11.13.09
Posted in All Categories, Alternative Investments, Stocks at 7:57 am by Michael Goode
A merger-arbitrage ETF is coming to town, ticker MNA. It should start trading in a month or so. With expenses of 0.75%, this looks like a nice addition to portfolios.
IndexIQ, a pioneer in the area of hedge fund and inflation hedge ETFs, is preparing to launch another fund, the IQ ARB Merger Arbitrage ETF. The fund is scheduled to begin trading later this month under the clever ticker MNA. The proposed ETF will track the IQ ARB Merger Arbitrage Index, a strategy that involves investing in global companies for which there has been a public announcement of a takeover. The index also includes short exposure to global equities as a partial equity market hedge.
Read more here.
Disclosure: No positions.
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06.27.08
Posted in All Categories, Alternative Investments, Bonds, Fraud, Microcap, Personal Finance, Real Estate, Stocks at 2:42 pm by Michael Goode
I am not one to use the term Armageddon lightly. But when major banks like National City (NCC) and Washington Mutual (WM) are trading under 30% of book and Wachovia (WB) is trading at under 50% of book value, what othe term is appropriate? The market is pricing in a fair probability of a number of very large banks being bought out at firesale prices (like just happened to PFB) or being taken over by the FDIC and then being dismantled.
That being said, while the coming two years will be a very bad time to own bank stocks or bonds or to have uninsured deposits at banks (over the $100,000 FDIC limit), the economy will not completely collapse (though we should have a decent recession) and the world will move on.
The main thing to do is make sure that you and any friends and relatives never have more than $100,000 at any bank. If you wish to keep more, you may want to visit the FDIC website to see if your type of account is protected for more money (some are). You can search for your bank here and find out if it is insured by the FDIC and you can view financial information on your bank, even if it is private. For example, try searcing for “Home State Bank NA” in zip code 60014* (see random note at bottom of post). Then click on “Last Financial Information”, and on the next page click on “generate report”. This brings you to the bank’s balance sheet. If you click on the link towards the bottom for “past due and nonaccrual assets”, you will be taken to the good stuff. You can see that past-due loans have more than doubled over the last year. Unsurprisingly, much of the increase ($2.5m) was from “construction and land development loans”. It also pays to note that this big increase in past-due loans was solely in the 30 to 89 days late category. A more agressive bank might still be accruing interest on those loans. However, this is a conservative community bank and as you can see towards the bottom of the page, all loans that are more than 30 days late are non-accrual. (An interesting discussion of regulatory vs. tax requirements for deciding which loans are non-accruing can be found here.)
If you go back to the main balance sheet page and click on “net loans and leases” you can find the breakdown of loans. This is a good place to find out how risky your bank’s loan portfolio is. Unfortunately for Home State Bank, 20% of their loans are construction and land development loans. This bank is based in the far northwest exurbs of Chicago, so I think it likely that the bank will take a huge hit here. If you click on “1-4 family residential” you can see the breakdown of these loans. Luckily, most of these are first mortgages. Overall, Home State Bank looks okay. What about your bank?
If you have accounts as a credit union, visit NCUA to see details on insurance of your deposits. You can find your credit union and then request that a financial report be emailed to you. As an example I uploaded the report on my credit union. You can download the Excel Spreadsheet here. When analyzing credit unions, be aware that they will generally have more real estate exposure than similar commercial banks. Important things to examine are delinquent loans as a percent of assets (sheet 2, line 21 in the spreadsheet), asset mix including the amount of REO (sheet 4). If you are afraid of a bank run sparked by articles similar to this, take a look at the amount of uninsured deposits (sheet 5, lines 46-50). Delinquent loan info is always interesting (sheet7). For most of the data in the spreadsheet, an average of peer group credit unions is provided as well, making comparison easy. Overall, I think West Community looks quite safe.
What should you do if your bank doesn’t look safe (such as National City, where I have multiple accounts)? First thing that you should do is make sure your deposits are insured. Then make sure that you have enough cash in safer banks so that you can last awhile if you temporarily lose access to your money. Up until now the FDIC has been very good at getting depositors quick access to their insured deposits at a failed bank, but if things get really bad and big banks go down the FDIC could become backed up and take weeks or months to grant depositors access to their money. It pays to be prepared for such a scenario, even if it is unlikely.
