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Tuesday, February 11, 2014

Notes on The Art of Short Selling

"For the last week I've been carrying "The Art of Short Selling" around with me just about everywhere. Every time I get a break, I just open to a chapter. Doesn't matter if I've already read it. I just read it again." - Michael Burry

These are my notes on Kathryn E Staley's Art of Short Selling. I found this to be a stellar book filled with interesting market history and techniques to help short sellers. The book was published in 1997 so the examples are bit aged and recommends slighted dated sources for idea generation but I believe the foundation is timeless. I do not detail all the vignettes -- I recommend buying/borrowing the book for them -- but I tried to emphasis the players in short selling and the techniques needed to be a more skillful short seller. I hope you find these notes useful.  All ideas belong to Kathryn F. Staley, any misinterpretations are my own - Joshua Wallis




Art of Short Selling Chapter 1: Overview:  Wealth with Risk

Short sale candidates are in three categories
     1. When management lies to investors and obscure events that affect earnings
     2. Companies with inflated stock prices
     3. Companies that will be affected in significant ways from external events

Signs that a company might be a good candidate for a short
     1. Accounting gimmickry
     2. Insider problems: insiders using the company as a personal bank or are selling the stock
     3. Company has a consumes too much cash
     4. Assets are overvalued or balance is in terrible condition

You can get subscriptions of insider transactions in 13Ds, they are reported in Barron's and the Wall Street Journal. There are newsletters such as Vickers and Insider Chronicle that also do this.  Standard and Poor's Daily Stock Price Record and the Quarterly History Tape also provide short-interest data.

[websites like www.dataroma.com already do a good job of this]

Be careful of companies with small floats due to higher risk of buy ins. 10M shares are less is generally considered a small float.

Art of Short Selling Chapter 2: Short Sellers

Well known short sellers: Robert Wilson (profiled in Money Masters), George Soros, Michael Reinhardt, Julian Robertson

Julian Robertson of Tiger Funds
Example of his short would be generic drug stocks. They had high multiples (30 to 40 times earnings) but Robertson felt these companies had no franchise value, no sales force and therefore would produce a commodity product.

Alex Porter of Porter, Felleman
Shorts stocks to reduce risk in the overall portfolio during protracted declines. Generally shorts stocks where management does not own much stock, the company is leveraged, the management is not realistic about the company's prospects or has a fatal balance sheet flaw. Alex Porter looks for companies where you can stay short without pain or expense.

Joe DiMenna of Zweig Funds
Shorts five types of situations (1) frauds (2) earnings disappointments (3) hyped stocks where there are holes in the Wall Street's consensus estimation (4) industry themes were macro forces are negative (5) a deteriorating balance sheet.  He tends to avoid stocks with strong earnings momentum solely based on momentum. He waits for the stocks to break before getting involved. He will avoid short candidates in a crowded field unless the company is terminal

The Feshbach Brothers of California (Kurt, Joe, Matt and the non-Feshbach Tom Barton)
They founded their short found in 1982, at one point they managed a lot more money than any other short sell fund. In 1990 they managed $600 million.  They look for terminal shorts with these four characteristics

1. Stock prices overvalued by at least 2X IV
2. A fundamental problem at the company
3. A weak financial condition -- working-capital problems or high long-term debt
4. Weak or crooked management

The brothers consistently look for dodgy stock promoters like the OTC Review's editor, Bob Flaherty (http://articles.chicagotribune.com/1989-02-26/business/8903080465_1_penny-stocks-penny-stock-stock-market) . Their first success short was Universal Energy.  Feshbachs work intensively and have information overkill. They don't short a stock unless there can be a price decline of 50%.

An example of their work is Kirschner Medical. Any analyst could show they had 400 days of inventory but their analysis showed they had $10M of obsolete inventory. "The reason we put so much emphasis on phone calls to competitors, suppliers, and customers is that's where we get our edge --in discovering what drives the numbers. Everybody knows that the numbers are on historical basis. If they don't, they're either illiterate or just lazy. Sometimes, they misinterpret them."

The brothers also shorted Circle K after doing heaps of homework. They discovered that due to sale/leasebacks the valuation for Circle K was much lower than previously thought of. They realized the company had a large amount of debt off the balance sheet as well. Circle K also started to out price their customers, during the same time the other competing stores were providing 24 hour service. The company had Wall Street coverage but the Brother's eventually covered their positions at $1.

The Feshbachs do not cover for a quick 20% decline profit -- they have specific price targets ad buy back when it hits those price targets. They will close a position if proven wrong or will add to a position as  more data is uncovered. The Feshbachs find talking to Wall Street or the management is not helpful. They are too biased in the positive to be useful.

