Interesting Times at Optimal Group

Optimal Group (Nasdaq: OPMR) is one of five stocks I bought last August in my fourth Magic Formula tranche. All except one, Vaalco Energy (NYSE: EGY), are down significantly since then. Since most of the conceivable bad news has been priced into the four stocks that are down, I've been waiting for their earnings to be released to sell them, on the off chance that some good news might move the stocks up a bit. Optimal Group released its earnings today, but, at the last minute, postponed its conference call to 9am tomorrow due to "pending news". Optimal Group was primarily an electronic payment processor that ran into trouble with (and had some assets seized by) the Department of Justice relating to internet gaming. Subsequently, it diversified into something completely different by buying a toy company called WowWee, which sells, among other things, a creepily realistic, animatronic talking Elvis bust (pictured above, but you need to click on that last link and watch the video to get the full effect).

Last August 13th, when Optimal Group was trading at $5.94 per share, a writer named Ross Greenspan wrote an astutely bearish article about the company on Seeking Alpha, "Optimal Group: A Home-Run Value Trap". Greenspan wrote,

Based on cash per share and book value, Optimal seems like the most home run value stock in the market. But management is going to have to grow the business before anyone really starts to take notice. Otherwise, you're investing on the hope of a reversal of the gambling ban in the US.

[snip]

This stock is a value trap in plain sight, with no near-term catalysts to reverse this slide. The selling today is overdone, but with no upside catalyst, a bounce is all you can hope for.

Nine days later, Greenspan added a surprising addendum, in the form of a comment on his article,

Since the tone of my article was negative, I feel its important to disclose that I bought 50 Optimal Group today (8/22).

Optimal Group closed at $5.64 on August 22nd, 2007 (I unfortunately bought this at over $6 per share). Today it closed at $2.10.

It will be interesting to see what news tomorrow brings on this one, and I'm looking forward to unloading it in any case. A few expensive lessons from this:

1) Sometimes stocks trade at a discount to book value for a reason.

2) Buying stocks from the Magic Formula list without applying some common sense and doing sufficient due diligence on them is a mistake.

3) Diversification provides little protection when you are diversifying among a basket of poorly-selected stocks.

"What's Wrong with Today's Value Investing?"

On Seeking Alpha, columnist Marc Gerstein asks, "What's Wrong with Today's Value Investing?"

That a veteran investor (see Gerstein's bio) would ask this question should give you a sense of how poorly many value strategies have performed recently.

Excerpt:

Remember the days when you could count on value investing as a solid defensive strategy? It worked that way as recently as the downturn we experienced earlier this decade. Lately, though, value has not been fulfilling this role. And there are reasons to wonder if this is more than a temporary oddity and whether the entire approach needs to be overhauled.

Later in his essay, Gerstein speculates on why value-oriented strategies may have under-performed recently:

This isn't the 1970s when the best source of market data for many investors was the monthly S&P Stock Guide (I'm not even sure they still exist). Back in the day, if a stock had such characteristics [low valuation metrics such as P/S, P/B, P/E, etc.], it could be because the investment community was neglectful. But in this day and age, with so much information so quickly and so widely available, it's likely that stocks have low valuation metrics because investors believe that's all the stock deserves.

It's a fair point that the wider availability of information today, via the Internet, may have made the stock market more efficient (thus making it harder to uncover mis-priced stocks¹), but certainly this was also true earlier in this decade, when (as Gerstein noted above) value strategies performed better. Gerstein is on firmer ground when he writes,

Success can't come from identifying cheap metrics. Anyone today can do that with a few mouse clicks. Instead, success comes from doing a better job in assessing company merit.

Since he is a "rules-based", or by-the-numbers investor, Gerstein addresses this by adding another metric to some basic value screens, this one based on revisions of analysts' earnings estimates for each company in his sample. This has the virtue of being a forward-looking metric, and one would think that securities analysts take into account macro trends when estimating future earnings. Gerstein mentions nothing about whether or how an individual investor ought to take into account relevant macro trends, or otherwise qualitatively asses companies' prospects -- this is beyond the scope of strict rules-based investing. There is no reason, of course, that an individual investor can't use a rules-based system (whether the Magic Formula, Gerstein's latest strategy, or any other mechanical screening system) to narrow down a universe of stocks into a smaller sample, and then use that sample as a starting point for further research.

¹"Mis-priced" in the sense that the market price of the stock is lower than the stock's intrinsic value.