*This bank, by the way, provided me with my first mortgage. Easiest mortgage I ever got — my father and I ran into Steve Slack, the bank president, while dining at the local country club, and I mentioned that I was buying a house in St. Louie. Slack gave me his card and told me to give him a call when I get close to finding a house. There are benefits to relationship banking–my extended family has banked there for three generations and uses the bank for a family company.
Disclosure: I am short several regional and local banks.
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05.13.08
Posted in All Categories, Alternative Investments, Fraud, Microcap, Stocks at 2:09 pm by Michael Goode
An SEC enforcement division press release today shows why penny stock manipulation remains popular and why I hate the SEC. According to the SEC:
“The Commission’s complaint alleged that, in August and September 2002, Hayden, Marc Duchesne, and others carried out a scheme to manipulate the price of Nationwide’s stock. The scheme was orchestrated by Duchesne, and began with a matched trade between Duchesne and Hayden that artificially inflated Nationwide’s stock price from pennies to $9.35 per share. The Complaint further alleged that, thereafter, Duchesne, Hayden, and others bought or sold Nationwide shares at inflated prices to increase the price of Nationwide stock, to generate volume, and to stimulate market demand for the manipulated shares. The scheme collapsed on October 1, 2002, when the Commission suspended trading in Nationwide securities. “
The judge “entered a Final Judgment of permanent injunction and other relief, including a bar against participating in offerings of penny stocks, against Jeffrey A. Hayden on May 7, 2008.” Hayden agreed to the judgment “without admitting or denying the Commission’s allegations.”
Midway through reading the press release I thought to myself, “Hey, maybe the SEC finally is starting to care about penny stock manipulation!” The description of the financial penalty imposed upon Hayden destroyed any last shreds of hope I might have had that the SEC cares about doing its job (emphasis mine):
“Hayden was liable for disgorgement of $290,798, together with prejudgment interest of $116,330, but payment of these amounts was waived based upon Hayden’s sworn Statement of Financial Condition. A civil penalty was not imposed for the same reason.”
There you have it! The only penalty to Hayden was a promise not to manipulate penny stocks. He did not have to pay one penny. That is less than a slap on the wrist. This is yet another reason why I believe that we should abolish the SEC and most stock regulations and instead pursue stock market fraud under the common law definition of fraud. Penalties would be far harsher and might actually scare people away from penny stock manipulation.
(Note–I am not a lawyer; if you are one and I am spouting nonsense, please let me know!)
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05.05.08
Posted in All Categories, Alternative Investments, Bonds, Fraud, Microcap, Stocks at 1:10 pm by Michael Goode
If a manager who runs a $30 million hedge fund decides to embezzle money, it usually makes sense to actually embezzle it and then run away, rather than just transferring it to a shell-company brokerage account and then losing half of it selling short Treasuries. Evidently someone forgot to give that sage advice to Matthew La Madrid and his hedge fund management company Plus Money. According to a recent SEC complaint:
The complaint further alleges that, unbeknownst to investors, in the fall 2007 Plus Money and La Madrid abandoned the covered call trading strategy, emptied out the monies in the Premium Return Funds’ brokerage accounts, and dissipated the money through a series of illicit transfers.
The SEC’s complaint alleges that investors were not told that in the fall 2007, La Madrid and Plus Money transferred nearly all monies from the Premium Return Funds’ brokerage accounts to Vision Quest Investments, a La Madrid dba, which in turn transferred $10 million to relief defendant Palladium Holding Company. The complaint further alleges that Palladium:
* Transferred $5 million to its own brokerage account and used the funds to trade in numerous short-sell transactions involving Treasury bonds; as of April 25, this activity had depleted more than half of the account’s value
* Wired $500,000 back to La Madrid
* Transferred $1.8 million to several real estate title companies
* Used $95,000 towards the purchase of two automobiles
* Transferred another $90,000 to a Denver-based car dealership
What I do not understand is why La Madrid did not simply make the losing bets in the hedge fund. If he had lost the money in the fund then he would have been guilty of little more than misleading his investors about his investment strategy (the fund was supposed to invest in covered calls).
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04.04.08
Posted in All Categories, Alternative Investments, Microcap, Stocks at 11:30 am by Michael Goode
The old adage that sex sells may be true, but if an investor wanted to invest in publicly traded peddlers of sex (in all its legal incarnations), that investor would have only a few poor choices. While those choices may soon expand (when Penthouse goes public, as it is expected to do soon), the anti-prude investor should steer clear of this field.