[The Fesbach Brothers are pretty interesting. They were massively into Scientology and based their short selling prowess on the teachings of dianetics. They eventually went bust.  Here are some great articles about the Feshbach Brothers:
  1. Los Angeles Times: Short Road to Success : Investing: The Feshbach brothers of Palo Alto have made a fortune betting that stocks will go down. But some critics question their short-selling methods. http://articles.latimes.com/print/1990-10-14/business/fi-3720_1_short-selling October, 19
  2. New York Tims: No Guts, No Glory: Short-Selling in a Bull Market http://www.nytimes.com/1992/01/12/business/no-guts-no-glory-short-selling-in-a-bull-market.html January, 1992
  3. Tampa Bay Tims: Scientology nearly ready to unveil Super Power http://www.sptimes.com/2006/05/06/Tampabay/Scientology_nearly_re.shtml/ May 6, 2006
  4. An Hour long video with John Hempton of Bronte Capital where he (partly) discusses the Feshbach Brother's and their downfall https://soundcloud.com/the-odd-lot/john-hempton-audio-interview ]

"McBear" -- launched his fund in mid-1983 at 40.
Major short ideas are based on extensive credit work. When shorting Caterpillar Tractors in 1984, he the main customers (oil drillers, mining companies, South American countries) were now broke or short on cash. Even though their customers were now broke, Wall Street was still expecting earnings of $4 in earnings per share. The company ended up losing $5 a share and because McBear realized the industry was changing it gave him insight into a structural problem in the economy.

Jim Chanos
At 24 he called the Baldwin-United bankruptcy. (note, book was published in 1997, so things might have changed.) He doesn't short frauds with small floats because of size restraints and generally doesn't have a problem with buy ins because he focuses on large-cap stocks. He maintains a concentrated portfolio of about 30 stocks with 10 positions accounting for more than 50 percent of his portfolio.

He typically shorts stocks where there are secular problems and the equity value is worth 0. He uses return on invested capital as a key financial indicator. "That ratio will reveal a lot of wormy companies and poor businesses. It's a tough number to screw around with. "

Chanos on financial companies "leverage inherent in some of these companies is incredible. When the accounting gets murky, people tend to shy away from rigorous analysis and rely on management and just take earnings per share at face value. Therein lays the opportunity."

When Chanos analyzed Baldwin-United he had to dig deep into tax accounting, research affiliated company transactions which convinced him the stock was a zero. The stock went from 20 to 50 dollars during his sell recommendation,and then Baldwin-United went bankrupt.

[This book was published before his famous Enron coup]

Art of Short Selling Chapter 3: Bubble Stocks

Often times the most brutal shorts are with companies with no assets or revenues. They are companies with a pipeline, either a technology or medical products company. Management can help push these stocks to unreasonable valuations.

ZZZZ Best
This was a hot growth carpet cleaning company that was headed by Barry Minkow. ZZZ Best announced a contract to clean to large buildings in Sacramento for $8 million. Carpet cleaning competitors told Feshbachs that the two largest contracts were MGM Grand and the Las Vegas Hilton and were capped at 3.5 million, so the Feshbachs knew something was wrong. The Fesbachs shorted aggressively but stock still went up. ZZZZ Best eventually went bankrupt sending Barry Minkow to jail for 25 years. The company had no contracts, no revenues and was a money-laundering scheme.

Harrier, Inc
This was a medical-products company that was headquartered in Utah. There were no assets, no sales, no products and a $30 stock price with a market capitalization of $84 million. The March 31, 1988 10Q showed a typo, repeating 1987 twice, insinuating the financial statements were not proofread. In the initial public offering or prospectus, the original owners were formed by a blind pool lead by Merlin Fish, the owners included a real estate developer in Charleston, Merlin's former California client, Merlin's brother who owned a construction company and a furniture company manufacturer's representative in Utah.

The first public offering included 25 million shares at $0.01 where the proceeds were for unspecific use. The company went on to do a 50-to-1 reverse stock split and start a company based on gobbledygook businesses including "biodynamic water", Hungarian polarized light and sold shares to a Liberian company. The most cheerful recommendation for Harrier, Inc came from the Merlin Group! The company eventually traded for pennies but not until he reached over $20 a share.

Medstone
The prospectus of Medstone provided the following information. (1) the product was not patented. (3) The competition was large and international with significant installed base (3) the gross margins were 60% but  were not sure since expenses and revenues were not appropriately matched.

