"Novastar" means it's collapsing and exploding

Herb Greenberg (not the MLB hall of famer Hank, whom I often confuse Herb with because they both hit so hard) wrote about the collapse of Novastar Thursday (trading at $27 in January, as high as $38 last spring, closed at $8.48 yesterday). The Bob O'Brien character is the same guy who supplied Patrick Byrne information about the "naked shorting" conspiracy.

" Much of the attempted deconstruction of criticism would spill over to a Web site run by an anonymous message board poster, who went by the name Bob O'Brien and who by then had also become pals with CEO Patrick Byrne - himself having gone on a "jihad" against critics of his own company. Both teamed up to also attack an illegal form of short-selling.

In spring 2005, O'Brien went so far as to post the address and names of the wife and son of one prominent short-seller of NovaStar in a message board post, with the tag line, "This is coming up on game over-time. Figure it out. Your playbook is known." In another post he wrote, "Anyone know Herb's wife's name, and his middle initial?"
...
The bravado was gone Tuesday in the wake of NovaStar's disclosures. "I have been body-slammed by this," wrote the anonymous poster, who has been identified by the New York Post as a former used-Cat Scan machine salesman named Phil Saunders. "Many of my friends are devastated by this. Some of my relatives, too. Personally, you bet. Very expensive lesson: Don't bet more than you can afford to lose. And don't bluff. I will not be buying anymore stocks in the U.S. markets, that's for sure. I'm quite done now. This casino has lost its allure."

I looked at Novastar back a couple years ago when some supposed "value" guys were trumpeting it as the next big thing. The yield was very juicy, at the time I think the dividend was $5 and the stock $30. But I could not understand it's financials, how it securitized loans and accounted for them, and essentially gave up. The critics said that the earnings were manufactured, that Novastar was using their REIT status and the tax code to front load earnings from the sale of their mortgages. As a REIT it was required to pay out 95% of these "earnings" as dividends. Since they hadn't recieved these "earnings" yet, Novastar had to borrow money to pay it's dividends and hope their front loaded earnings always turned out as estimated. Well today we know that they didn't.

Novastar illustrates two important principles. The first is, if something seems too good to be true, then be very, very, careful. Paying out illusionary dividends is a time tested marketing technique for attracting suckers to overpay for a stock. You can see it occasionally in the closed end fund business. Most close end funds trade at somewhere between a small and large discount to their net asset value (NAV). Some enterprising fund managers have learned they if they pay out very high large dividends their fund will begin to trade at a large premium to NAV. Where does the excess yield come from? By return of capital. Most investors don't understand why the fund is yielding 13%, they jump in thinking they've found a magic investment that will afford them high retirement income. As the NAV declines over time, they figure it out too late that it was their own savings they were spending.

The second principle is one of the bedrocks of value investing. If you can't understand it, don't invest in it. I couldn't understand Novastar, so I passed. It's clear now the "value investors" who were smitten by it's high yield never really understood how that yield was generated, and the risk Novastar took in writing those loans. At the time I figured I must just be too lazy to figure Novastar out. But because there is some virtue in focusing efforts on things that are easy to understand, my results were much better than I would have gained from Novastar even had it not collapsed. As Buffett says, figure out your circle of competence, and stick within that circle. You'll do much better there.