Many people have argued that the current high house price to income ratio is not reason for house prices to decline, considering that interest rates are very low now. These people argue that what is important is not the actual price of the house, but the mortgage payment required to carry the house (for an example see user jcrash’s comments on my previous articles on the coming mortgage crisis at SeekingAlpha).

To some extent, these arguments are correct. Most home buyers use mortgages, and the difference in monthly payments between a 5.5% and a 8% mortgage is staggering. However, there are two important reasons why low interest rates do not mean that houses are affordable now: household debt is at an all-time high and mortgage rates will certainly go higher.

Things are different this time. And, that is what I argued in my previous post on the coming mortgage crisis. Exploding option ARMs will lead to record foreclosures, which will cause house prices to further decline, which will cause many households to have negative equity. Rather than pay mortgages that are larger than house values, people will simply walk away.

One additional factor that will cause great harm to the housing market is that many stated income loans fraudulently overstated income ( I almost committed mortgage fraud myself). Bond insurers and buyers of RMBS and CDOs will force these back onto the balance sheets of investment banks and mortgage originators, leading to a further decrease in lending and an increase in lending standards. This will increase the cost of buying a house and put further downward pressure on house prices. The Market Ticker blog has a good discussion of this problem and the harm it will cause to banks.

Few companies can release a proxy statement to which stockholders react by dropping the company’s stock price by 15%. However, Research Frontiers (REFR) [$5.91 0.00%, market cap: $91.3M] does earn that dubious distinction. When I last wrote about Research Frontiers, the stock closed at $14.93. At a recent price of $5.19 per share, the stock is down over 64% since I called it a ‘failed company.’

While the proxy contains the standard stock options (including $900k to the Chairman), stock appreciation rights, and other payments to executives, the interesting part is the company’s take on a shareholder proposal. The proposal reads in full (bold text mine):

If you read the papers and watch the news, you may believe that we are in and have been in a subprime mortgage crisis for the last year or so. That is true. Many pundits are also saying that the subprime crisis is nearing its end. That is also true, to a point. Subprime mortgage troubles will not inflict that much more damage on the broader economy. However, prime and Alt-A mortgages with toxic features will cause troubles that will make the current troubles look like a walk in the park. Furthermore, broad-based declines in housing prices will start to wreak havoc on housing markets across the country.

The Cataclysmic Shift

The old adage that sex sells may be true, but if an investor wanted to invest in publicly traded peddlers of sex (in all its legal incarnations), that investor would have only a few poor choices. While those choices may soon expand (when Penthouse goes public, as it is expected to do soon), the anti-prude investor should steer clear of this field.

The largest publicly-traded sex-related company, Playboy (PLA) [$8.69 0.00%, market cap: $289.1M], is the quintessential poor investment. Over the last two decades Playboy stock is only up 42%, while the Dow Jones Industrial Average is up 520%. Even as Hugh Heffner continues to cavort with silicone-enhanced playmates one-third his age, the company’s centerpiece magazine continues to lose subscribers.

I have previously criticized Noble Roman’s (NROM.OB) for being over-aggressive in its expansion and for management blaming its franchisees when those franchises failed. Noble Roman’s has now taken over six struggling Indianapolis-area stores from a franchisee in a bid to prove that its franchisees can operate profitably. This reeks of desperation, and it is also a repudiation of the company’s recent strategy of owning no stores.

Additionally, Noble Roman’s did not file a form 8-k to announce the move, something that appears to be required giving the materiality of the takeover for Noble Roman’s shareholders. See Cory Schouten’s excellent article at the Indianapolis Business Journal for more details.

Stifel, Nicolaus & Company (SF) [$47.19 0.00%, market cap: $739.2M] has a reputation as a straight-shooting company. The regional brokerage, based in St. Louis, avoided accusations of biased stock research that ensnared many other brokerages at the time of the tech-stock bust. The company has not previously seen any of its Missouri brokers charged with securities violations by the state Securities Division. But all is not well with the company.