The largest publicly-traded sex-related company, Playboy (PLA: $3.42 -4.47%, market cap: $114.5M), is the quintessential poor investment. Over the last two decades Playboy stock is up 42%, while the Dow Jones Industrial Average is up 520%. Even as Hugh Heffner continues to cavort with silicone-enhanced playmates one-third his age, the company’s centerpiece magazine continues to lose subscribers.
The story is much the same at cable-smut purveyor New Frontier Media (NOOF: $2.187 -0.59%, market cap: $42.6M), where the stock has appreciated 2% over the last decade. The DJIA is up 64% over the same time period. The problem with cable porn is that it will suffer the same fate as newspapers: it is going to be crushed by internet competition. So despite a cheap P/E of 15, New Frontier will likely be a poor investment.
Rick’s Cabaret International (RICK: $14.22 -0.07%, market cap: $133.4M), a chain of strip clubs (see a commercial for it here), has been kinder to its investors than the above companies. Over the last decade it has outperformed the DJIA, 270% to 64%. But Rick’s is trading now at a stratospheric P/E of 34, which is out of line with companies most comparable to it: staffing companies such as Administaff (ASF: $20.03 +1.62%, market cap: $512.2M) and Manpower (MAN: $56.92 -0.26%, market cap: $4.478B), both of which trade at P/E ratios under 15. While Rick’s provides stripping services in branded locations, it is not really that different from staffing firms that provide administrative and other services to companies. It relies upon its ability to recruit skilled workers, and its brand is far less important than the actual capabilities of its workers. Also like the staffing firms, it is vulnerable to a recession.
The last public sex company of which I am aware is the worst, yet it comes with the most wholesome reputation. This company is Berman Center Inc. (Pink Sheets: BRMC). This is a sex therapy center and website that caters to couples looking to improve their sex lives. Its eponymous founder, Dr. Laura Berman, is not only knowledgeable but also good at getting press. She has appeared on Oprah Winfrey’s show and she is a columnist for the Chicago Sun-Times. Despite the advantages the company has, its financials are a mess. The company, with a market capitalization of $12.5 million, has a book value of negative $1.3 million (see the most recent 10Q for details). The company lost $1.3 million over the first nine months of 2007 and lost $1.2 million over the first nine months of 2006. The company is also delinquent in filing its 2007 annual report.
Overall, sex makes for a poor investment, at least in terms of public companies.
Disclosure: I have no position in any stock mentioned. My disclosure policy is considered obscene in Utah, because it is transparent and it prohibits stock fraud, front-running, pump-and-dump scams, and MLM schemes.
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03.10.08
Posted in All Categories, Alternative Investments, Bonds, Fraud, Microcap, Stocks at 7:37 pm by Michael Goode
Your humble blogger is not averse to eating crow. So it is time to admit that I have been wrong so far about Frederick’s of Hollywood (FOH: $1.1999 +4.34%, market cap: $31.7M) (Movie Star Inc prior to a recent reverse merger). It is difficult to invest without knowing all the information, and I appear to have been over-optimistic about the growth of the company. Especially with competitors like Limited Brands (LTD: $23.74 +0.55%, market cap: $7.651B) (owner of Victoria’s Secret) selling quite cheaply, Frederick’s does not look like a worthwhile stock to buy. Frederick’s stock has recently fallen from $3.60 to $2.80 (its 52-week low after adjusting for a recent 2-for-1 reverse split).
On the other hand, my bearish advice continues to be very good: since scolding Patrick Byrne and Overstock.com (OSTK: $14.53 0.00%, market cap: $331.8M) in a Dueling Fools article (for The Motley Fool), the stock has declined from $15.76 to $8.90.
In other news, despite Exmocare (OTC BB: EXMA, formerly 1-900 JACKPOT) being a horridly overvalued useless piece of trash with no sales and no significant book value and no chance of ever being worth one-tenth of its market cap, its stock has gone up since I pledged the profits from my short position in the stock to charity. The 1st Annual GoodeValue.com Short-a-Thon was a failure and raised $0 for charity.
Disclosure: I have no position in any stock mentioned. I trained in the dark arts of Jedi under the Sith Lord himself. My disclosure policy wants you to read it.
