A Glorified Confidence Game?

Most illegal pyramid schemes that make the rounds today are a version of the original developed by Carlo "Charles" Ponzi in the 1920s. Believing he could take advantage of the difference between U.S. and foreign currencies used to buy international stamp coupons, he promised to double people's money in just 90 days, guaranteeing he'd pay his "investors" 50% interest in just 45 days.

Of course, the problem with Ponzi's scheme, and all such confidence games, is that it takes ever greater numbers of investors to pay off the interest. Early investors can make fabulous returns, but later investors are invariably burned as more money becomes scarce and the whole setup implodes. Think of the Social Security system as a more modern glorified Ponzi scheme, though they didn't start too far apart in time. The only difference is that one is promoted by the United States government.

A new Ponzi stamp scheme?
There's some concern that AfinsaBienes Tangibles, the majority owner of Escala (Nasdaq: ESCL  ) , formerly the New Jersey-based Greg Manning Auctions, is itself engaged in a massive Ponzi-type confidence scheme. The difference, however, is that no one is suggesting that what Afinsa is doing is illegal; it's just not a smart investing strategy for individuals. Because Afinsa, the Spanish stamp and coin collecting powerhouse, is the third-largest collectibles company in the world behind Sotheby's (NYSE: BID  ) and Christie's, it pays to consider the charges.

Most of the allegations surrounding Afinsa, as well as another Spanish stamp trading outfit called Forum Filatelico, center on how the company markets its stamps, particularly in Spain, where stamp "investing," rather than collecting, has become a national passion. It's estimated that more than 140,000 Spaniards have sunk some $6 billion into stamp investments for guaranteed rates of return as high as 10% a year, easily surpassing the 3.5% interest being paid on Spanish government bonds. This program accounts for three-quarters of Afinsa's $450 million in annual revenue.

Essentially, Afinsa guarantees it will pay interest as high as 10% a year to investors (and gives them a post-dated check for the amount) for a stamp investment. After a year, Afinsa will either find a buyer for the stamps at the original purchase price or buy them back itself. The investor can then get his or her original investment back, too, or choose to invest in more stamps. To date, it has been wildly popular, and most people seem to reinvest their money.

The people investing in these stamps are not necessarily or even primarily collectors. They are speculators buying stamps based on Afinsa's 25-year track record of being able to find ever-greater numbers of people to buy more stamps, a reputation that has served it well but could be tarnished should the Spanish version of tulip mania implode. What might be a catalyst for such an implosion? Critics say the true value of the stamps Afinsa is selling is vastly overstated because it sets prices based on those appearing in various stamp catalogs. Dealers say the catalogs are simply a guide and that actual prices paid for stamps tend to be much lower.

This is problematic because the investor never actually holds the stamps once he buys them. Rather, Afinsa holds onto them in a vault and insures them based on those catalog values. One such insurer, the prestigious Lloyds of London, withdrew its insurance of the stamps with both houses over concerns about their actual value. Afinsa dismissed the significance of the policy cancellation, noting that the loss of one insurer out of 150 is not a critical concern.

It should also be noted that, many times, stamps sell for well in excess of the catalog value, but dealers say the only way to determine fair value is at auction. Because Afinsa and Forum Filatelico essentially operate closed markets, the prices end up becoming whatever they say they are. To a certain extent, much of the grousing can be dismissed as professional jealousy. Similar to small convenience stores complaining about Wal-Mart (NYSE: WMT  ) or Costco (Nasdaq: COST  ) opening in their neighborhood, small dealers of stamps feel shut out when Afinsa comes to dominate a market. Yet concerns for investors in Escala (I am one) should be greater.

A captive audience
In a sweetheart of a deal, Afinsa acquired about 72% of Escala's outstanding shares in 2003 in return for its becoming the primary buyer of its coins and stamps. The original deal called for Afinsa to buy $250 million worth of collectibles over five years, but it renegotiated the contract to buy $1 billion worth over 10 years. It's been an arrangement that has worked quite well for Escala.

For the latest quarter, sales to Afinsa grew 86% year over year and contributed to 70% of Escala's gross profits. In contrast, sales to all other customers rose just 1.4%, and gross profits from them totaled only $6.6 million. There may indeed be a "parenting advantage", as fellow Fool David Meier noted in his article when the Afinsa deal was made, and part of Escala's growth is based on making smart acquisitions, but there's also the "slave to the master" disadvantage to consider.

As an investor, I've been quite pleased with the stock's performance since I bought Escala shares back in March -- shares that have more than doubled in price. But I should have been more circumspect in my analysis of the company. Any time a business is beholden to another company for a significant portion of its revenues and profits, it is a cause for concern. When one is virtually dependent upon another company for the vast bulk of its sales, a wise investor should understand the perils in the situation. Afinsa could experience a run on its bank of stamps that could upset the $10 billion stamp market, leaving Escala with no place to sell its inventory. There was immediate consternation earlier this year, when sales to Afinsa fell below the prior year's numbers.

There is nothing to suggest that Afinsa has engaged in any illegal skullduggery or that its operations are not on the up-and-up. What is of concern, particularly to investors in Escala, is the sustainability of Afinsa's business. Manias have come in many forms, whether it's tulips in Holland or tech stocks on Main Street. Afinsa has a long, rich history of being a successful operation and of always being able to find new buyers for its stamps. Its continued success, and ultimately that of Escala, rests on its being able to keep the trading going. But any time an investment guarantees you a specific rate of return, a red flag ought to be raised.

A Foolish final word
The Motley Fool has a strict disclosure and trading policy for its writers. I cannot buy or sell shares in a company for at least 10 days before or after I write about it. I could have sold my stake in Escala, waited the 10 days, and then written this story. That might satisfy the letter of the policy, though perhaps not its spirit. For that reason, I have decided to submit this article and sell my entire stake in Escala when the waiting period expires. It's not because of any concern about the legality of what Escala or Afinsa are doing; I have no doubt they are clean. I will sell my shares because I believe Escala is simply too dependent on Afinsa for its sustenance and that any change in Afinsa's outlook would boomerang back to Escala.

You can put Escala under the magnifying glass with these related Foolish articles:

Costco is aMotley Fool Stock Advisor pick. For more stock ideas, click here.

Fool contributor Rich Duprey owns shares in Escala and Wal-Mart but does not own any of the other stocks mentioned in this article. The Motley Fool has a disclosure policy.


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