Confessions of a Short Seller

The Oxford Club’s C.A. Green comments on a rather savvy group of investors with "both a nasty contrarian streak and a predisposition to fly the Jolly Roger."

I never thought of myself an as unpatriotic.

I always stand for the national anthem. I pay my taxes. (Most of them, anyway.) And while it’s true I’ve said a few things about the Clintons that can’t be reprinted in a family paper, I’ve never turned a calloused eye towards baseball, apple pie or the swimsuit segment of the Miss America pageant.

So I’ve never understood why some folks call me "un- American," simply because I enjoy selling short.

Would it be more patriotic if I bought and held all those technology stocks that are rumbling down the Nasdaq like an avalanche in spring? If I rode Microstrategy from $300 a share to less than $2, would that make me more civic-minded?

In my experience, most investors fall into one of two broad camps. The first are optimists. They think the market will go ceaselessly higher and so they cast their bread upon the waters in hopes of outperforming a passbook savings account…or at least the know-it-all who lives next door.

Some are more successful than others.

The second group of investors, those with a more skeptical bent, believe that even if stocks have gone up 11% a year since the pilgrims landed on Plymouth Rock, they won’t in the future. They sit comfortably in cash and short-term Treasuries, waiting for the storm to hit.

But there is still another group of investors, with both a nasty contrarian streak and a predisposition to fly the Jolly Roger. And we enjoy selling short. Which is nothing more than the reverse of an ordinary transaction.

For instance, if you buy a stock at $10 and later sell it at $15, you’ve made $5 a share. On the other hand, if I first sell a stock at $15 and then later buy it back at $10, I too have made $5 a share. The difference is you "went long" and I "went short."

Experience tells us stocks always go down faster than they go up. (Just ask any shareholder of Worldcom or Global Crossing.)

Right now, for instance, I’m short Eastman Kodak. The company’s net income has decreased 74% in the past year and the future looks even worse. Digital cameras are doing an end run around the traditional film business. And the former blue chip continues to announce one expensive restructuring after another.

I’m also short Merrill Lynch. The company just announced a 26% drop in earnings on a 37% freefall in revenues. And when the news broke that the company’s all-star internet analyst privately called his own stock recommendations "dogs" and "powder kegs," how could a short seller complain? Mark Spitzer, the New York State Attorney General, is looking for a $100 million apology. Expect other states and tort attorneys to follow the trail of bread crumbs.

And the list goes on.

Short selling is not for everyone. It takes time, practice and plenty of due diligence. And, since there is no limit to how high a stock can go (at least theoretically), it takes a disciplined approach that allows you to cut losses early and let your profits run. In my view, if it’s okay to bet on the market’s potential winners, why not bet on potential losers?

Like companies whose revenues are taking a nosedive. Companies that are missing earnings. Companies that are diluting earnings with lavish option compensation. Short sellers are betting against inept management. Companies that are losing market share. That pull accounting tricks to prop up their earnings. We’re betting against companies that are slow to innovate, that have poor risk management, that have lost credibility with investors.

Companies whose products or pricing have become uncompetitive. We’re betting against companies that create unrealistic expectations in shareholders. We’re betting against companies with high leverage that have to struggle to service their debt. Companies that break laws, that violate contracts, that bring expensive litigation on themselves. We’re betting against companies whose shares trade at ridiculous multiples. That show low returns on equity. That have paltry operating margins. And some that, just maybe, should have waited to see if their business plan was viable before going public.

If there’s a spectacular example of a company that embodies many of these qualities, it’s the clear winner of 2001’s Golden Fleece Award and a favorite topic of conversation here at The Daily Reckoning: Enron. The company mismanaged company assets, overstated earnings by hiding losses in thousands of off-the-books partnerships, lied to employees, cheated shareholders, duped the investment banking community, and acted as a cheerleader for the stock while insiders quietly unloaded over $1.1 billion of the stuff in the 12 months before filing bankruptcy.

