Shipwrecks versus bull ships

It struck me that it is better to short a company that burns through cash than it is to short a company that plows cash into blatant stock promotion.  When a company wastes a million dollars a year on travel expenses, that money is never coming back.  But when a company spends money on blatant stock promotion, some of that money might actually come back and increase a company’s intrinsic value.

Overall, stock promotion is dangerous to short sellers for the following reasons:

  1. Stock promotion often works in the short term, causing the share price to go up.  This can cause a short squeeze.  Short sellers have to deal with illiquidity, buy-ins, more expensive borrows due to the higher share price, etc.
  2. Some stocks turn into quasi-pyramid schemes where the company continually sells shares at higher and higher prices.  The early participants in a pyramid scheme will actually make money.  The early short sellers will lose money.  Even if the short sellers are correct on the timing, some stocks tend to keep the charade going for several years.  This hurts the short sellers’ rate of return.
  3. Sometimes other people will buy into the hype surrounding a company.  The company may manage to sell itself for a large premium, hurting the short sellers with a permanent loss.
  4. Blatantly promoted stocks tend to be extremely easy to spot.  For example, the website tracks spam emails and physical mailers that are sent out to promote stocks.  Because blatantly pumped stocks are so easy to spot, they attract more attention and become crowded trades.
  5. Many of the guys running pump and dump scams have lots of experience and understand that short sellers target their promotions.  I suspect that some of them intentionally engineer buy-ins if the opportunity ever presents itself.
  6. The most blatant stock promotion tends to attract retail investors.  You know what I don’t like about retail investors?  They rarely lend their shares out.  A thin float is very dangerous to the short sellers as there is a much higher chance of buy-ins, short squeezes, and expensive borrows.  A shareholder base that shifts towards retail investors may unintentionally create a buy-in situation.
  7. Some pump and dumps are attached to wonderful businesses like Steve Madden.  Just because a stock has been blatantly promoted does not make it a good short.  Stocks like Liberator Medical are probably a trap for short sellers.

What makes a company “bad”?

  1. Management steals from the company or otherwise wastes the company’s money on personal enrichment.  While companies do not always have to disclose how much money is wasted on corporate jets and expensive meals, it is a good idea to look at the level of G&A at a company to see how much waste is going on.  These management teams are almost always promotional so there will be problems that come with shorting heavily promotional stocks.  I’ll probably short promotional stocks anyways.  However, one thing I will work on is spending more time analyzing the quality of a company.
  2. Management is not very good at managing the business.  The retail industry tends to be very Darwinian and tends to be about survival of the fittest.  There are honest, stand-up people like Ron Johnson (JC Penney’s ex-CEO) who are unfortunately outclassed by their peers.
  3. The industry has terrible economics.  e.g. almost every solar sub-industry, phone directories, Oscar-winning Hollywood visual effects studios like Digital Domain, etc.

I believe that there is a small universe of stocks out there which are bad without being overly promotional (#2 and #3).  These may be the best stocks to short.

However, these shorts are a little harder to figure out.  Bad CEOs don’t make it obvious that they are bad at their jobs.  Industry leaders rarely tell you about how awful their industry is (except in Hollywood visual effects and in semiconductor manufacturing).  Bad companies tend to attract a little less attention from short sellers because frauds tend to be sexier shorts.

The bottom line

I like shorting scumbags.  It feels good to short them.  I dislike shorting industry innovators like First Solar and Avid.  I dislike shorting nice guys like Ron Johnson.  But I’m trying to invest more rationally.  Promotional stocks attached to great businesses are not good shorts.  Unfortunately this is something I need to work on because I have shorted Salesforce and Workday in the past.

*Disclosure:  Currently short FSLR, AVID, CRM (puts) and no position in JCP or LBMH or WDAY (I covered my WDAY short at a loss).  Long Alderon via Altius Minerals.

One thought on “Shipwrecks versus bull ships

  1. Pingback: Learn how to run a pump and dump | Glenn Chan's Random Notes on Investing

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