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Harry Koza

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Extreme? Can we talk?

Harry Koza

I was gambling on some tech stocks,

I took a little risk.

Send lawyers, guns and money,

Dad, get me out of this!

—Apologies to the late, great, Warren Zevon (“Lawyers, Guns and Money”).

TORONTO (GlobeinvestorGOLD)—"Write me a column on "Extreme Investing," said the editor, oxymoronically.

"What, like averaging down your Nortel from $120.00 to $2.00 wasn't sporty enough for you, now you want me to tout some really foolhardy investments? And you're asking me, Mr. Risk Averse himself, to recommend something extreme? Me, whose investment philosophy can best be summed up as, 'Bland is Good, But Boring is Better'?"

Geez, I dunno, this may be a sign of a new market top. I mean, sure, I realize that for the twenty-something crowd, "extreme" is the new byword. They're into extreme sports like mountain biking down Mount Everest, cordless bungee-jumping, nude javelin catching, and going over Niagara Falls without a barrel. They listen to 'extreme' music like acid-jazz-house-rap-speed-metal-thrash, whatever that is, sport dozens of tattoos, and have odd bits of metal stuck through their various body parts with alarming insouciance.

Fine. I can understand that kind of extremism, even if I would not choose to partake of any of it myself, especially the body-piercing part. But investing? Can we talk?

It hasn't been that long since everyone was running from tech stocks, looking for safety in fixed income instruments, and the investment press was full of talk about "the new prudence" and preservation of capital. Now the new prudence, having lasted about as long as a Chrétien campaign promise, is out the window and people want "extreme" investments.

Speculation nation

We already have extreme investing: it's called speculation. That can range from talking a punt on Moose Pasture Mines Inc. to buying earthquake or hurricane derivatives, to trading pork-belly or frozen orange juice futures, to buying a lottery ticket. While that sort of thing may be fun, especially if you are doing it with someone else's money, it's definitely not investing.

Before we go any further, let's just refresh a basic concept here. My dictionary defines investing as "committing (money or capital) in order to gain a financial return." Note that last part: it's in order to gain a financial return. One doesn't invest in order to get struck by lightning, win the lottery, find buried treasure, or spin straw into gold. One invests in order to gain a financial return.

Buying a Super 7 lottery ticket gives you 1 chance in 62,891,499 of winning the jackpot. To put that into perspective, the odds of getting struck by lightning are only 1 in 300,000, yet few people would touch that bet. Super 7 is an 'extreme' lottery, designed by the government especially for those people for whom the 1 in 14 million odds on Lotto 649 aren't skewed enough (the odds of winning the 649 jackpot are exactly the same as the odds of you dying in the next fifteen minutes. Never happen, right? Think about that the next time you're lined up with a fistful of 649 forms at your local Seven-Eleven). This is a perfect example of Harry's First Law of Capital Markets: "Make the Stupid Pay."

I think what the Editor had in mind by 'extreme investing' is speculative, or high-risk investments. The online hyperdictionary defines "high-risk" as "Not financially safe or secure; a bad investment; high risk investments; anything that promises to pay too much can't help being risky; speculative business enterprises."

Step right up!

Well, if it's a flutter on the sporty side you're looking for, come on down! There are plenty of exciting investments out there for those looking for a walk on the wild side of the Street, and plenty of salespeople who will happily help you to 'maximize the velocity' of the funds in your account. There are commodity futures, penny stocks, movie partnerships, gemstones, junior mining stocks, vacation timeshares, junk bonds, weather derivatives, earthquake futures, unhedged hedge funds—you name it.

Hell, back just before the Fall of Milken, Drexel was launching derivatives based on the air rights over office buildings (You've got to admire anyone who can sell air as real estate). If it floats, flies, flares or, well, whatever, there's some corporate finance geek out there who can turn it into a security.

Nowadays they securitize everything: David Bowie song royalties, car loans, trailer parks, hurricanes, tobacco company cancer lawsuit liabilities. Everything. Anything. If there's any kind of risk in it, there are, as they say in the Chicago commodity pits, usually a bunch of dentists in Peoria who are willing to strap it on.

I have to admit, I myself have bought shares in many a moose pasture in my time. I'm not against speculation, which is defined as "engagement in risky business transactions on the chance of quick or considerable profit." There's nothing wrong with taking a punt on pork bellies or a flyer on flax futures. Just remember the speculator's Prime Directive: never bet more than you are prepared to kiss goodbye. Don't put your entire portfolio into Bre-X at $200 a share, or six carloads worth of pork belly futures. Believe me, it's no fun when the Teamsters show up and ask "Where do youse want we should put your 'bellies?" But, if you've got a couple of grand to risk, and the lack of which won't cause you to miss any car payments, then go for the gusto.

Buy what you know

Personally, I've always preferred junior mining stocks, since I could talk the talk—metavolcanics, strike, dip, true width, induced polarization, all that rock stuff—and I knew a lot about the mining game, having knocked around the trade in my younger and— dare I say—more extreme days. And also, they were cheap. That's why they call them penny stocks. There's a lot to be said for a good 10-cent mining stock. New Consolidated Golden Peat Bog Explorations Ltd., at a dime a share, can double a lot faster (sometimes even several times in a day) than a $50 bank stock can. Plus, for a relatively small amount of money, you can buy a lot of stock, which lets you feel like a macher, a shooter. You can call up your broker and tell her to buy you 10,000 shares of Dry Hole Oil and Gas Inc., and you sound way cooler than if you just ask her meekly to buy you an odd lot of Citigroup shares. And every once in a while, that little mining stock turns into a Diamond Fields, or an International Corona.

