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SAN DIEGO (MarketWatch) -- If investors learn nothing else from the debacle now known as NovaStar Financial, it should be that no matter how the financial markets have changed, no matter how smart people may think they are, no matter how much it may feel that this time is really different, one basic rule of investing stands: The higher the reward, the higher the risk.
That hit home in the hardest way Tuesday after NovaStar (NFI : novastar finl inc com
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Last: 10.10-7.46-42.48%
4:36pm 02/21/2007
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10.10, -7.46, -42.5%) , with its 30% dividend yield, reported fourth-quarter results that left investors stunned as the REIT's shares plunged 33% in aftermarket trading to $11.81. That's lower than they were when I first started raising red flags over the subprime mortgage lender in December 2002.
While investors ignored the warnings, lured by a rising dividend, make no mistake about it: Even back then NovaStar was a high-wire act. Critics questioned the company's earnings quality, lending practices, its business model, its REIT-related accounting and the granddaddy of all concerns: Whether NovaStar really ever really earned its dividend, which is paid based on taxable - not net - income. NovaStar routinely dismissed such concerns, saying that it did indeed earn its dividend.
Whether it does or doesn't is now a moot issue, because NovaStar made it clear on its earnings call that next year's dividend could fall to $4 this year from $5.60 in 2006. Beyond that, the company said it may abandon its REIT status altogether, for good reason: It also said there will be little to no taxable income from 2007 through 2011. (The implication, of course, is that there will also be no dividend.)
All of this has no doubt come as something of a surprise to the NovaStar faithful, who were expecting so much more. On Dec. 20, 2004, newsletter writer Alan Newman wrote a bullish piece on NovaStar that quoted Nelson Woodard, co-manager of the Scudder-Dreman Small-Cap Value Fund -- NovaStar's largest holder then and now as saying that dividends in 2006 could hit $9, rising to $11 or $12 in 2007. (Oops!) Newman then wrote that if Woodard is correct, "our earlier guess of 'possibly $18 in dividends in the next three years' could prove way too conservative. Could it be $25 to $30 in dividends?!"
He then added, "Given that the shorts have totally misplayed their hand and botched their analysis, the outcome could be disastrous for them." The stock at the time was about $50.
Newman's comments were cheered by investors who congregated on the NovaStar message boards on Yahoo Finance, a town square of sorts for NovaStarians, who often bragged about how they had made a killing on their NovaStar stock. They would also go there to read the latest efforts to discredit critics, including yours truly, who had become Public Enemy No. 1.
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 Overstock (OSTK : overstock com inc del com
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Last: 18.64-0.39-2.05%
4:41pm 02/21/2007
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18.64, -0.39, -2.0%) 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?"
Fast-forward to a week ago: On another Web site's NovaStar message board, that same poster now known as "Easter Bunny" - continued to cheer on NovaStar as an investment. In response to one poster who wondered whether NovaStar's stock would be $20 or $13 after posting earnings, he wrote: "That's very amusing. Really. Thanks for the lift. So, if that is what cutting the dividend and reducing their 100% payout policy for the first time in half a decade would do, what do you think that sustaining the dividend with ease at $5.60 and paying out 100% will do to the price?"
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."
So, hopefully, has the notion that high reward doesn't come with high risk.
Herb Greenberg is senior columnist for MarketWatch and contributor to CNBC television based in San Diego. He does not own stocks (except for shares of his employer), and he does not sell individual stocks short or invest in hedge funds.
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