Medstone was considered a "doctor stock". Doctors are considered to be suckers on new drug or medical-products. The doctors promote the stocks to peers and friends and enthusiastically inflate the market value.  The founder and president sold shares before the deadline on insider trading. The chairman and founder resigned. The company ended up selling for pennies.

Reading prospectuses is extremely important in finding shorts. Information can be found on prospectuses that can't be found anywhere else. It's extremely useful information. You can find out about past problems the company has.

The Happiness Express
86% of the sales came from Power Ranger toys, and 56% came from sound effect gloves alone. It was an obvious fad stock with an eventual decline.

The "ShortBuster Club" was run by Ray Dirks. Dirks would try to organize short squeezes. Most of his companies he tried to protect eventually succumbed to failure -- not because of short sellers but because of fundamental failures of the business.

[More information on Ray Dirks:
  1. New York Times: Wall Street;A Fast-and-Loose 'Short Buster' http://www.nytimes.com/1992/08/02/business/wall-street-a-fast-and-loose-short-buster.html 1992 written by Susan Antilla
  2. Businessweek: Tops With The Shortbusters http://www.businessweek.com/stories/1998-11-22/tops-with-the-shortbusters 1998

Art of Short Selling Chapter 4: High-Multiple Growth Stocks, Part 1: High Risk, Low Return

Fad companies don't always as quickly as short sellers would like. Coleco Industries promised a cheap home computer for under $600. The computer didn't arrive on ship date and the computer boards were poorly assembled. The company would have died quicker but the cabbage patch doll fad helped them limp along.  Other examples of fad stocks that lasted too long were Scoreboard that repackaged baseball cards and sports memorabilia, J. Bildner & Sons that offered upscale yuppy 7-Elevans, Jiffy Lube with its aggressive financing to franchisees and competitive landscape.

Art of Short Selling Chapters 5-10:

The book goes on to detail on a number of companies. There are too much information to go into detail in each company. Here is the a list of the rest of the companies covered -- definitely read to the book to understand the context of each short candidate.

Chapter 5: High-Multiple Growth Stocks, Part 2: High Returns, Faltering Growth

Beverages:
Cott Corporation
Snapple Beverage Corporation
High Tech: Media Vision

Chapter 6: If You Can't Read It, Short It
National Education
Autotote
The Weasel: Western Savings and Loan
Insurance Companies: Who's on First?

Check out insurance commission filings at NAIC (https://eapps.naic.org/cis/) Kathryn Staley offers a roadmap on how to go through NAIC filings to check asset allocations and reserves of insurance companies. Staley recommends: Clair and Joseph Galloway's Handbook of Accounting for Insurance Companies. (http://www.amazon.com/Handbook-Accounting-Insurance-Companies-Galloway/dp/0070227454) This book goes for 70+ on Amazon.

"Experience suggests that if you cannot understand a report, officers are hiding something worse than you expect. It's almost an iceberg phenomena: If you find five or six serious questions in financial statements, you can be sure that there are many more that you cannot see. If a call to the company for explanation receives a garbled response that sounds suspiciously like the company official is speaking in tongues, you have go a live one." 

[This reminds me of the chapter of Too big to fail where Warren Buffett reads Lehman Brother's 10-K but passes because there are things he doesn't understand]

 Quote from Sorkin's Too Big to Fail "Buffett decided to hunker down that evening at his office and pick apart Lehman's 2007 annual report. After getting himself another Diet Cherry Coke, he began to read Lehman's 10-K, its annual report, when the phone rang; it was Hank Paulson. This seems orchestrated.

Paulson began as if it were a social call, knowing all too well that he was walking a fine line between acting as a regulator and a deal maker. Nonetheless, he quickly moved the discussion to the Lehman Brothers situation. "If you were to come in, your name alone would be very reassuring to the market," he said, careful not to push his friend too far. At the same time, in his roundabout way, he made it clear that he wasn't going to vouch for Lehman's books--after all, for years Buffet had heard him, as a top executive at Goldman; rail against other firms he thought had been too aggressive in both their investments and their bookkeeping.

  After years of friendship, Buffett was familiar with Paulson's code: He was a hard-charging type, and if he wanted something badly enough, he would say so directly. He could tell now that Paulson wasn't pressing too hard. The two promised to stay in touch then bade good night.