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02.20.08
Posted in All Categories, Alternative Investments, Bonds, Fraud, Real Estate, Stocks at 10:05 pm by Michael Goode
A slidshow on Google Docs. Enjoy.
Disclosure: I did not create the comic and I do not know who did.
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02.07.08
Posted in All Categories, Alternative Investments, Bonds, Real Estate, Stocks at 9:49 am by Michael Goode
The traditional thinking in the world of finance is that to increase returns you need to increase risk. This view is quite logical. Let’s consider an investor who wants a minimum of risk. She can buy certain blue-chip stocks such as Wal-Mart, Home Depot (HD: $32.45 +1.00%, market cap: $54.484B) , and GE (GE: $17.04 +3.40%, market cap: $181.8B). The stocks offer low risk because they are all giant companies with dominant market positions; I think it is a fair bet that all three companies will still be around in one form or another 50 or 100 years from now. For such low risk our investor will get a relatively low return because these companies are so huge and have less ability to grow than they had in the past. Now, with such great blues chip stocks available why would our investor choose to buy shares in a company such as DayStar technology (DSTI: $0.375 -2.06%, market cap: $12.6M) or Cheniere Energy (LNG: $3.39 +2.11%, market cap: $180.2M)? Neither of these companies currently makes a profit nor has any significant revenue. In owning such companies an investor has significantly more risk of losing her capital. Therefore, no rational investor would buy the stock of such companies without being assured that those investments offer the potential of very great reward.
This thinking underlies the Capital Asset Pricing Model (CAPM). Now, for the most part this works quite well. However, there are some problems with the capital asset pricing model. One huge problem is that in this model risk is defined as the stock’s volatility. Volatility is of course a measure of how much a stock’s price changes each day, week, and year. For those of us who are long-term investors, however, volatility is an inadequate measure of risk. What matters more for us is the stability of the future earnings of a company.
For financial analysts and portfolio managers, volatility is most commonly measured by something they call beta. Simply put, beta is a measure of the correlation of the stock’s price to the broader stock market as a whole. Therefore, an index fund would have a beta of 1.0. Let’s say we have a stock that has a beta of 2.0; this means that in general, when the market goes up 10% the stock will go up 20%, conversely, when the market goes down 10% the stock will go down 20%.
Since we’re already talking about beta and financial analysts, I might as well mention alpha. Alpha is a measure of a portfolio’s performance. An alpha of zero indicates that a portfolio matched the market’s return. An alpha of one would indicate that a portfolio outperformed the market by 1% annually.
The goal of a professional portfolio manager, at least according to the capital asset pricing model, is to construct a portfolio with the desired amount of alpha in order to maximize returns without exceeding a certain level of risk (beta). According to the model, it is impossible to consistently beat the market because the market is efficient. This aspect of the model is known as the efficient market hypothesis and I obviously believe it to be wrong. I will deal with why this is wrong in a later article. For now let’s return to risk.
One finding that has been problematic both for the efficient market hypothesis and for beta is the finding that low P/B stocks outperform high P/B stocks. According to the CAPM, this could not happen without low P/B stocks being more risky than high P/B stocks. However, low P/B stocks do not have higher betas than high P/B stocks. The creator of the efficient market hypothesis himself, Eugene Fama, realized then that beta do not adequately measure risk. He and his collaborator Eric French argued that low P/B stocks are more risky than high P/B stocks. I disagree with this but the important point is that as of their paper in 1992 (unfortunately not available free online), beta was officially dead or at least dying.
So how can we measure risk? There are no easy ways to do so. We must rely on sound fundamental analysis. Risk obviously decreases the more products the company makes and the more customers to which it sells. Thus, GE and Berkshire Hathaway are less risky than almost all other companies because their revenue streams are so diverse. Conversely, ExpressJet (XJT: $3.70 -4.15%, market cap: $57.9M) and the other regional airlines are very risky because they all have only one or two customers. Similarly, small defense contractors are risky if they sell only a few major products and to only one major customer: the United States government.
Another risk factor is debt. Companies with more debt are much less likely to be able to survive a recession or industry downturn because they would be unable to meet their debt obligations if their revenues drop more than slightly. For this reason, companies such as Fortune Brands (FO: $47.34 +0.28%, market cap: $7.195B), Blockbuster (BBI: $0.41 -2.38%, market cap: $79.6M), and Ford (F: $13.34 +3.33%, market cap: $44.933B) have elevated risk due to high debt loads.
