The short selling playbook

This post is about the most common reasons why I think short sellers decide to target a stock.

The basic plays

Pure pump and dumps

Pump and dump stocks are the easiest to predict.  They typically go to 0 as there is no real business.  They’re not too hard to find because:

  1. These companies spend money on stock promotion.  You can sign yourself up for stock spam and browse websites that often advertise pump and dumps to find this stock promotion.
  2. Hired stock promoters often state how much they were paid to promote a stock.
  3. The regulatory filings will show far too little expenses for a real business.

Most pure pump and dump stocks reside on the OTC Bulletin Board and on Pink Sheets.  In rare cases these are listed on NASDAQ, AMEX, and the NYSE (it’s mainly Chinese reverse mergers that account for the bigger frauds).  My theory is that the pure frauds go down the fastest because the fraud is easier to spot without a real business attached.  On top of that, regulators tend to go after these because they are easy targets.  They tend to avoid difficult targets because losing in court is bad for careers.

Pump and dumps mixed in with real businesses

This is the same idea as pump and dump stocks except there is a real business involved.  Sometimes these stocks do not go to 0.  Steve Madden (SHOO) is an example of a pump and dump that turned into a highly successful company.  Short selling a stock simply because it is heavily promoted and shady won’t always work out.  The short seller should analyze the attached business.  In practice, I think that too many short sellers assume that the operating business is bad because of the promotional aspects of a company.  This may be a mistake.

There is sometimes a pyramid scheme dynamic that can be very dangerous to short sellers.  Those who get into a pyramid scheme early will actually make money.  If a company trades its inflated stock for real assets or cash, its intrinsic value will go up.  Short sellers who get into a pyramid scheme too early will lose money.

There are many junior mining and independent oil and gas companies that operate on this model.  G&A at these companies is very high because of the money spent on stock promotion.  Development stage pharmaceutical companies are also a good place to look.  Sometimes the legitimate business is serious and those operating the legitimate business are trying very hard to make money for shareholders.  Robert Friedland’s Diamond Field Resources hired geologists who discovered Voisey’s Bay, which became a multi-billion dollar mine.  In other cases, the attached business has little hope of making money.  The same Robert Friedland used to peddle underwater mining schemes that had little hope of ever making money.

In some cases, the people behind promotional stocks will buy bad assets that look good on the surface.  For example, there are many mining assets out there with extremely high grades but are uneconomic because of some fatal flaw.  They may also peddle bleeding-edge technologies that have little hope of being commercially viable.

Frauds

Spotting these companies are a little harder.  The insiders are working very hard to create a sophisticated facade of a real business, unlike blatant pump and dump frauds.  Short sellers like Muddy Waters has some excellent reports on these types of companies.

In general

There is a continuum of fraud.  Some stocks have good businesses involved (e.g. Steve Madden).  Some stocks have bad businesses involved (e.g. flawed mining properties, flawed pharma drugs, underwater or placer mining, poorly-operated oil and gas companies, etc.).  And other stocks have no real business and are complete frauds.

The level of sophistication among frauds vary.  A few stock promotions don’t even pretend that there is a real business involved.  They pander to the most degenerate retail speculators out there.  Others will create the illusion of a real business and try to dupe sophisticated institutional investors.  Some Chinese reverse mergers for example hosted investor tours of fake factories.

The advanced plays

Promotional stocks

Management is trying to mislead investors without actually lying or doing anything illegal.  In my opinion, it is a bad idea to short a stock simply because management is promotional.  Promotional management does not mean that the underlying business is bad.  In other cases, being promotional is part of the insiders’ strategy for increasing the share price in the long run.  They are trying very hard to use inflated stock to buy real assets.  Smart management teams may choose to do this because the potential upside is high and the cost of their stock promotion is low.

Massively hyped stocks (tricky)

Some companies are involved in technologies that are changing the world or revolutionizing an industry: the Internet, surgical robots, 3-D printing, social media, electric cars, etc. etc.  Some short sellers like to short hype or cite it as a reason to short a stock.