In fact, Stifel, Nicolaus has recently shown that it has little concern for its brokerage clients, beyond its desire to extract as much money as possible from them. One of the company’s brokers, Girard Augustus Munsch Jr., was recently sanctioned and fined by the Missouri Securities Division for excessive trading in client accounts. How excessive?

I have previously written about Continental Fuels (CFUL.OB) a number of times. I called it the most overvalued penny stock I had ever seen when it was trading around $2.50 per share (although there are now some good competitors for that honor). When its stock price had fallen to $0.70 per share, I said it remained 100-times overvalued. With a current stock price of $0.05 per share, I can finally say that the stock’s inevitable fall is mostly over (although it would still be a poor investment).

The moral of this story is do not invest in over-hyped stocks. Do not invest in stocks mentioned in spam emails, junk faxes, or junk mail. Do not invest in any individual stock unless you have read, and understood its financial statements. For those who are not savvy investors, don’t worry, just invest in broad-market index funds and you will do better than most investors and mutual funds.

Lighting Sciences Group (LSCG.OB) is a step above the everyday vermin that inhabit the OTC BB. It has two real businesses, one of which manufactures and distributes LEDs, and the other of which installs LED and other lighting systems. The one problem with Lighting Sciences is that its value as a real company is dwarfed by its market cap. In this way it resembles some other companies I have criticized in the past, including Continental Fuels (CFUL.OB) and Noble Roman’s (NROM.OB).

Market Cap

In the search of good value we must be willing to take necessary risks. We must be willing to bet on struggling companies, sometimes with bad management, sometimes in struggling industries. However, we must never combine those three things. Most important of all, we must shun excessive debt like the plague. While I prefer to avoid companies with significant debt, in cases in which the company has consistent earnings and the ability to maintain those earnings (because of strong brands or monopoly status), debt is forgivable.

For companies with tough competition and little competitive advantage, debt is a very, very bad idea. Two great cases in point are Movie Gallery (MOVI) and General Motors (GM). Both companies have historically strong brands and decent business models. They are both extraordinarily cheap, and if they had less debt they would be great companies to buy. Saddled with debt, however, they lack the ability to survive their cut-throat industries.

It is one thing for a speculative company low on cash to get more money in a PIPE at a discount to the stock’s market price. But, it is quite another for such a company to give that opportunity to insiders, and then to shamelessly announce in a press release, that it was good news. Yet, this is exactly what Cytocore (CYOE.OB) just did.

Daniel Burns (a director), and Robert McCullogh (CFO and CEO) each purchased a large number of shares from the company for $2 per share on January 22. This was an 18% discount to the stock’s close on that day. And still the fools who “invest” in the company’s stock rejoiced by pushing the share price up 51% in the three weeks since this happened.

This article should not surprise you, but I think it important to emphasize points I have previously made about the predictable irrationality of investors. I recently came across a paper written by Dale Griffin and Amos Tversky, entitled The Weighing Of Evidence and the Determinants of Confidence (no full-text version is available online). This article gives evidence as to why investors ignore regression to the mean, and why they do not pay attention to the reliability of certain kinds of financial information.

The research behind the article is neither brilliant nor even very interesting. But, what is exciting is the theory that Griffin and Tversky put forth. They also review relevant prior research, but it is best to start with their theory.

What I report is nothing new, but I have not seen anyone else call it for what it is: a massive violation of GAAP and common sense accounting. At issue is Channel Reinsurance, a reinsurer that is 17% owned by MBIA (MBI) [$16.36 0.00%, market cap: $2.051B]. MBIA has already written down the value of its investment in Channel Reinsurance to $0.

If MBIA thinks that Channel Reinsurance has no value, it should certainly not be counting on the company to reinsure over $40 billion of bonds. In that case MBIA should take a portion of those bonds back onto its own balance sheet or take a reserve against money it may not be able to recover from Channel Reinsurance. Its failure to do so makes its situation look less precarious than it is. This is fraud, pure and simple.

I’m not much for predictions (because they are usually bad), but I thought I’d give it a try. Here is how financial Armageddon could come to pass this year.