  Buffett returned to his examination of Lehman's 10-K. Whenever he had a concern about a particular figure or issue, he noted the page number on the front of the report. Less than an hour into his reading, the cover of the report was filled with dozens of scribbled page citations. here was an obvious red flag, for Buffett had a simple rule: He couldn't invest in a firm about which he had so many questions, even if they were purported answers. He call it a night, resolved that he was unlikely to invest. "


Chapter 7: Money Suckers: Coining Money to Live
The Nine Lives of Integrated Resources, Inc
Summit Technology, Inc.
Companies with no profit and little revenue can survive longer than rationally expected if they can promise prospective shareholders a bright future. Mining companies, technology companies and pharmaceutical companies are commonly guilty of this -- look at the Cash Flow from Financing to see if the cash normally stems from equity raises. 

[Bronte Capital mentioned a pharmaceutical company that is guilty of this. Galena Biopharma (GALE) -- consistently goes to the market for equity raises.  Bronte Capital outline's dodgy business practices here: http://brontecapital.blogspot.com/2014/02/get-your-opiates-for-free-capitalism.html]

Chapter 8: If You Can't Fix It, Sell It
Harcourt Brace Jovanovich Escapes Maxwell's Money
Texas Air: Flying with Frank
Kay Jewelers Sells Out (or Tries to) at the Annual Sale
Morris Knudsen

Chapter 9: Industry Obsolescence: Theme Stocks
The Arizona Land Race
American Continental: What's All the Ruckus About?
Sun State Savings Acquired on Margin
Valley National: Uncharacteristic Wall Street Battle

Chapter 10: All of the Above: Crazy Eddie
An Identifiable Story Stock
A Private Family Bank or an Electronics Chain?
Does a Medical School Count as Vertical Integration?
Wall Street Hysteria and Home Shopping
The Plot Develops
The Big Break
Notes


Art of Short Selling Chapter 11: Shortcomings

Three sins of short selling: sloth, pride and timing

Sloth
Doing too little work is always a problem for investing -- without proper doing the proper work (spreadsheets, notes, readings) you'll lose conviction when the position runs against you and you'll inevitably take a loss. "Shorting's easy. You short a stock, watch it double, cover in panic, then wait for the inevitable bankruptcy"

Pride
The pride problems comes out in two different areas (1) using formulaic analysis to short companies. An example of that would be seeing six great savings & loan shorts and shorting the seventh without deeper analysis. The real estate or economic environment might be different for the seventh bank causing your thesis to be proven wrong. (2) shorting good companies. Julian Robertson and Jim Chanos have both identified this error. This is another way of saying don't short just based on valuation. Good management is tends to fix problems, which when solved cause already overvalued stocks to shoot higher.

Timing
There is no solution for this. You find a great short selling candidate only only to see i turn into a 2% annualized rate of return because you were too early. First reason for bad timing is underestimating the insanity of the public market. Horrible companies can continue to exist on the promise of great products. Drug companies tend to have this problem. The second reason for band timing is the investment bankers ability to raise money to keep bad companies on life support. Sometimes companies end up resolving their problems before the market realizes the fatal flaw. Sometimes the macroeconomic environment changes and lifts the company out of it's problems, such as a change in interest rates. Short sellers might also underestimate a company's ability to grow out of their debt load. When the business environment is good -- business might survive a surprisingly long time with a crushing debt load.

Short sellers have several techniques to try to remedy the timing problem. Michael Murphy covers automatically after a 25% price run-up and waits to short again. Other managers wait until the stock cracks, after the first drop when earnings and price momentum have slowed. Joe DiMenna never shorts a stock with great relative strength.

Other small problems with short selling
  1.  Don't short commodities through a stock. It is easier to short companies based on their financials than it is based on their commodity production. If you do short a company that is highly influenced by the commodity, make sure you understand the commodity cycle of that product, for example if you are a short a chicken stock make sure you understand how weather and corn feed prices will affect chickens. Sometimes you'll find companies that are growing their inventories faster than revenue, but if that is the case your thesis should be built on bad financials but not the underlying commodity of the inventories.
  2. Many short sellers avoid technology stocks. Normal signs of a good short do not apply to these companies. Often inventories will rise when a new products is coming. Insiders will own and sell stock without regard to the company's condition. Margins can fluctuate based on product cycles and pricing curves. Tech stocks have infamously caused problems with short portfolios -- American Online, US Robotics and Iomega.
  3.  Squeezes tend to be a self-inflicted wound for short sellers when they don't recognize the importance of float. Since short sells are based on getting loans for stock, when shares are no longer available for a lend it is inevitable you'll have a buy-in. Companies who want to be aggressive toward short sellers may ask their shareholders to take theirs take their shares out of a margin account (therefore hard to borrow) and into a cash account. They could also issue cash dividends or preferred shares that could make short selling more expensive. These tactics don't work well for companies with large float but might work well for companies with a small float. The books gives examples of infamous short squeezes such as Total Systems, General Development and Chase Medical.
  4. Leveraged buy-outs s can cause stocks to be bought out at ridiculous valuations. Especially be worried during a flurry of deals -- private equity groups can start paying outrageous prices.
  5.  Fear causes short sellers to buy back their positions after a large run up. Generally if it scares you to death to short more of a company, the better move is to short more.
  6.  Be able to change your outlook if the facts change. Don't stick with the same thesis if the facts change.
  7.  It is easy to fall in love with your own analysis if the problem is highly complex. If you spent loads of time in the analysis it is easy to say you must have an opinion on the stock, when one might not be recommended.
  8.  Crowded short positions are also a problem. Amateur short sellers might buy a position when one might not be recommended.
  9. Last but not least, shorting a company that is going through a "hiccup", instead of shorting a company that's having it's core business being overwhelmed. When a company is growing you can hide bad accounting practices for a while. Never short a good company.

