The worst of the worst

Lately, I’ve been generating too many short ideas.  On the short side, I have somewhere around 100-400+ ideas.  Because of this, I need to prioritize and focus on only the best short ideas.

Pump and dump scams (unattractive)

Let’s start with what doesn’t work.  In many classic pump and dump scams, stock promoters will promote a stock through spam email, physical mail, boiler room tactics, etc. etc.  The ones that are promoted through the Internet are pretty easy to find.

These scams generally target retail investors who do not lend their shares out.  Because of this, the borrow is incredibly difficult.  As well, the fraudsters intentionally keep the share price low to make the shares difficult to borrow.  I’ve never figured out how to really profit from these.  For example, I shorted CHMR (see somebody else’s writeup on VIC).  In theory, I’ve made money on this position.  But now I cannot close my position easily without picking up the phone and paying around a hundred dollars for a human trader at IB to close the trade for me.  So, the position sits in my account using up margin and preventing me from shorting other stocks.  (EDIT: I’m an idiot.  The cost to close my position was at normal commission rates, which was around a dollar.)  In other cases, I lost money on penny stocks due to forced buy-ins.

Sophisticated pump and dump scams

More sophisticated pump and dump scams often have a real business attached to them.  The real business should be analyzed as there may be value there.  These scams tend to be harder to spot and often attract institutional investors.  The borrow is usually less sketchy because institutional investors tend to lend their shares out.

These scams are easy to find once you figure out all the scumbags who do this as a career.  (The hard part is figuring out the tricks to easily find these people.  I suspect that most people who read this blog won’t put in the work to figure it out.)

These scams often involve insiders illegally selling shares without reporting their trades as insider trading.  This is the reason why insiders in many scams do not appear to sell their shares.  They simply don’t report their sales.

If illegal activities are taking place, there is often adverse selection at work.  Such scams tend to attract kleptomaniacs who will likely loot the company (if for some reason it makes money).  Shady people have a way of finding other shady people.  Any looting shows up on the income statement as excessive G&A expenses (see my post on that subject).  It is really good for the short sellers whenever management decides to loot the companyThere is a spectrum in terms of how much money management takes from the company.  Some management teams take more money out of the company they run than others.  The companies in the upper percentiles of excessive G&A spending tend to be better shorts.

Ponzi schemes (somewhat unattractive)

If the company sells shares with the proceeds going to the company, then a scam begins to resemble a Ponzi scheme.  The incoming shareholders are essentially paying off the original shareholders.  The problem with Ponzi schemes is that those who get in early will actually make money.  Shorts can lose money if they short the stock too early.  Also, Ponzi schemes can last for several years or more.  The Sino Forest fraud lasted over a decade.

While Ponzi scheme stocks are probably worth shorting, an ideal short position would not have a Ponzi scheme element to the stock.  I prefer scams where insiders are selling shares rather than the company.  Insider sales depress the price of the stock and do not increase a company’s intrinsic value.

Most mining stocks are Ponzi schemes attached to an exploration or mining business.  With the larger mining companies, the Ponzi scheme component tends to be a much smaller part of the overall company.  While I’m not optimistic about mining stocks in general, it isn’t the most attractive area to look for shorts right now.

Roll-up stocks (unattractive)

A roll-up is a stock that continually uses its expensive or overpriced stock to acquire other companies.  This is also a legitimate strategy occasionally used by famous CEOs:

  • Henry Singleton / Teledyne
  • Warren Buffett / Berkshire Hathaway
  • Thomas Murphy / Capital Cities
  • John Malone / Liberty Media and various other Liberty companies

Examples of bad roll-ups would be:

  • Worldcom

I’m actually not that familiar with bad roll-ups so I can’t name too many examples off the top of my head.  Many companies are somewhere in between the spectrum of “good” and “bad”.  Many senior mining stocks can be considered roll-ups.  They constantly use their overpriced stock to acquire junior mining companies.  To find some of these, figure out which senior mining companies are sponsoring theaureport.com.  Some or all of those companies may be playing the roll-up game.