In the process, the company moved up from being the country’s seventh largest…to the most despised.

While some of this information came to light only after the company’s collapse, Enron was no stranger to professional short sellers. Indeed, James Chanos was on the road making Powerpoint presentations about Enron’s future demise for months before the company’s trousers hit the floor in public.

Was shorting Enron unpatriotic?

If so, let me grab my passport.

Right now, for instance, I’m short a biotech company that has dropped more bombshells on shareholders lately than Tommy Franks has on the Taliban.

In January they announced that fourth quarter losses were triple the level of a year ago. And way below consensus estimates.

Then they warned investors to expect even bigger losses in the year ahead. But – they reminded shareholders – they would soon have a blockbuster impotency drug to compete with Viagra that would turn everything around.

Instead they turned everything upside down two weeks ago, when management announced product delays that pushed everything into at least 2003. The stock lost 34% in a single session.

And the stock is still a wonderful short. The company sports both a negative 85.9% profit margin and a negative 39.8% return on equity.

It’s companies like these – with faltering sales, dashed expectations, and a balance sheet awash in red ink – that make me proud to be a professional short seller.

And to some, I suppose, a bit unpatriotic too.

C.A. Green,
for The Daily Reckoning
May 08, 2002

P.S. The stage is set. With their cash burn rate, the biotech I’m referring to is going to need to go back to the trough again and again, taking on debt or issuing more shares, diluting shareholders in the process. Yet, investors are still buying into the Viagra-clone story. Given their negative 85.9% profit margin… this stock has plenty of room to the downside.

Mr. C.A. Green, a fifteen-year Wall Street veteran, is Investment Director of The Oxford Club. In addition to writing on global investing for Wall Street Week’s Louis Rukeyser, he has been a writer or contributor to several financial publications including Global Insights, Short Alert, Insider Alert, Momentum Stock Alert, The Financial Sentinel, World Market Perspective, and The Fleet Street Letter.

Gold hit $312 yesterday, while gold stocks fell 2%. The stocks have probably gotten ahead of themselves and can be expected to cool off a bit.

For reference, the price of gold is up nearly 25% from its August ’99 low…but it’s still down a few bucks from its October ’99 high. If and when it gets back above $327, gold bugs will be very excited – believing the way clear for a major bull run.

The Dow and Nasdaq are probably ready for a break – the Nasdaq has fallen almost every day for the last 2 weeks. It’s got to bounce sometime.

The Greenspan Fed may have done the market no good yesterday – but at least it did no harm. As expected, rates were left where they were – with overnight money available at a 40-year low.

All the world expects a rate hike later this year – in response to the developing recovery. Wouldn’t it be funny if the Fed cut rates instead? We’re not predicting it…but the bettors are so thick on theRecovery=Inflation=Higher Rates Hypothesis, we can’t help but want to take the other side of the trade.

"It should not be surprising that the U.S. is at the brink of outright deflation," writes Stephen Roach. Deflation is what you get when an economy goes into recession. The U.S. economy is supposed to be coming out of recession…not going into one. Mr. Greenspan appeared before a congressional committee last week and told us everything was going just fine. The committee members asked the usual dopey questions.

But the Mogambo Guru notes there were a couple of questions the congressional hacks failed to ask. for example:

"Mr. Greenspan, do you realize how stupid you sound? This is the same waffling twaddle that you used all through the years….given the excruciatingly poor performance of the Fed, do you have even one single bit of evidence that you have any ideas what in the hell you are doing, or why anyone in his right mind would have the least confidence in your or your policies?"

Eric, more details from Wall Street, please…

******

Eric Fry in New York…

– Stocks stumbled through another trading session – like a drunk down a back alley. The Nasdaq staggered back and forth from plus to minus, before ending the day four points lower at 1,573. Meanwhile, the Dow frittered away a triple-digit advance to end the day 28 points ahead at 9,836.