Art of Short Selling Chapter 12: History and Controversy

This is chapter describes history of short selling, dating back to the tulip bubble to present day; the history of regulation and prohibition of short selling in different countries and at different times. The chapter offers vignettes on famous early 20th century short sellers like Jesse Livermore, Barnard Baruch, "Sell 'Em" Ben Smith, and Joseph Kennedy.

The history of short selling can be summarized by a cycle of prohibition and constant suspicion. Companies that have squealed about the terror of short selling, almost inevitably succumb to failure due to bad business practices rather than speculators.

"No law can protect a man from his own errors. The main reason why money is lost in stock speculations is not because Wall Street is dishonest, but because so many people persist in thinking that you can make money without working for it and that the stock exchange is the place were this miracle can be performed." Bernard Baruch


Art of Short Selling Chapter 13: Six Pillars of Fundamental Short Selling

The Short Seller's Random Walk for Ideas:

Some of the best ideas are found in Barron's, Wall Street Journal and Forbes. Generally after a good short expose on Barron's, the stock drops immediately after publication and recovers. It takes about a year for it to become a great short -- that is when the short thesis becomes fully saturated. Companies with large short interest increases can good places to hunt, this companies have generally developed fundamental problems therefore causing the short interest increase and making them good candidates. The one thing short sellers need to be aware is the short interest relative to float.  In the early 1990s, short positions in excess of 15% of float seemed to cause buy-ins. Other good short candidates can be found by observations, such as toy fads that aren't meeting the expectations of your child because they have not hit stores before the holiday season.

1. The Pessimist's Guide to Financial Statements

Short sellers attempt to discover the meaning behind the numbers and what drives the business. Books to read to increase your understanding of financial statements include. Leopold Bernstein's Financial Statement Analysis, anything written by Abraham Briloff, and Thornton O'Glove's Quality of Earnings.

Short sellers should research the company's last six 10Qs; the last two 10Ks, proxies and annuals, and any 8Ks.  After studying these documents a short seller might need to go back farther chronologically.

Quality Control

The most useful part of the financials will be the footnotes.

Start with the last dated balance sheet and look for assets of suspicious value:
  • securities not marked to market
  • inflated real estate values
  • obsolete inventories
  • aggressively booked receivables
  • receivables with low loss provisions
  • bad loans
  • fuzzy or empty assets
Accounts receivable and inventories should be tested by looking at the growth in receivables and inventories versus previous year and comparing that to the growth in sales and cost of goods. If receivable growth is substantially greater than growth in revenues, problems with earnings will be likely. Growth in inventory versus growth in cost of goods is the single most reliable sign that a manufacturer or retail company will stumble. That red flag urged investors to sell U.S. Surgical, Cott Corp., L.A. Gear, Snapple, Royal Appliance, American Power Conversion, and Sofamor Danek in advance of dramatic stock price collapses. Deferred charges might also been an area of abuse -- deferring expenses can cause earnings reversals if revenues stop growing.

Goodwill and other intangible costs might be signs a company has overpaid for acquisitions, failing to expense drilling costs or software development. Check footnotes for the schedule of expenses for policy manuals which might have capitalized over too long of a period.

If accumulated depreciation drops when gross PP&E rises, the company might have changed average life assumption and run a reversal through in the income statement.

On the liability side of the balance sheet, look for odd descriptions or uncommon types of liabilities. Be especially suspicious of liabilities approximated or the present valued with assumptions made by management. Check footnotes for and notes on financial conditions to see if the company has any off-balance-sheet liabilities, any debt guarantees, or recourse-factored receivables. Check for growth in short term and long term debt.