Another risk factor is obviously competition. Companies and highly competitive industries have greater risk than companies with monopolies or that for other reasons do not have much competition. There are many ways that a company can avoid too much competition, including patents, trade secrets, operating in a niche market, and effective branding. Ceteris paribus, a dollar of earnings that is at lower risk from competition is worth more than a dollar of earnings that comes from a highly competitive industry.
This is not to say that companies in highly competitive industries cannot be great investments. Those companies that are wildly successful in competitive industries usually have some key advantage that gives them an edge in that is not easily copied. This advantage is not always easy to identify. For example, Southwest Airlines (LUV: $13.00 +1.25%, market cap: $9.662B) had the important advantage over legacy carriers of not having an established business prior to airline deregulation. This meant that Southwest was not burdened with the same costs that hindered the larger airlines. In addition, Southwest’s fares were simple and did not penalize travelers for arbitrary reasons such as not staying over a weekend. Another good example of a successful company in a competitive industry is Wal-Mart (WMT: $53.90 -0.13%, market cap: $205.1B). What did Wal-Mart offer that Kmart (SHLD: $103.35 +1.70%, market cap: $11.865B) and other discounters could not? One thing it offered was everyday low prices. By avoiding sales Wal-Mart gained both the reputation as the low-price leader and it gained more consistent profitability. Wal-Mart has also been known for some time for the effectiveness of its distribution system. In an industry with low profit margins and high inventory requirements, any improvement in logistics drops straight to the bottom line.
The last important risk factor is the elasticity of demand for a company’s products. The business cycle is a fact of life; any company that suffers less during recessions, whether because it sells products that are always in demand or because it sells to people who are not greatly affected by recessions, has lower risk than the average company. Big industrial companies such as auto manufacturers and aircraft manufacturers are usually very cyclical. Cyclicality of earnings is not in and of itself a black mark against a business. However, combined with high debt and stiff competition, a cyclical company in an industry downturn can be a very risky bet. See, for example, General Motors (GM: $0.75 0.00%, market cap: $N/A) or Northwest Airlines (NWA: $0.00 N/A, market cap: $N/A).
While it is not possible to exactly quantify risk, it can still be approximated. Any decision to invest in a company should come only after carefully weighing the possibility for reward against the risk that company presents. In certain circumstances, adequate calculation of risk and reward cannot be made, such as with development stage companies with no revenues. In such cases, the conservative investor would do well to watch from the sidelines unless she is an expert in the field and is sure that she is not paying too much.
On a related note, I urge you to read Richard Russell’s article on the perfect business, which discusses the ideal business from the standpoint of a small-business owner. The points Russell brings up are also important to large publicly traded companies.
Disclosure: I have no position in any stock mentioned above. I have a full disclosure policy.
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12.07.07
Posted in All Categories, Alternative Investments, Fraud, Microcap, Stocks at 11:03 am by Michael Goode
I often write about companies I dislike and companies that I have sold short. I have made a good return on my short sales. Yet I have always recommended against short selling. Why I recommend against short selling was amply demonstrated by the stock of microcap Noble Roman’s (OTC BB: NROM) yesterday. The stock shot up 46% on no news. What happened? My bet is that the critical article on Noble Roman’s that I posted on Monday encouraged some people to short the stock and it encouraged some momentum longs to sell. That drove the price down 30% over the next two days. Yesterday some short sellers started to cover and that drove the stock price up a bit. Momentum players jumped back in long and soon the stock was back up to where it was Monday. Of course, this is just my idle speculation, but the effect on the stock price is quite real, no matter how it happened.
If someone shorted the stock at its low yesterday, that person would now be out a lot of money. They might even blame me for their losses. Yet for any stock, the short term is not indicative of the long term. In the short term the stock market is a voting game. Especially for small, illiquid stocks, prices fluctuate greatly depending upon supply and demand. But in the long term, the stock market is a weighing mechanism, and poor companies’ stocks will inevitably flounder. Most people have a hard time holding on to stocks they have bought (long) despite swings in short term prices. It is even harder to hold on when, with short selling, losses can theoretically be infinite. So stay away from short selling.
Disclosure: I am still short NROM and have not traded it since my first article on it last Monday, as per my disclosure policy.