– Even though the stock market is sinking, however, the government tells us that our productivity is on the rise. According to the Labor Department, U.S. workers achieved the biggest annual increase in productivity in 19 years during the first three months of 2002. The report showed that productivity jumped to a sparkling annual rate of 8.6%, thanks to a 5.4% drop in unit labor costs.

– Of course, "falling unit labor costs" might just be another way of saying "rising unemployment." Over the short run, falling employment can boost "productivity." In any event, all this productivity stuff seems like it ought to be good news. The only problem is that the economy does not appear to be in any better shape as a result of our terrific productivity. Corporate profits are still low, corporate debt is still high and a sustainable economic turnaround is still nowhere in sight.

– Most investors would probably trade some of our highly productive slow growth for a bit of woefully unproductive fast growth.

– Unfortunately, slow growth is what we’ve got, as the latest unemployment numbers attest. Many Wall Street strategists would like to dismiss April’s 6% unemployment rate as an "aberration." But the troubling report cannot be dismissed so conveniently.

– ISI points out that "several indicators suggest weaker labor markets." Namely, the "jobs hard to get" index and the U.S. "help-wanted ads" index are both heading lower and close to multiyear lows.

– And money that is not earned in the workplace must be borrowed. That’s one reason why indebtedness is soaring throughout the U.S. economy. Household, government and corporate debt levels are all heading higher. In fact, U.S. non-financial corporate debt is now equal to nearly half of U.S. GDP – that’s the highest such reading on record.

– Soaring debt doesn’t seem like a particularly productive trend. But what do we know?…

– Remember "page views," "eyeballs," "mezzanine rounds," "exit strategies" and all the other buzz words from the venture capital go-go era of 1999 and 2000? Way back in those days, when absolutely everybody knew that venture capital investing was the fast-track to riches, institutional investors begged for a chance to throw money at the Silicon Valley venture capital funds.

– But now that many of these funds have lost one third of their money or more – in some case a lot more – this same hot-money crowd of institutional investors is begging for a chance to get out.

– "After venture-capital funds returned an average 163% in 1999," the Wall Street Journal observes, "a total of $145.4 billion poured into the sector in 2000 and 2001, more than the previous 10 years combined."

– (Question: How did all this "dumb money" get its hands on $145 billion in the first place?)

– Like making a fine wine, successful venture capital investing requires a bit of time. But the hot-money crowd has no interest in hanging around for the prospective future profits. Up and down the Silicon Valley, many of the investors who clamored to get in at the top are now clamoring to take what’s left of their money and get out.

– These folks would rather start chasing after the next hot thing, so that they can start losing money in new and exciting ways. As the hot money crowd moves along to its next investment disaster, very few new investors are lining up in its place. Interest in venture capital investing is drying up faster than a keg of beer at a frat party.

– "Hopes that venture-capital investing had stabilized now seem premature," says the Wall Street Journal, "For the first quarter, money invested by venture capitalists fell 23% to $6.2 billion from $8.1 billion in the fourth quarter of last year." And that’s less than half the amount invested in the first quarter of 2001.

– The Journal concludes: "These days almost no one is willing to make a prediction about when the slide will end since there is so much uncertainty about the economy."

– Hmmmm…sounds interesting. When the hot money is dying to get out and new money is afraid to get in, a contrarian investor might want to sit up and take notice.

******

Back in Paris….

*** Wow! Productivity rose at a 8.6% annual rate during the first quarter – according to the Labor Department’s number crunchers. Productivity got a big boost from lower unit labor costs – down at a 5.4% rate.

*** Businesses were able to produce more without adding labor. In fact, the number of hours worked actually fell at a 1.9% rate.

*** This is great news, if you believe it. "It’s something that will keep inflation in check," said Daiwa Securities’ chief economist. The world’s most flexible and dynamic economy just keeps getting better all the time. Where will it all end?

*** The war in Europe came to an end on this day in 1945. Paris is as quiet as the Western front today. Much different from the way it was 57 years ago.