February: Lenders and counterparties give up on ACA Capital Holdings (ACA), the smallest and weakest monoline bond insurer. It declares bankruptcy. The bailout of the other bond insurers fails. Ambak (ABK) [$11.13 0.00%, market cap: $1.130B], already in run-off mode, is downgraded to junk. MBIA (MBI) [$14.85 0.00%, market cap: $1.862B] survives a bit longer. Harry Macklowe loses much of his real estate empire when he fails to refinance his short-term debt. Rents decrease in Manhattan for the first time in years.

Performing a discounted cash flow (DCF) analysis is a subject which I have meant to write about for some time. It is the culmination of the search for an objective means of valuing companies based on the total profit it will produce in the future. Various equations exist for calculating a company’s net present value. I will present one of the simpler equations for two reasons: it is easier and it involves fewer assumptions that could be wrong.

For a handy spreadsheet to calculate the present value of future cash flows, given expected growth rates and current cash flows, see this workbook (Excel format).

I have mentioned before the differences between earnings and cash flows, and how cash flows can be used to make sure that the earnings reported by a company are real. Here I will address differences between accrual accounting (used in earnings reports) and cash accounting. I will also give my opinion of EBIT and EBITDA. Earnings are the basis for P/E ratios, and are the number to which most people pay attention. However, earnings are not real cash going into or out of the company.

This is because earnings includes non-cash items. At first this may seem stupid—why confuse people with charges and gains that do not actually occur? This would be stupid, but the non-cash items in earnings are used to approximate real losses and gains that truly occur yearly but are paid infrequently. The two main negative accruals are depreciation and amortization. These two terms can be used (for the most part) interchangeably. They both refer to the decrease in value of equipment, buildings, or intangible assets. For example, my 2003 Mazda Protege was worth $15,000 when new. To account for the reduction in its value (its depreciation) each year, I could look at the Kelley Blue Book Online and see what its value is.

With apologies to Charles Trenet, Home Solutions of America (HSOA) just went “Boum.” Allegations of fraud by journalists, contractors, and short sellers are one thing, but to have a board member quit and list details of numerous fraudulent activities–well, that usually spells the end of a company.

The following is Stephen Sewell’s resignation letter (from the SEC filing here):

Comcast (CMCSA) [$16.84 -2.88%, market cap: $51.752B] has agreed to pay its founder a salary for a full five years after he has ________. The logical (and upsetting) conclusion of that sentence is “retired.”

No public company or even private company with minority shareholders should ever pay an executive who is retired or otherwise not contributing. However, Comcast has decided to take callous disregard of shareholders to a whole new level by agreeing to pay its founder for five years after he has died. He will even be paid a bonus in that time. Ouch.

Perhaps one of the most important pieces of information that an investor needs to decide whether a company is fairly valued or not is the number of shares outstanding, particularly the number of fully diluted shares outstanding. With that information, and the stock price, an investor can calculate the market cap of the company and use earnings and book value figures to calculate valuation ratios or run a DCF analyis.

I just ran across one company that evidently does not think that is important information. Cytocore (CYOE.OB) is not unlike many of the other companies that arouse my ire. It is an OTC-traded microcap with little in the way of book value or revenues. I came across it while searching for more companies to short sell (a favorite hobby of mine). What struck me about Cytocore is that the company has not published figures anywhere that reveal the number of shares outstanding and thus the company’s market cap.

It is merger time! My favorite micro-cap reverse merger is going to happen in just one month. Movie Star Inc. (MSI) [$1.63 0.00%, market cap: $25.6M] will buy the larger, private Fredrick’s of Hollywood. I previously wrote about this transaction back in August when MSI’s stock price was around $2.20 per share. It currently trades at $1.60.

After everything is done, the combined company will have no net debt (or net cash), $215 million in annual sales, and 55.75 diluted shares outstanding (including conversion of preferred stock). Given the current price of $1.60, the implied diluted market cap is $89 million. There is a rights offering in mid-January that will raise $20 million. This offering is priced at $1.76 (only shareholders as of late November can participate). At that price, the implied diluted market cap of MSI/Fredrick’s is $98 million.