Sometimes the hype can cause the stock price to skyrocket, squeezing the shorts.  Sometimes the hype helps the underlying business’ brand and advertising, which is the case with Tesla’s electric cars.  Sometimes the hype will drive sales, which was the case with the Internet bubble as companies aggressively chased the bubble and drove consumption of computer hardware, software, networking equipment, and consulting services.  These self-reinforcing dynamics can cause short sellers to be squeezed.  And every once in a while the hype turns out to be correct.

Aggressive accounting

This is something that encourages short sellers.  Signs of fraud are:

  • Days of inventory don’t make sense for the business.  If inventory is extremely high, this may be because most/all of the inventory doesn’t exist.
  • Days to collect on receivables doesn’t make sense for the business.  This may simply be because most/all of the receivables are fake.
  • Profit margins are too good to be true.
  • Future revenues are being aggressively booked as profits, even though these sales may not materialize.
  • Lots of expenses are being capitalized instead of being expensed (e.g. Worldcom).  This will show up as weak free cash flow.  However, some companies will legitimately have poor free cash flow if they are spending a lot of money on expansion.

Accounting can also be aggressive without being fraudulent.  The most common form of this is to aggressively capitalize expenses Worldcom-style.

Shorting on aggressive accounting alone is probably not a good idea unless there is a very high level of fraud involved.  For example, Blackberry was often cited as having aggressive accounting for many years.  Those who targeted Blackberry too early were in for a world of pain.

Rapidly growing businesses that are “overvalued” (dubious)

This setup tends to destroy short sellers left and right.  Some examples are Lululemon and Chipotle Mexican Grill.

Rapidly-growing businesses tend to be wonderful businesses.  You usually want to go long wonderful businesses, not short them.

Overvalued businesses (dubious?)

On Value Investor’s Club, there are some writeups that argue that a particular company is overvalued (but not that overvalued).  I’m just going to state my opinion here.  Some of these writeups are a bad idea.  The author could be wrong about the company being overvalued.  The overvalued company may stay overvalued for a long time.  A short squeeze can occur if the overvalued company becomes even more overvalued.  If the company is profitable, the overvaluation may disappear.  The company may sell stock or convertible debt, causing its intrinsic value to rise.  So many things can go wrong.  The potential upside is low when the stock probably won’t go to 0.  It’s not a good idea to chase trades with low upside and a lot of risk.

Roll ups (dubious?)

These are companies that constantly gobble up other companies.  They often use their ever-increasing stock to buy out smaller companies.  Often, the argument for these acquisitions is that the mergers/takeovers generate value due to the scale advantages of the larger company.  The argument against roll ups is that they tend to be associated with fraud, stock promotion, aggressive accounting, etc.

Examples of a legitimate roll up would be Berkshire Hathaway, Capital Cities, Malone’s various Liberty stocks, etc.
An example of a bad roll up would be Worldcom.
Some companies are a mix of a legitimate business and roll up dynamics.  Large mining companies such as Goldcorp will often use their overpriced stock to buy real assets.

Roll ups often promote their stock so that they can use it as currency to buy other companies.  This tends to create a pyramid scheme dynamic where the early investors will actually make money while the later investors are the suckers.  The pyramid scheme dynamic can be a problem for short sellers if the short seller is too early.

Reversion to the mean (dubious)

Some short sellers like to bet on wonderful businesses turning into average businesses when all of their competitors copy what they do.  Or, the argument is that competition will enter the field and drive prices down.  I think that this is mostly a bad idea.  Wonderful businesses tend to stay wonderful.

Some have made such arguments about Lululemon (and other yoga apparel companies), Chipotle Mexican Grill, Blackberry, etc.

Fads

Some short sellers will bet on a fad fading away.  Some people have argued that Crocs, SodaStream, Heelys, yoga (apparel), etc. are fads.

