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Rogue Traders and Stock Screwups

I know that these trading fiascos are bad things ... and yet part of me is strangely pleased about them. I like having big object lessons that show what happens when people break the rules and refuse to cut their losses short. Rogue traders aren’t greedy criminals - none of the big ones have made any money for themselves on their dealings. But their mistakes remind us that anyone who reacts to losses by making increasingly riskier trades can parlay bad luck into a financial catastrophe of amazing proportions.

Mark Twain once said that it’s not what people don’t know that hurts them; it’s what they know that’s not true. The Internet is swarming with stories about all kinds of atrocities, tragedies, outrages and every other kind of bad behavior right down to simple rudeness.

The problem is that many of them aren’t true.

This morning, when I got to work, I had an email asking me (and 52 other recipients) to boycott Starbucks. The reason, the message explained, was that Starbucks had refused to support U.S. troops in Iraq.

According to the story, a U.S. Marine had sent a letter to Starbucks saying how much he liked the company’s coffee and asking for some to be sent to his unit. The reply from Starbucks, again according to the message, was to the effect that the company didn’t support the war, nor anyone in it, and that they wouldn’t send any coffee.

It’s a shocking story of behavior that’s at least unsympathetic and possibly unpatriotic ... but it’s NOT TRUE!

Fortunately, as the X-Files used to reassure us, The Truth Is Out There.

There is a truly great Web site called snopes.com that collects the rumors, legends and myths that swarm the Internet and tries to determine whether they’re actually true. Snopes’ researchers say that they first encountered the Starbucks story in late April 2004. They subsequently contacted Sgt. Howard C. Wright, the Marine who sent the original email, for confirmation and found that he couldn’t produce the disrespectful letter his buddy had supposedly received from Starbucks. No record of such a correspondence could be found at Starbucks either.

Sgt. Wright has since written a letter retracting his allegation and asking that people stop circulating the original and send a copy of his denial to everyone who got the complaint.

But still it circulates, just one of the persistent Internet hoaxes that keep circulating despite all efforts to stamp them out.

Story Refuses to go Away

This is sad, but hardly surprising. The mother of all urban legends is a message (still circulating in one form or another) about a British boy dying of brain cancer who wants to receive enough greeting cards from all over the world to earn a place in the Guinness Book of World Records before he dies.

The story was originally true ... back in 1989. What’s more, his plan worked. The 1997 edition of Guinness says that by May 1991, he had received 33 million cards.

But the boy (whose name I won’t use for fear of giving new life to the legend), who was nine years old at the time, had successful surgery and is now a healthy man of 28 who really doesn’t want any more cards from anyone, anywhere, ever again.

The story, however, refuses to die. The boy’s name has been misspelled all kinds of ways; the story has been transferred to other boys (and girls, including some in the U.S.); the desired object has shifted (business cards or get-well cards, for instance); and even the means of transmission has morphed (including one version that brought so much mail to the Children’s Wish Foundation International of Atlanta, that it was forced to move its headquarters to escape the deluge). The Guinness book has given up on the whole idea, retiring the category from its publications. The British government has even given the original address of the family’s home its own postal code so they can manage the seemingly perpetual flood.

The technical term for emails like this one is glurge, which includes all the inspirational stories of miraculous escapes, stunning coincidences (... or are they?!) and touching appeals that now clog the Internet, just as they used to clog snail-mail boxes. There’s nothing like a good sentimental story that allows people to feel good for doing something inconsequential (like sending a card or just forwarding a message).

So what’s the connection with investing? (You knew there had to be one, right?) I’m not sure. It’s probably something mundane like: If it seems too good to be true, it probably is. That applies to the stories of companies as much as to tales of people.

I once heard a story from my doctor about a new drug in late-stage clinical trials that was going to virtually conquer diabetes. He had heard about it from a representative of a big pharmaceutical company during a sales call. He asked me to check it out to see if this was a great investment opportunity. I did ... and it wasn’t. But if my doctor hadn’t asked me about it, it’s likely that he would have bought some of the stock, which may be just what the drug rep had in mind.

Know your sources, do your due diligence and don’t send either flames or glurge to your email contacts without confirming things for yourself, no matter how satisfying they are.

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A few weeks ago, Jerome Kerviel was a mid-level nobody with a middling education and a routine job making hedging trades for French bank Societe Generale. Today, at least in the financial community, he’s an instant celebrity, an infamous fraudster who has leaped to the top of the list of people who have gotten frisky making unauthorized trades and - with one bad trade leading to another one to cover it up - lost their employers massive amounts of money.