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11.15.07
Posted in All Categories, Alternative Investments, Fraud, Microcap, Stocks at 3:17 pm by Michael Goode
The point of this article is threefold: to associate the nickname “The Reaper” with me and my short selling activities so that when I become as famous as Jim Chanos or Manuel Asensio or at least Andrew Left, I can appear on the cover of Forbes magazine wielding a scythe (see picture below); to inform investors about short selling so that they realize the folly of buying into stocks just because of a so-called “short squeeze”; and to inform those crazy enough to actually try short selling about different strategies for doing it.
There are a number of websites dedicated to finding stocks that are prone to a short squeeze and recommending that traders buy those stocks. A short squeeze can occur under two different but similar situations. In each case, there is widespread negative sentiment about a stock in which short sellers have sold short a large percentage of the outstanding shares of the stock (leading to a high short interest ratio). In one case, routine speculative buying on the part of traders pushes up the price of the stock, which creates losses for the short sellers and this may lead some of them to cover their short positions (buy back the shares they borrowed and sold), and this buying on the part of the short sellers drives the stock price up even further.
The other case is where some good news comes out about the company which leads to the same outcome. In this case, a quick witted daytrader or momentum trader can easily make a lot of money. The trader might see the headline and quickly buy the stock at the same time the quickest shorts start covering, and by the end of the day there can be a whole lot of profit as mounting losses cause most of the other shorts to cover as well. I found myself on the wrong end of this kind of short squeeze in early February 2007 with Onyx Pharmaceuticals (ONXX: $30.86 -0.26%, market cap: $1.925B) (see chart of squeeze). The market expected poor results from a drug trial, but the company reported outstanding results. Considering that the drug in question was one of only a few that the company was developing, this was incredibly good news for Onyx. Shares doubled from $12 to $24 in one day. I was quick and got out of my short position in the stock with only a 50% loss. A quick witted trader could have read the same headlines I read and bought as I was covering and realized a 30% profit in one day. Of course, I do not recommend such daytrading because most people are very bad at it, but I do recognize that some people do it well and they serve a purpose in the markets.
Non-news-driven short squeezes are much different despite looking very similar on the price charts. The problem with this kind of short squeeze is that there is no fundamental reason for the stock price to go up. As I have previously written (and written elsewhere), stocks targeted by short-sellers tend to do worse than the market as a whole, and people who buy a stock just because the short interest is high and just because there’s a possibility of a short squeeze would do well to remember that. Another thing to keep in mind is that if a company is bad enough, the short-sellers are very strongly convinced of their negative opinion of the company, and the short sellers have deep pockets, there is no reason why the short sellers need to cover just because of a temporary increase in the stock price. A good example of this is the various price increase in the stock of Home Solutions of America (HSOA: $0.00 N/A, market cap: $N/A). The critics of the company are convinced that it is both fraudulent and insolvent and that the stock is worth nothing. So they will likely just hold onto their short positions and grit their teeth to withstand the short-term losses because they believe that within a few months or a year they will be sitting on a 100% profit.
Now, because I am a reasonable and conservative person, I feel obligated to warn you that short selling is highly dangerous, speculative, and for most people it is simply dumb to do it. In fact, we expect the return from selling short stocks to be about -10% per year because on average that’s about how much stocks go up per year. So unless a short seller has a lot of time, talent, guts, and knowledge, he or she should expect to lose money over time.
Short Selling for Fun and Profit
The one rule of short selling is this: don’t do it. If you ignore the rule you deserve what you get, whether it be fortune (if you have great talent and good luck) or poverty (if you have modest talent or great talent and bad luck). Consider yourself warned.
Now that we have that out of the way, there are two ways to profit from short selling stocks: momentum shorting and what I call steel-gut shorting.
Momentum shorting
As mentioned above, selling on negative news can be profitable. It is hard to tell what will continue to fall and what will bounce back. There are a few strategies to use. I have tried using certain influential blogs as my ‘news’ sources.
I receive emails of updates to those blogs or see the postings within an hour of them being published because I subscribe via RSS and I check my RSS reader often. If I see a negative comment about a stock I can quickly check to see if I can short it and then I can quickly short sell it.
This strategy has been a mixed bag and I have probably broken even. While Terra Nostra Resources (OTC BB: TNRO) gave me a nice profit, and Uranerz (URZ: $1.88 +1.08%, market cap: $120.7M) gave me a respectable profit, I saw small losses on several others, including Cellcyte Genetics (OTC BB: CCYG).