Roll-ups resemble Ponzi schemes and share some of the same problems.  They may last a very long time.  Because there is typically a real business involved, it is possible that the real business generates so much value that intrinsic value grows significantly.  Shareholders may very well make money (even the ones who get in late).

Talented management teams will also occasionally engage in roll-up strategies.  They can create value by taking over poorly-managed assets.  It is generally not a good idea to bet against talented managers.

Massive frauds

These are most common with Chinese reverse mergers, where there are few consequences for committing very egregious forms of frauds.  In some cases, the businesses are completely fictitious.  The fraudsters may have borrowed another company, put up their own signage, and taken investors on tours of the “business”.  In other cases, the business is real.  Unfortunately, shareholders do not actually own the business due to VIE structures.

Eventually, these go to 0 (or close to 0).  There is some danger for the short sellers however:

  1. Short squeezes, buy-ins, etc.  Because the fraudsters make stuff up, the stock can get out of hand.  Some frauds have market capitalizations that reach into the billions (e.g. Bre-X).
  2. These frauds may last for a long time.  Sino Forest lasted over a decade.
  3. Sometimes these frauds are taken private and the short sellers lose money.

Not every short position will work out.

I suspect that the better frauds for short sellers are the ones which do not raise capital for the company.

Bad businesses

Really awful industries (rare)

There are many visual effects studios which do excellent work for Hollywood movies.  The industry is filled with people who are honest, hard-working, innovative, smart, intelligent, etc. etc.  Stay the hell away from this industry.  If another stock like Digital Domain becomes publicly listed, you should probably short it.  Every year, at least one of the major visual effect studios will go bankrupt.  It doesn’t matter if the company has won an Oscar for producing excellent work.  Most Oscar-winning companies such as Digital Domain are in or have gone through some sort of extreme financial distress.

I’m not sure what other industries are as bad as visual effects for Hollywood movies.  Phone book directories and solar panel manufacturing have historically been awful industries.

Silly businesses operated for promotional purposes

Some stock promoters will ignore the economics of a business because they are most concerned about telling a story to investors.  Sometimes this involves “science projects”- bleeding-edge technology that very few people understand.  In many cases these sciences projects have negative expected returns.

Cash flow negative mines

Some promotional CEOs will intentionally lose money mining.  They are running a scam where they are trying to trick investors into thinking that the company will make money in the future.  This is highly unlikely when it comes to mines because the mine operators will always try to mine the most economic ore first to maximize the net present value of the mine.  Fraud or no fraud, there is no reason not to do this.  These companies are the easiest mining stocks to figure out as there is less and less uncertainty the longer a mine has been operating.

Mines that shouldn’t be built

These take a lot more work than cash flow negative mines.  I basically do my own quick and dirty feasibility study on a project.  I look at similar mines and try to extrapolate what the economics of the uncompleted mine will be.  Sometimes, promotional management teams will build out uneconomic mines to keep the story for the stock going.

Unskilled CEOs

Some companies happen to have really bad CEOs.  They may be extremely honest but they simply happen to be very, very bad at what they do.  Unfortunately these CEOs take a little work to find.

In the retail industry, double digit declines in same store sales is usually a massive red flag that the CEO is unskilled.  Otherwise, I don’t know of an easy way to find these CEOs.

Failing businesses that turn to stock promotion

I haven’t figured out why this happens, but there are some publicly-traded companies that have been around for several years or more that turn to stock promotion.  They tend to be failing businesses facing serious headwinds.  For whatever reason, the CEO decides to waste shareholder money on paid stock promotion.  It could be that the CEO is trying to keep the company afloat by raising equity.

These companies are easy to find if you simply follow stock promoters.  These stocks tend to perform poorly because the underlying business is bad.