Note all lines of revenue that appear to be nonrecurring:
  • sale of equipment, land, and real estate
  • sale of securities
  • Interest on securities or cash equivalents
  • tax credits
  • currency gains as a reduction in cost of goods sold
  • one-time credits from manufacturers
  • reduction in provision for doubtful accounts
  • one-time license agreements
  • change in account
Check the assumptions the company makes to book revenue and read the notes that explaining earnings in the current period. Check for any odd sources of revenue. Readjusted earning per share for fully diluted shares. Adjusting for the fully diluted shares can be a bit tricky, add in all convertible shares if they close to conversion or likely to be converted and any options and warrants.

Important Ratios

Check to see if company is trying to appease the street by giving a nice trend for earnings per share growth, and if so, see if they are trying to massage the numbers. Look at capitalization: long-term debt to equity, total debt to total capital, long-term debt to capital. Compare several years of balance sheets to see the trend in these ratios.

Check ROE, ROA and ROIA. ROIA (Return on invested assets) is calculated by income before interest and taxes divided by equity plus all interest-paying debt. Look for trends and volatility of returns over time. It also tells, by comparison how the company does relative to other companies in the same industry, whether the company returns more than its average and marginal cost of debt, currently and historically.

Key valuation ratios are Price to Earnings, price to book, price to revenue and price to cash flow. If a takeover occurs in a similar company, these ratios calculate quick comparables. Certain ratios are better for comparison in different industries. Price to revenue is higher for retail than for manufacturing. Price to earnings reflect growth potential. Price to cash flow is a buy-out indicator.
  • Minimum list of ratios include the following
  • Checklist of Ratios
  • Capital Structure
  • Return Ratios
  • Valuation Ratios
  • long-term debt to equity
  • return on equity
  • price to earnings
  • total debt to total capital
  • return on assets
  • price to revenues
  • total debt to equity
  • Return on invested assets
  • Price to operating cash flow
Go to the income statement to common size the statement:

Put everything in percentage of revenues to see if the percentage relationships are changing. R&D or Advertising as a percentage of revenue declining? Compare anomalies to the balance sheet. If SG&A is declining as a percent, are prepaid expenses or other assets rising? Is depreciation flat while fixed assets increase? Compare pretax operating profits. What is the sequential trend, as well as the annual one? Does it make sense for the business? Look for deviations and trends.

Cash Flow is King

It is often difficult to determine what the necessary cost from a business point of view is.  The quickest check is to look at the "Cash Flows from Financing." See if the company is constantly going to the markets to keep afloat. Is short and long term debt escalating? Is there a stock or convertible issue every year?

Find out what the companies spends to do business. This can be calculated in different ways but here is one. Net income + depreciation, amortization, deferred taxes - non-recurring items (tax-adjusted, if possible) +/- changes in current assets (without cash, but broke out by lines to see what specifics are causing the cash drain)  +/- changes in other items  perceived to be relevant (like some portions of capital expenditures).

Check how cash flows and capital expenditures change year of year. Check up on any anomaly. If the company able to meet their debt repayments? Check the PIK (payment in kind), zero-coupon bonds and other odd instruments.

Reading the Sleep-Inducing Verbiage

Read the 10K description of the business and the competition. Try to understand the financials in relation to that business plan. Try to drive the company, what the two or three most relevant numbers are. What is the most important number to watch to identify a developing problem? If it is a low-margin business, the key is probably revenues and inventory-turnover ratios. If it's a franchisor, it might be system sales or same-store sales. Does the financial structure make sense for the business? (do not leverage a cyclical company too much, do not build inventories too high if there is potential product obsolescence.)

Think About It

Think of the three financial statements as a 3-D chess game, see how they interact and see what tugs and pulls on what.  Determining the key variable in the health of a company is the most complex part of analysis. If this skilled could be mastered, finding great ideas in the long and short side will come easier.  Read Qs and Ks from first to last to see how things change over time.  Read the annual report and see if the executives say what you saw in the 10Ks and Qs.  Watch out for near meaningless buzzwords like synergism. Look for any oddities in the annual report like pictures of babies in a defense or drilling company -- suggesting the executives are a bit clueless.   Watch for auditor turnover which can truly be indicative of trouble.

What was not in the financials but you did not understand? Look for the lack of:
  • description of nonrecurring revenues
  • information on explicit valuation procedures of odd assets
  • clear disclosure of revenue-booking procedures
  • fuzzy liabilities
  • comprehensible breakout of divisions: revenues, income, assets
  • description of effect of an acquisition on inventories and receivables
Determining what the relevant piece of information is the most part of analyzing a company.  What runs or ruins the business.