In Monsieur Kerviel’s case, the total damage came to $7.2 billion. For the sake of perspective, that’s about the 2006 GDP of Cambodia and more than the GDPs of Barbados and Laos put together. Part of the avalanche of selling that buried European markets on January 21 is said to have been the rapid unwinding of M. Kerviel’s losing positions in European stock futures.

Nick Leeson of Barings Bank is probably the poster boy for the League of Extraordinary Rogue Traders. He tried to be a hero while trading Japanese stock futures for the bank and wound up losing $1.4 billion. Ultimately his losses sent Barings Bank, the personal bank of Queen Elizabeth, into insolvency and bankruptcy and in 1995, just 233 years after it was founded, it was bought by Dutch bank ING for one pound sterling.

After a few years in the slammer, Leeson’s fame led to two books (one autobiography and one on handling stress), one movie (Rogue Trader starring Ewan McGregor) and a continuing career as a speaker.

Poor Yasuo Hamanaka of Sumitomo Corp., on the other hand, got the jail time, but no books or movies. Hamanaka used to control about 5% of the global copper market, trading contracts and futures for great profits. But just one year after Nick Leeson blotted his copybook, it came out that Hamanaka had been covering up years of wrong, increasingly costly futures bets that ultimately wound up losing $2.6 billion of Sumitomo’s money. Unfortunately, Japan is a shame-based culture, so Hamanaka-san had no chance of a publishing and speaking career like Leeson’s. Still, he held the rogue trading record until M. Kerviel came along, so I guess that’s something.

I know that these trading fiascos are bad things ... and yet part of me is strangely pleased about them. I like having big object lessons that show what happens when people break the rules and refuse to cut their losses short. Rogue traders aren’t greedy criminals - none of the big ones have made any money for themselves on their dealings. But their mistakes remind us that anyone who reacts to losses by making increasingly riskier trades can parlay bad luck into a financial catastrophe of amazing proportions.

This is why Cabot’s strategy for growth investing includes strict loss limits and indicators that get our subscribers out of markets when conditions are threatening. Traders trying to be heroes can ruin entire companies, and individuals refusing to accept losses can wreak havoc with their personal fortunes.

AdFeed Industries

My investing idea today may be another warning lesson (sorry, this market just has me in a warning mood). It’s AgFeed Industries (FEED), a Chinese company that sells premixed food for livestock, especially pigs. As the company points out, it makes pre-mix fodder for all stages of a pigs life, and there’s no doubt that pigs are important in China.

Pork makes up almost two-thirds of the meat consumed in China, which helps to explain why the country raised over 530 million hogs in 2006, compared with only 100 million in the U.S. In 2006, Agfeed’s output amounted to 20,300 metric tons, with pre-mix sales accounting for about 85% of revenues. Pre-mix is an important product because its use can lower the time-to-market for hog raisers from one or two years to a little as five months. And given the situation in China, the quicker the better.

The situation, as you probably know, is that a condition known as “blue ear” has been killing Chinese pigs by the millions, sending the supply down and the price up. So the Chinese government, always eager to keep its people happy, has declared the hog raising industry to be exempt from the flat corporate tax rate of 25% on earnings.

This should be great news for AgFeed, which has been diversifying into the hog raising business itself. So, in addition to its direct sales to large producers and retail sales to small producers via its over 500 stores, AgFeed will be using its own feed (and expertise) to put more pork on Chinese tables.

So what’s the warning? Mostly it’s that much of this information came to me through a message from a stock-touting service, one of those companies that’s paid to pump up a stock’s price, usually so a large holder can dump a bloc on the market at the elevated price. I’ve actually gone through the report and verified all the information in it. So what I’ve written here today is really true.

But I still can’t recommend the stock. First because anyone who buys now will have to endure a big selling campaign should the stock make any progress. The people who paid for the publicity are counting on it. But second, and maybe more important, FEED, the stock, just hasn’t shown the kind of strength that we look for in the stocks we recommend. Good news is nice and a compelling story is always a good thing. But there’s no substitute for a stock that’s advancing strongly with good volume support. And FEED isn’t doing that.

So the right thing to do with FEED is to write it’s name on a sticky note and put it on your computer monitor somewhere to remind yourself to check in on it occasionally. That’s what I’m doing. And if the stock makes a big run, rising above its old high weekly close just above 13 on good volume, I’ll take another look. But for now, the stock is all talk and no action.

Paul Goodwin
For Cabot Wealth Advisory

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Paul Goodwin is a news writer for Cabot’s free e-newsletter, Wall Street’s Best Daily.