Dykstra: Another Too-Good-To-Be-True Story

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The Lenny Dykstra tale is like the story of the housing bubble itself. Both were always too good to be true, filled with plenty of warning signs that were ignored by a public and a media that gobbles up a good investing narrative if it promises riches without reservation.

Dykstra, of course, is the former major league baseball player (Mets, Phillies) known for his tough, hard-nosed play, which earned him the nickname Nails. Dykstra was always something of a character-a potty-mouthed, irreverent, resolutely anti-intellectual man-of-the-people who once said that he didn't read books because reading hurt his batting eye and, even worse, "it makes you think too much."

You gotta' love a guy like that, but would you buy investment advice from him? Apparently, yes. In the last few years Dykstra gained an improbable reputation as a whiz in business and a stock-picker extraordinaire, which prompted admirers to solicit his investment advice and persuaded banks and other backers to loan him millions of dollars.

Behind Dykstra's notoriety was a good story, and if there is one thing that some people love more than the hard work of building a portfolio and watching it work over the years, it is a good story. Dykstra claimed that after an investment adviser lost a hunk of his money he educated himself in the markets and began investing on his own--making a bundle. His lifestyle, which included flying on private jets, motoring around in expensive cars and residing extravagantly in a big mansion, seemed to support his claims of a ‘knack' for picking stocks. More important, he got endorsements from the pros, including Jim Cramer, head of TheStreet.com, who called Lenny "one of the great one's in this business" and gave him a regular column.

But the Dykstra story goes beyond stock market mania. Once Lenny garnered notoriety as a stock picker, it seemed there were lots of investors who wanted to double down with him in other ventures that he had similarly limited experience with. He persuaded a company called Doubledown Media to back an idea he had for a magazine, dubbed Players Club, with investment advice for professional athletes, and a stockpicking newsletter. A New York literary agent sold the rights to Dykstra's story for a $106,000 advance, then loaned Lenny $250,000, which he was supposed to pay back with $50,000 in interest from the proceeds of a car wash business Dykstra was selling.

These deals were based, apparently, on the notion that if an inexperienced stock picker could score in the market, surely a guy with no publishing experience could produce a glossy magazine successfully and dash off a book in the meantime, even though he thought that reading makes you think too much.

But in this age of sophisticated financial instruments and computer-driven quantitative analysis, there aren't many individual stock-picking systems that haven't been conceived of and tested already, and Dykstra's was nothing new-or special-except for one thing. He largely used a system that can produce quick profits, especially in a rising market (can't they all), but that had the potential for larger losses down the line. In the ‘grab-for-the-brass-ring now' investing environment of the last few years, that was enough to attract a following despite warnings from pros about the inherent, undisclosed dangers of his technique.

Dykstra advised almost exclusively buying deep-in-the-money call options which give a holder the right to purchase a certain number of shares of stock at a certain price (the strike price) by a certain date (set forth in the options contract). The strike price of a deep-in-the-money option is well below that of the actual price of the stock, which is why it's called in-the-money. Since these options contracts sell for considerably less than the actual price of a share of the stock, Dykstra promoted this strategy as a way for small investors (presumably his audience) to "control" significant blocks of stock and limit their risk. Dykstra advocated exercising these options quickly, on small moves upward in the stock, often booking as little as $1,000 profits on a position. His strategy was to build up lots of little wins.

The problem is that Dykstra was minimizing to his readers the downside. It is very possible to lose one's entire investment in these options if a stock sinks quickly and deeply, sending the value of the option to zero. And so, for instance, even though by following Lenny's advice you might have put down only $6,000 to ‘control' $20,000 worth of shares, you could lose your entire $6,000 investment, especially in the volatile market of the last year. As Michael Comeau, a former researcher at TheStreet.com and now a financial blogger, wrote of Dykstra's strategy: "A portfolio of DITM [deep-in-the-money] calls is nothing but a leveraged bet on the market, even if you only select the most conservative, well-managed companies. If the market goes down 30%, you're broke. If it goes up 30%, you're rich."

Which way has the market gone since last summer?

Dykstra has claimed that his system had picked 99 winners to just 1 loser, but Comeau points out that because options contracts remain open until you exercise them or they expire, Dykstra was sitting with lots of potential money-losers that he wasn't counting as bad bets-sort of like not adding up the losses on stocks you've purchased unless you sell them.

Back in April Comeau predicted that Dykstra would file for bankruptcy because of the long market slide and because, "I've never met a rich person that tried so hard to look rich." And indeed, Dykstra's bankruptcy filing suggests that most of his outsized lifestyle was financed by debt, not big market profits. He declared just $50,000 in assets while claims against him amount to more than $30million. He's lost his $18.5 million home to foreclosure and had his Gulfstream jet taken back for failing to pay some $228,000 for remodelings. In an article in GQ, a former Players Club employee claimed Dykstra used his credit card number to wrack up some $14,000 in charges to rent a private plane after Dykstra's financial woes started. He similarly stiffed his mother for $23,000 after using her card.

He's also left a string of unpaid bills for his business excursions. Doubledown is asking for $350,000, while a Minneapolis design firm says it's owed $250,000. He owes two law firms nearly $2 million (not a great move if you are filing for bankruptcy), while a California doctor, Festus Dada, claims Nails owes him $500,000 because he tried to change the terms of a deal to sell Dada one of his California properties then, when Dada balked, Dykstra kept the half million down payment and walked away.

Along the route to this train wreck there were plenty of signs that Nails might have not be the best of investing partners. He occasionally responded to critics or questioners with profanity-laced tirades that might have once sounded charming directed at a home plate umpire, not when aimed at people with legitimate concerns about the cost of buying into Nails' ideas. And those he hired to work with him told tales of his strange work habits which included an often distracted lack of focus on the task at hand.

Yet those who signed on with Dykstra apparently didn't do much due diligence. Isn't that the way of things these days? Banks discarded the notion of due diligence during the housing bubble when they approved the most transparently phony loan applications in pursuit of every last mortgage transaction. And how many folks with a computer and a dream want to make themselves into day traders riding on the advice of the Lenny Dykstra's of the world, without the merest effort to investigate his techniques?

These kinds of stories don't occur occasionally or cyclically, but are ever-present. Even as Lenny crashes into bankruptcy and our financial system struggles to recover from the bubble, some people right now are eagerly buying into the next set of implausible stories ("Make millions off foreclosures! Invest in commodities now!"). No amount of new regulation or oversight will protect them, because there's no legislating against gullibility and the apparently overwhelming desire for a quick score.

Steven Malanga is an editor for RealClearMarkets and a senior fellow at the Manhattan Institute

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