Mediocre short ideas

Overpriced stocks

Overpriced stocks tend to have all of the same problems as the situations mentioned above.

However, it is rare for management to loot the company at the same rate as a pump and dump.  Legitimate companies that happen to be overpriced tend not to be as overpriced as frauds, scams, and stock promotions.  The underlying business often makes money instead of losing money.

Web 2.0

Many of these stocks are genuinely wonderful businesses.  The CEOs are often honest, smart, hard-working people who are trying to make money for shareholders.  Other industries have similar levels of overvaluation but without the integrity and with much lower quality businesses.

I think that Web 2.0 stocks will work out much better for shareholders than pharma, mining, and oil & gas.  At any given time I may be short a few of Web 2.0 stocks but these types of stocks do not get me excited.

The big picture

By far, the best way to find good short ideas is to find career criminals.  Note that there is a difference between career fraudsters and career criminals.  Smart fraudsters don’t do anything illegal.  As I said before, it’s a little better to short stocks associated with people who are crazy/lazy/stupid enough to risk going to jail.

Some of the other pages in my short selling playbook are good too but they take more work.

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10 thoughts on “The worst of the worst

  1. Glenn, I’m always wondering when I read your blog: why are you focussing so much on avoiding frauds / shorting? At least that’s how it appears to me. Don’t you see any value on the other side?

    • Good question!

      Lately I’ve been spending too much time looking at shorts. Short selling is seductive to me because some short positions are so easy to figure out. I feel like I understand short selling and I’m very comfortable with it. On the other hand, I am not as comfortable in my understanding of certain stocks on the long side. It’s easier for me to spot BS than it is to spot brilliance.

      To some degree, I’m a permabear. I want to short everything. Even if it’s not a great idea.

      Since I started investing, I made money short selling and lost money going long (due to QXM/XING). And this was more or less during the 2009-present bull market. I made money shorting a bull market.

      There is value on the other side and I’d like to get better at it. Unfortunately, I spent a lot of time learning about mining (I went to the library and started reading textbooks). The problem with going long mining stocks is that it’s a very, very difficult game for me to play because I can’t do due diligence on them. I don’t see any good long opportunities in mining right now. There is too much fraud, BS accounting, too many part-time CEOs, etc. etc. I can count the honest people on one hand… the industry is messed up.

      • Thanks for your explanation, interesting. One caveat: sometimes it’s easy to identify the stocks to short, but hard to make money shorting them. Borrow costs, short squeezes, position sizing, timing issues, all much easier on the other side. But apparently you have been doing good. Nice. I like your blog, keep up the good work.

  2. I imagine you find yourself digging around SEDI from time to time. Do you tend to find things in there that point to something fishy? In my experience there are a lot of times numbers don’t appear to add up when cross-referenced with other documents, like financial statements. What I find hard is to determine is if it’s just things being mis-filed, or not updated, or if it is actually someone trying to get sneaky. It could also be that I am misunderstanding how different things get reported on that site. Input errors on SEDI are frequent enough there is a top ten list about it (http://securities-administrators.ca/industry_resources.aspx?id=61). I feel like I see #2 quite often. Common shares that appear to come from nowhere, but which match the outstanding warrents owned by the same person… and yet the warrent position does not get reported as “exercised”. I can’t tell if that’s just lazy reporting or someone’s way of appearing to have more skin in the game that they actually do.

    What are you experiences on that site, and how useful do you find it in putting together pieces of the puzzle?

    • I mostly use CanadianInsider.com because SEDI is a pain in the butt. I haven’t really found things in SEDI that are fishy.

      Insider selling is a good tool for short selling. But it isn’t that reliable. John Malone for example presumably got margin called in 08/09… he sold Liberty Media shares which would later skyrocket in price. Some of the best shorts are the ones where insiders aren’t reporting their sales. Obviously this will not show up as insider selling on EDGAR or SEDI.

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