2. In Search for Greed and Sleaze

Useful forms provided by the Securities and Exchange Commission (SEC)
  • Form 144. Key officers of a company are required to file this form when placing a sell order of their company stock. Barron' and the Wall Street journal report some insider sales. Vickers and the Insider's Report, also publish a list. [www.dataroma.com is a good source for this material now]
  • Form 4. Insiders of the company must file this form if purchasing or selling shares. The list needs to be published 10 days after the last day of the month in which positions are increased or decreased.
  • 13-D When an entity purchases 5% or more of a stock, they must file with the SEC in 10 days. These publicized in the news Barron's, Vickers, and the Insider Report, as well as the proxy.
  • Proxies: The annual meeting is the trigger for this publication. The publication tells the stockholders what they can vote on during the annual meeting. It also reveals how much stock is owned by management, what their salaries and employment contracts are (including options, bonuses, and some perks) and the stockholders who own over 5 percent. The proxy tells who the accounts are, if there are any pending lawsuits, and other relationships and related transactions are pertinent. It is a great source for information about management philosophy. Look under "certain transactions" for some possible hidden information about creative management contracts
Benchmark Proxies: Pantheon of Stars or Pigs at the Trough?

Watch out for companies with excessive executive compensation relative to net income. Plenty of good short candidates come from executives who pilfer the shareholder's coffers with excessive compensation, benefits or related party transactions.

If you need to read a proxy three times to understand it, chances are you have hit a likely short candidate

Checklist of Proxy Questions

     1. Lookout for exorbitant executive salaries. Look at cash compensation relative to company earnings.
     2. Does the company pay out large bonuses? Why do they pay out large bonuses, was it for doing an abnormally good job or that was just a normal bonus. Is the bonus based on increased sales, return on equity, or some measure or combination of measures? 
     3. Does the company pay a percentage of pretax profits to the primary offers in the form of bonuses? Are executives paid a percentage of revenues? Is the bonus calculated on a quick stock price appreciation.

Stock Options
     4. Stock grants, stock options and stock appreciation rights (SARs). SARs are the most generous because they guarantee cash money and are bankable immediately with no stock price appreciation necessary.
     5. Does the company pay for stock options?
     6. Does the company pay a bonus for taxes on options?
     7. Do executives get special deals if there stock/rights offering of company or a sub's stock?
     8. What percentage of the stock is owned by the primary officers?

Parachutes
     9. Does the company have an unusual severance pay contract, especially in case of merger or buy-out?
     10. What are the terms of retirement contracts?
     11. Are there extra perks such as large insurance policies, apartments, automobiles use, plane us?

"Certain Transactions"

     12. Does the company allow primary officers to do business with the company by owning other businesses? Does the company give those officers favorable terms in those contracts?
     13. Are many of the officers related to each other?
     14. Does the company deal with any relatives of the officers?
     15. Does the company loan money to the officers? Does the company charge interest?
     16. If the company engages with limited partnerships does it pay the officers to become general partners or limited partners? Does it grant bonuses for the participation in those partnerships? Does it give those partners the tax loss?

Miscellaneous

     17. Are there many lawsuits, what is the liability?
     18. What is the age range of the officers? Are they all young or all old?
     19. Who else owns the stock?
     20. Check the board biographies? Is it a "good ol' boy" club? Is it an independent board? (Quaker Oats used to pay their board members $1,000 for each action taken by unanimous written consent)

Make sure officers are getting paid for doing things before the stockholders. See what the top employee's total packages are relative to income. Check proxies over the year see how many executives have left the company. Attrition is not always free available data and requires research.

3. The Bigger Puzzle

Research

Review the industry -- the 10K should give you a good overview of the competitors, customers and suppliers.  Check value line and Stand & Poor's Industry Survey's for the industry fundamentals. Check trade publications and if see if any government office tracks data relevant to that industry. Services like Washington Researchers can provide comprehensive information on any topic. Read other publicly traded company's financial is a useful source of information. You can check a competitor's financials to compare margins, return on invested assets, growth rates, and inventory and receivable turns can give an analyst what is out of line and what looks different.

Store Checks

After you have decided what the business of the company is and what were the important/relevant metrics.  Use this information for checking out the market place. "If the key is store volume, visit a store and count customers, check average ticket size, talk to the store manager. If it is a hot new company with a to-die-for product, see if competitors have heard of the product yet. If it is an oil & change franchise, count cars at peak hours to see if franchisees are hitting break-even assumptions"

Do not make conclusions on one store alone. Outliers due (possibly to do geographic area) might be an outliers on volume. Observing will give you an idea on the company's execution.