A few years back, the papers were full of Barrick Gold Corp.'s failed attempt to buy an Africa-based gold producer. I figured that, having gone through all that effort to acquire an African gold mining company with a big land position and having been rejected, Barrick wouldn't just go home and lick its wounds, but would look for something similar. Enter Pangea Gold, a small TSE-listed gold mining company with a huge land position in the greenstone belts of Eastern Africa. The stock was around $3 a share at the time. I bought 1,000 shares, and within a month or two, Barrick took the company over at $7 a share. Of course, I was disappointed that I hadn't bought more, but then, if it had gone to 50 cents, I would have been disappointed that I owned too much. This is called the Rule of the Wrong Amount, one of the governing principals of capital markets.

Timing is everything, though. A few years back, I read an item in Scientific American about a physicist at Los Alamos who was developing fuel cells small enough to power laptops and cell-phones for up to six months between recharges. Cool idea, I thought. A few days later, I saw a story scroll by on a Bloomberg screen about how a small OTC bulletin board company called Manhattan Scientifics had bought the rights to the technology for a big block of stock. The stock was trading around $0.25 (U.S.)—right in my price range—so I bought 4,000 shares. I called up the president of the company, and dropped the name of the large investment bank I worked for at the time, and asked him if I could to talk to the scientist about his research.

Know your limit

The researcher called me back from his car phone a little while later and we had a nice long chat about energy densities and other esoteric fuel cell topics. Within a few weeks, the stock had tripled to $0.75, so I sold enough to cover my costs. Now my remaining position was all gravy.

Over the next few months, as the tech bubble inflated, the stock rose, getting as high as $7 and change. I was long gone by then, however, having sold my last shares around the $6 mark. I looked the stock up again today and it's selling for under a dime a share. Pity the poor saps who bought it at $7.

So, penny stocks can be a lot of fun. Just don't play with more than you're prepared to kiss goodbye: my portfolio still has some dogs that I bought at $1.50 some years ago that are trading at $0.05 today. It hasn't hurt my overall return because I never put much into any one of these speculative stocks. The ones that do well make up for the dogs.

Now, commodities are something I've never had much success with. I dropped $5,000 in a few nanoseconds once on options on bond futures, and decided I didn't know what I was doing so I had better quit.

If you want to speculate in financial futures, take a look at one of the technical analysis magazines like Futures. You'll notice that those magazines are chock full of advertisements for secret trading systems that are guaranteed to beat the market. I dunno, though, if I had some secret never-miss futures trading system, I sure wouldn't be selling it to all comers for $387.50 a pop in the back of some magazine. I'd be retired on my private island in the Caribbean—maybe Jamaica—and be quietly running the world from my estate there.

Leave cattle to the cowboys

Actually, commodity futures are great if you are in a commodity business, like if you are a wheat farmer hedging your crop against a drop in prices when you go to sell it at harvest time, or if you own a chain of gas stations and want to hedge the risk of a gasoline price spike. Or, if you make lumber, raise cattle, grow oranges or cotton. For the average retail investor, however, the old adage holds: the best way to make a small fortune by trading commodities is to start with a large one. Yes indeed, we have met the dentist from Peoria, and he is us.

As for movie limited partnerships, you really need to be in a high tax bracket (alas, in Canada that basically means that you have to have a job), and you need to have high net worth and a lot of disposable income, with a particular emphasis on disposable. Besides, you probably won't get to meet Uma Thurman anyway, as she will have become suddenly unavailable for the movie you're backing about the time your cheque clears, and will be replaced by the producer's cousin.

Junk bonds are ok, too. Just stick to a well-run junk, er, high-yield bond fund. You really need diversification with a capital D for this racy class of asset. Leave it to the pros. Putting a lot of money into any one junk issue is a stunt best not attempted at home. The high yield market has had a very nice run, and while there may be a bit more steam left in it, rising interest rates will slow it down considerably.

Finally, remember the key rule of speculating: don't bet the farm. Yeah, I know, I've mentioned this one about six times already, but it is the one necessary, carved-in-stone secret of successful speculating, and too many people ignore it.

When I think back to my younger days, when I was an avid speculator, I recall that many people in the investment business used to look askance at me, as if speculators were some lower life form than investors. Speculation was the red-headed step child of investing, a raffish practice of dubious reputation, indulged in by guys with cigars who hung around at the racetrack, or near the snooker tables in the Engineer's Club.

Nowadays, everyone is a speculator, yet they think of themselves as investors. Worse, people got spoiled during the Bubble: they think that double-digit equity returns are the norm, and with markets looking to generate returns in the 6 per cent to 8 per cent area for the next several years, they're willing to push the envelope to try to get them. That, to me, suggests that the excesses of the bubble have not yet been squeezed out of the market.

Be careful out there. Lawyers, guns and money may not be enough.

Harry Koza is Senior Analyst in Canadian markets for Thomson Financial/IFR. At various times in his career, Mr. Koza has been a prospector, metallurgist, project manager, engineer, as well as an institutional bond salesman for 15 years. His current area of expertise is in high-yield distressed securities and corporate bonds in general.

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