Macro

Some short sellers will target a particular stock due to macroeconomic forces in that particular sector.  In the past, short sellers targeted First Solar because they thought that there would be a glut of polysilicon supply that would make conventional solar much cheaper than First Solar’s cadmium-telluride panels.  They were right.

Not all macro shorts work out.  If you shorted American homebuilders too early, you would have waited for several years before the bubble started collapsing in 2005.

In general I’m not very good at macroeconomic predictions.  For that reason, I’m not a fan of macro shorts.

Buggy whip manufacturers

Some short sellers will make bets on an industry’s dynamics changing.  e.g. Gamestop, phone directories, etc.

Cyclical industries and bubbles

Short sellers may target industries that are at the peak of a cycle.  Micron (MU) has somewhat high short interest likely because the shorts are expecting the history of the semiconductor industry to repeat itself.  High profits will likely cause existing players to overinvest in new capacity, causing a huge glut of supply and massive losses for the industry.

Permabears (dubious)

Some people are always pessimistic and want to bet on stocks going down all the time.  I believe these people tend to get wiped out quickly… unless they don’t trade stocks.  Be careful about listening to sources that are bearish all the time (e.g. news sites like ZeroHedge).

Bad businesses and assets that are difficult to value

It makes sense to short businesses that are losing a lot of money and will likely continue to lose money in the future.  I like situations where promotional management is intentionally involved in a business that is almost guaranteed to lose money.  They don’t know how to run a business profitably but they know how to mine investors.

Promotional management teams will often buy advanced deposits or producing mines with some type of fatal flaw (veins too narrow, mine is at the end of its life, political risk, refractory ore, underwater mining is uneconomic, etc.).  Many of those deposits and mines have terrible economics but are easy to promote due to high grades.  In pharmaceuticals, some companies will spam a large number of drugs through phase I and phase II trials until they get lucky and have a phase III candidate.  These drugs may have little scientific basis for their efficacy but most investors are not sophisticated enough to catch on.  In independent oil and gas, there are a few rare management teams that are very good at losing money (e.g. Miller Energy).

Then there are legitimate companies with honest management teams that aren’t skilled operators.  Short sellers will target retailers where bad management teams are causing the company to lose money.  JC Penney, Radio Shack and Sears Holdings are notable retail stocks with very high short interest.  (These stocks also happen to be value investing favorites.  I think that the value investors are wrong about these companies.)

Some of these shorts may have good catalysts.  If a business is quickly burning through cash, running out of money will push them into bankruptcy if there is debt involved.  If an overhyped mine is about to ramp up and enter production, disappointing cash flow will reveal that the mine has bad economics and cause investors to trade the stock at lower prices.  The catalyst is when investors come to that realization.  Because there will be delays in the startup of a mine, the catalyst may take longer than originally anticipated.

Overpaid insiders / related party transactions

Insiders can drain some money from a company.  However, it is rare for them to take so much money out of a business that it is worth shorting the stock based on overpaid insiders alone.  But nothing is impossible.  In the case of QXM/XING, the CEO simply ran off with everything.  In other cases, insiders may be constantly using related party transactions to enrich themselves.  This happens a lot in the shipping industry.

Multi-level marketing (tricky)

MLM is generally shady.  Some short sellers like to target MLM companies because they argue that MLM is fraudulent or that the MLM pyramid scheme is about to collapse.  I’m not a fan of shorting these things as there are many ways of losing money.  MLM companies tend to be extremely profitable.  Some/many MLM schemes are vaguely legitimate and are unlikely to be shut down.  Some people like to cause short squeezes in MLM companies (e.g. Herbalife).  I don’t see the appeal of shorting MLM.

Asymmetric shorts

Out of the money options and credit default swaps have much more upside than downside.  These types of trades rarely pay off but make great stories when they do.  Michael Burry is famous for buying credit default swaps on pools of bad mortgages, as chronicled by Michael Lewis in The Big Short.

Cause the stock to go down

Many hedge funds will try to cause their short positions to go down by talking to journalists, regulators, auditors, etc.  They may publish their research publicly whether it is correct or not (e.g. Barry Minkow, who is now in jail).  I think that some of these practices lead to healthier markets while other practices are abusive.