4. Who Owns It?

High institutional ownership and high Wall Street coverage can make for quick collapse if something unexpected happens. Always follow short-sale numbers to tell you when a squeeze might develop so that the relative impact on a portfolio can be monitored. Watch option volume and relative pricing to note takeover speculation. Pay attention to 13Ds and 144s.

5. Check the Water Temperature

Accumulate brokerage reports to provide the company-think and Wall Street's attitude. Brokerage reports can provide pertinent industry data. Often companies will send brokerage reports if you ask. Brokerage reports sent from the company bound to be positive.

"As you read Wall Street reports, remember the job description of analysts: They are not paid to make waves or disagree or to be on the cutting edge of stock analysis. Analysts are relative: They are supposed to do a little better than their peers and charm the institutional clients who vote on the Institutional Investor all-star list. The problem is that some misinformed clients expect analysts to read the financials, even their bosses do not. Use analysts for indications of Street-think and as conduits of management information. It is not good guys versus bad guys, shorts versus analysts; the point is how effectively you use the information presented to you."

"Forbes and Barron's do good, strong, analytical fact-finding. Nobody fires them if they make waves. Many indexes carry only two or three years of references, but make sure you have at least five because ancient history is relevant to corporate hanky panky or to the firm's cultural tradition of hanky panky"

6. Pay Attention

If you decide not to short a stock based on your preliminary analysis, it might be a good idea next year. if you short now, watch it. Events move slowly in the financial world, it can be hard to maintain concentration.

First watch for earnings releases. Note when they are expected to be published and what Street expectations are. The date of the earnings release is also statistically relevant: the later they are, the worse the numbers. Many companies will fax the PR release, together with the income statements and balance sheet. Quick information is important. If it is a large, Street-covered stock small investors are at a disadvantage because Street analysts get the faxes and phone calls first, little players sometimes not until days later.

Next, know when financials are expected out. The 10Qs and 10Ks are read slowly by Wall Street, so quick attention can yield important data -- little players can make up for the delay on receipt of earnings-release information. Waiting for new financials is like waiting for Christmas. It is fun to see if you were right and how things are developing. Go first to the key numbers, then the cash flow statement, finally the verbiage. Read the Qs carefully.

Keep watching -- once a potential target, always a possibility. If you know a company well, you might recognize trigger, like the Zises' selling their Integrate stock, or HBJ selling Shamu, or J. Billder's closing stores or running over expected costs and out of money. Be quick to admit defeat. If you are shorted the stock because the investors were too high and the 10Q shows the company has corrected the problem, cover--NOW.

Do not cover just because of price movements; wait until the resolution of the scenario. If Integrated looks like death, wait till it is buried. Short selling can be much like a cat waiting outside a mouse hole - the level of persistence, patience, and attentiveness is not for everyone, especially over sustained periods of time.

Concept Recap

The short seller's credo can be summarized into several points:

1. Dissent is Okay.
2. The facts are somewhere, free for the digging.
3. Hard work is old fashioned, so if you do a little, you will be far ahead. Analyst look at company PR rather than fundamentals and financials, and that provides opportunities and longer periods of market inefficiencies.
4. Computers confuse and build false confidence in portfolio managers, and that also provides opportunities.
5. Some accountants sanction everything, and that helps a lot, too.
6. Finally, Wall Street ices the inefficient cake with compulsive conformity. Everyone gets on the bandwagon and stays until the evidence is too compelling, then they all fall off with a jolt.

Conclusion

The key points to remember about selling, short selling or simply not buying are several
  • Never assume that a certain investment theme applies to all stocks. Each company and industry is different, so it is lazy to measure by the same scale if the yardstick is not relevant. If a company owns land at 1932 prices, do not worry about earnings or price/earnings. Think about the business and decide what the market wants you to pay for (cash flow, assets, earning). Then, after thoughtful consideration of the prospects, value the company according to your own analysis.
  • Do not genuflect in front of a business, an executive, or an analyst. Keep your distance and you objectivity. The stock market is about people disagreeing over stock prices. Short sellers are entitled to their opinions, as are executives and analysts. And so are you. Do not take it seriously; it is only money
  • A short seller is a skeptic with a constructive, optimistic bent. If you are appalled when an executive lies about earnings prospects, do not just sell the stock consider shorting it.
  • When the short interest peaks at a staggering percentage of total volume and the marked has embraced pessimism.  This might be a good time to go long and cover short positions.

2 comments:

  1. Thanks man for the summary tried to download pdf but it didnt work but this actually helped hopefully i will start shortselling soon.

    ReplyDelete