SEC issued a Wells notice. Knowing ahead of time that a handpicked board of directors is unlikely to help shareholders by changing management is a big advantage to short sellers.
20) The famous poker adage, “Look around the table and if you don’t see a sucker…you are it!” always applies to buying or shorting stocks. Buying and shorting for absolute returns assumes the person on the other side of the transaction is going to be wrong and getting the worst of it. When equity investors are convinced a bullish trend will remain in place, but it is actually about to change for the worse, they become the suckers. LPHI had a strong earnings and dividend history until recently. Short sellers saw there were lots of suckers owning the stock at a high price who didn’t believe the allegations behind the life expectancies. The suckers didn’t believe the negative publicity of the SEC investigation and numerous law suits would destroy sales. Suckers looked at the financials at face value and missed a potential cash drain from premium forwarding. The suckers didn’t see the need to increase reserves or the need to revalue life settlements held for investments (part of a Colorado fraud settlement). The suckers never expected earnings to decline to current levels, which I believe are now negative. The short sellers looked around the table, saw suckers and played their hands appropriately.
I believe the above 20 lessons will help any investor analyze stocks. Sometimes using the kind of logical lessons listed above trumps hours of analysis. I hope you use these 20 lessons in good (financial) health.
Disclosure: I am short LPHI.