Free Money for the Taking?

If you believe in the immutability of compounding, then the experiences of great investors such as Oseola McCarty should show you that it is indeed possible to start with a tiny amount of money and end with a large one. Don't know who Oseola McCarty is? Read this.

Sure, you've seen the promises of investment methodologies that will make you filthy steeenking rich. You may have even seen such suggestions here at The Motley Fool. But many of you only have a modest amount of money.

Well, there's another sort of numerical law: In order to turn $1,000 into $1 million, you must first turn it into $2,000. Oh, sure, you could've bought moonshots like Qualcomm (Nasdaq: QCOM  ) in 1999, Taser (Nasdaq: TASR  ) in 2003, or Kmart -- now part of Sears Holdings -- this past year. Or you could be a Google (Nasdaq: GOOG  ) insider. Whatever gets you there, man.

The odds are that for most people, wealth will come somewhat slower. There are several ways to do this, of course. If you bought Cemex (NYSE: CX  ) along with me when I recommended it for Stocks 2003, you've doubled your money. Buying companies at a discount to their value is a not-tried-enough-but-true way to the investing promised land.

But there are other ways. One in particular is a strategy I like to call "FREE MONEY." It violates almost every single investing principle I have. It's short term in nature. It involves coming into a stock after much of the money has been made. And it works without much consideration of the quality of the underlying company.

I can't stand drinking downstream from the herd. And yet in these cases, I do.

Here's the trick: Find a company that is going private by cashing out its shareholders. Last year, for example, ASA International elected to delist its stock, which at the time traded on the Nasdaq. To delist, companies must file reams of paperwork with the SEC, but they can avoid doing so if they have less than 300 shareholders. So ASA determined that if it did a reverse split of its stock at 600:1 and then cashed out anyone with partial shares, it would get rid of enough shareholders to delist. It announced that it would cash people out at $5 per share. After ASA had cleared out the rabble, it would re-split its now-unlisted stock at 600:1.

Now, you might presume that the moment ASA announced that it was going private at $5, its share price would pin itself within a few pennies of that price. You'd be wrong. This is a tiny company, without much liquidity (which is why being public no longer made sense), so selling shareholders exited the company at prices as low as $4.25 after the company had announced that it would essentially cash small shareholders out at $5.

Me? At $4.40, I bought 599 shares -- the maximum number of shares that would guarantee that I would be cashed out, and I did so several months after the going private transaction was announced. If we do a little math, we see that my earnings were $0.60 x 599 - transaction expenses, which comes to about $350. In my case, it took about two months to close, so my holding period return was about 13% (pretax). Annualized, that would work out pretty well. About a double, actually.

Now, $350 is not retirement money. But if you are of the mind that this is an amount of money not worth concerning yourself over, please feel more than free to send me a check for $350. It spends. I could get to Bermuda for $350. I'd like that. Scoring $350 by simply reading The Wall Street Journal (where I find many of the "going private" announcements) and then taking a position in a company and filling out some paperwork doesn't seem too onerous to me.

There are a few reasons why this works. These are tiny companies, and they don't get much attention, even as they make their denouement from the ranks of public companies. Big funds are not going to bother, nor are institutions, for a few hundred bucks. And when the going private transaction is announced, it creates its own selling pressure. Imagine an ASA shareholder who owns 1,000 shares. She may not be that excited to own a non-public, non-reporting company, so what's she going to do? Sell at least 401 shares, that's what.

OK, still, I see you're skeptical. There must be a hitch, right? Yep, there are several. First of all, by their very nature, these are tiny deals. You won't find such opportunities in big merger arbitrage deals such as General Electric (NYSE: GE  ) seeking Honeywell's (NYSE: HON  ) hand. They're not scalable. You can't count on five deals one year, 10 the next, and so on.

Furthermore, they can be complicated. One "going private" transaction that I just participated in, Northeast Indiana Bancorp, counted shares at the stockholder-of-record level, meaning if your broker held your shares in street name, you were in for a rude awakening when the check didn't come in and the company was already delisted. The only reason you'd know this was by reading the company's proxy. How many investors do this? Not all. Another company currently seeking to go private, BF Enterprises (Nasdaq: BFEN  ) , has said that it reserves the option to do so if the total cash required to pay out exceeds $3 million. As a minority shareholder, you have no idea whether this will happen or not, adding an element of chance.

Companies that want to go private don't always succeed in doing so, which means that the transaction you counted on doesn't take place, leaving you with an illiquid but far-from-worthless position in a small company you may not know much about. And nearly as damaging, sometimes these transactions are completed, but take so long to do so that the time value of money destroys much of the benefit.

You also have to be patient. Market orders are not for you -- better to set a limit price, and then walk away if it does not fill. A $5 stock that fills at $4.95 isn't going to net you anything after your commissions are paid.

Scared away? Don't be. This is a hidden corner of the stock market, and given the rising costs of SEC compliance (thanks to some of the more onerous provisions of Sarbanes-Oxley), there will be plenty more companies deciding that being public just isn't worth it. It certainly seems worth it to me to pay attention to them.

Bill Mannis the guest analyst for the Motley Fool Hidden Gemsnewsletter. Want to see what other hidden gems he and Tom Gardner have unearthed? Afree 30-day trialis yours for the taking. Bill does not own shares of any company mentioned in this article. Taser is a Motley Fool Rule Breakers recommendation. The Fool has adisclosure policy.


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  • Report this Comment On April 15, 2011, at 11:30 PM, Migell45 wrote:

    In my modest opinion to my understanding from article is that a good possible much better retirement gain will be by including in the retirement/stock formula the power of leverage by means of from every one aporting to the system a 5% to 10% range should be putting aside for when retirement time come along. But forgetting the 70 or 85 years old in "labor system", what I mean is about the age from 45 to 60 years old in the "labor system" instead in order for the worker to enjoy the end of meaningful life to the next level before the doom day come down. The "labor system" is made off just for that. But with the 5% to 10% leverage input from everyone aboard in the work force all retirees will start to enjoy a meaningful retirement time and enjoy life all the way to the end of it. Foget the "labor System" as it is, it's just doesn't make any sense at all. Great theme on the 'Free Money' keep up the great JOB and wishing all more success ahead, absolutetly!

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