Steel Gut Short Selling
Imagine selling short a worthless company only to see the market double or triple its market value. You hold on. No–you don’t just hold on. You sell more. You borrow money and sell more. The company approaches a valuation that is absurd and crosses it. You sell more. You take out a loan against your house and you sell more. You borrow from friends and sell more. You sell your car and your house and you sell more of the stock. If the stock returns to only modestly overvalued you will make a fortune. If not, you lose everything.
This story ends in a couple ways. If you were unlucky and sold short Amazon.com or Yahoo or Lucent or any other overvalued tech stock in 1998 or 1997 then you were ruined. If you sold short in late 1999 or 2000 or 2001 then you made a fortune.
There are a few keys to making this work. First, be diversified in time and in stock. Make sure that no loss, no matter how incredible, will put you out of business. Second, stay liquid. Don’t get anywhere close to your margin limit. Have some backup cash or a credit line ready so that if the stock shoots up you can wire in some more money and short more. Third, don’t short a stock unless there is something that will force it down. In other words, don’t go against stock momentum or bet against a ‘high-tech’ company, even if the product is a rumor and the company’s sole asset is a promise and a ‘vision’. At the very least, if you do that, make sure that it is a small part of your overall portfolio.
At the risk of repeating myself I will repeat myself: do not short stocks that are valued at a multiple of promises and dreams. My only significant losses in short selling have come from Research Frontiers (REFR: $2.9681 +2.35%, market cap: $49.0M), Document Security Solutions (DMC: $4.11 +1.48%, market cap: $62.4M), and Parkervision (PRKR: $2.34 -4.49%, market cap: $77.5M). None of these companies has an operating business worth more than 10% of its market cap. Parkervision and Research Frontiers have great new technologies (that I think are totally bogus) and Document Security Solutions has a patent and a court case. If you take a look at Research Frontiers, you will find that it has been promising for decades that its great technology is just around the corner, and yet it never seems to sell anything (see my previous article on Research Frontiers).
Even after avoiding stocks that sell at a multiple of hope, it is important to avoid companies where there is no clear reason why the stock should go down in the short run. Short sellers of Imergent (IIG: $6.88 -0.43%, market cap: $78.7M) and Usana (USNA: $31.62 +0.51%, market cap: $491.9M) would do well to remember that. The sad fact is that companies with a bad business can last far longer than they should.
So what is left to short? There are wildly overvalued stocks that are overvalued only because no one knows about them. This is the type of stock that Continental Fuels (OTC BB: CFUL) was. I sold it short around $2.70 and rode it all the way down to $0.50. It is now trading at $0.60. When I shorted it, its diluted market cap was over $1.5 billion and yet it had maybe $10 million in sales, no promising technology, and a negative book value. However, it is very tough to find such stocks, and getting ahold of their shares to short is very hard.
Then there are the fading stars. These are once-highflying companies that run into problems and have little hope of evading them. Examples include Vonage (VG: $1.43 -0.69%, market cap: $285.3M) and Krispy Kreme (KKD: $3.84 -0.26%, market cap: $259.0M). Krispy Kreme I just missed, while by the time I became active in shorting, Vonage was too cheap. This is also the category into which most housing-related stocks would fall. Everything from Countrywide (CFC: $0.00 N/A, market cap: $N/A) to New Century Finance (now bankrupt) to DR Horton (DHI: $13.00 +0.31%, market cap: $4.133B) and E*trade (ETFC: $1.65 -1.20%, market cap: $3.165B) (didn’t realize they had a big mortgage operation, did you?). [Note: amusingly enough, when I first wrote about E*trade as a short it was weeks prior to its recent stock market crash. I did not actually short it, though it would have been quite profitable to do so.]
Trends, no matter what kind, tend to last longer than anyone thinks. So if you had waited until after the first mortgage problems had made themselves evident in January and February and after panic subsided, you could have shorted a large number of financial and house-building stocks at attractive prices.
If you short sell, good luck. If not, good luck. But even if you do not short sell it would behoove you to pay attention if short sellers target your favorite stock. Imagine the happiness of those few Enron shareholders that sold after hearing about Jim Chanos’ shorting of the stock.
Disclosure: I have no position in any stock mentioned. My disclosure policy makes for good reading. The picture of the grim reaper above is me. Yes, I do realize that I need to sharpen my scythe. No, I do not take myself too seriously.
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