The opposite can happen too.  There are a lot of hedge funds that will conspire to cause short squeezes.  They may transfer their shares into a cash account so that they cannot be lent out, causing buy-ins to occur for the shorts.  I believe that such practices are market manipulation and are illegal if you get caught.  Some people like Carl Icahn will appear on CNBC and imply that others should pile in to cause a short squeeze in Herbalife.

Arbitrage

In general, I’m not a fan of arbitrage.  The popularity of these trades is a problem.  Overcrowding in a short position will increase the chances of short squeezes, buy-ins, and the borrow cost going up.

Long distressed debt + short the common stock

Sometimes those trading the bonds will have very different ideas about a stock than those trading the common.  Bond investors care mostly about cash flow.  Equity holders often get dazzled by promotional management and overvalue a stock.  Sometimes the price discrepancy between the bonds and stock is so extreme that it makes sense to go long the bonds and to short the stock.

Stub trades

Suppose that there are a million shares of company A.  Company A owns a million shares of company B and some type of operating business that has nothing to do with company B.  Buying one share of company A will entitle you to (1) a share of company B and a (2) partial ownership of company A’s operating business.  In rare cases, the shares of company A is so cheap that one share of company A is cheaper than one share of company B.  By buying one share of company A, you get one share of company B plus the operating business thrown in for free.

These types of situations can happen when a company decides to IPO a hot subsidiary.  In the tech bubble, 3com IPOed shares of its Palm subsidiary.  There was a glaring market inefficiency because it was cheaper to buy Palm through buying 3com than it was to buy Palm shares directly.

Flawed ETFs

Some ETFs sell out their shareholders.  There are hidden fees or costs that may be extremely high.  Leveraged ETFs often have excessive costs because they must trade every day.  On top of that, they are designed to trade illiquid products instead of liquid products like S&P 500 futures.

Share class arbitrage

Share class arbitrage is when one class of shares should be worth more than another class of shares (e.g. it has more voting rights).  However, it irrationally trades at a lower price than the other class usually due to lower liquidity.  Academics like to pretend that markets are efficient and argue that the price discrepancy is due to a “liquidity risk premium”.  Arbitrageurs can take on risk and arbitrage the situation by going long one class of shares and shorting the other.  They are betting on the spread going down.

I don’t like these trades because the upside is low and the downside is theoretically infinite.  If the share price increases, the spread will widen and the trade will take up a lot more margin.

There is a low-risk form of share class arbitrage if one class of shares can be converted into the other.  These are good trades but good luck finding them.

Red flags

CFO and director resignations

What would cause a CFO to inexplicably resign?  In most cases, they are resigning because the company is involved in some type of fraud and the CFO doesn’t want anything to do with it.  Some short sellers will target a stock simply because the CFO resigned under mysterious circumstances (and there are other red flags for fraud or improper accounting).

Directors resign for various reasons (e.g. health, they don’t have the time, etc.).  Shorting a stock because a director resigns is not a good idea.  However, it is a bad sign if multiple directors resign in mysterious circumstances.

There is never one cockroach in the kitchen

If a company reveals that it did not reveal material information (or admits to some form lying), this may simply be the tip of the iceberg.  Many short sellers will bet on this being the tip of the iceberg.  There may be a number of other things that management has been keeping hidden from shareholders.

The CEO is eccentric or bizarre (dubious???)

Some CEOs are… “colorful”.  Short sellers have often criticized Patrick Byrne for his strange behaviour (see Sam Antar’s article) and vendetta against naked short selling.  It so happens that those betting against Overstock have been losing a lot of money lately.  (To be fair, Overstock has been targeted because it has been unprofitable for a long time and it has constantly restated its financials.  The CEO’s bizarre behaviour is not the main reason for shorting the stock.)

Some of the world’s most successful CEOs have made it onto this list of the bizarre habits of obsessive CEOs.

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