Contango Oil and Gas (MCF)

History

The CEO, Ken Peak, took his life savings of $400k and started the company, which was traded on the OTCBB.

One of the original strategies was to focus on oil and gas exploration as it is an area where a lot of value can be created.  Exploration skill tends to follow an uneven distribution where a minority of people will account for almost all of the oil and gas discovered.  (Much like the 80/20 rule, how sports superstars command most of the pay, how superstar actors make almost all the money, etc. etc.)  I believe the explorationists came from Xilka Energy, which had a very good exploration track record.

When Contango started out, it couldn’t afford to drill the wells itself.  Its business model hinged on generating good exploration ideas and then convincing other people that they are good ideas.  Other companies would drill the well and give Contango a cut of the profits.

Over time, Contango has been selling its prospect generation business to the explorationists who run it.  Remember that the explorationists can simply walk away and restart the business with their own capital.  The current situation is that Juneau Exploration (“JEX”) is pretty much owned by its explorationists and acts as Contango’s partner.  JEX generates ideas for Contango and Contango pays for much of the drilling costs (they don’t farm a lot out anymore as Contango is a much bigger company).

Venture Capital

This was Contango’s other big idea when Contango first started out.  Unfortunately it did not work out so well and Contango only recovered about half of its capital.

Alta Resources / Unconventional gas

Contango entered into a joint venture with Alta Resources, which did research into extracting natural gas from shale.  Once they started understanding the process, they knew what types of shale/land are good for shale gas production.  The joint venture bought a lot of land rights before other people really knew its value for shale gas.  Ultimately the joint venture hired investment bankers to help flip all the properties to other companies.

Nowadays Ken Peak isn’t that keen on shale gas.  While wells do vary in production, there isn’t a lot of exploration risk when many wells are drilled.  And it doesn’t take a lot of capital to drill a lot of wells compared to drilling in the Gulf of Mexico.  Ken Peak characterizes shale gas as ‘factory’ production.  As the process is more understood now, there isn’t a lot of room for value creation (this is why Ken Peak notes that landowners are getting much smarter now).  He is also worried about the environmental movement, as developing shale gas involves injecting fracturing fluids into the ground with the potential of contaminating groundwater aquifers.  Companies do not currently have to disclose the composition of fracturing fluids(!).  There may be regulations in the future and/or NIMBY protests that will lower profits for shale gas companies.

Contango’s current partnership with Alta Resources is to look at extracting shale gas from offshore reserves.  This is partially a speculative bet on much higher natural gas prices in the future.  With natural gas prices so low right now, a lot of onshore shale gas is not economic.  There is potential opportunity as landowners may not realize the value of offshore shale rights, which seem pretty worthless right now.

Liquid natural gas imports

Back in the day, it was thought that the US would have to import natural gas to meet its energy needs.  Contango made a private investment in Cheniere Energy (symbol LNG) when its stock price was extremely depressed and things look bleak for the company in getting a LNG facility fully permitted and built (a de-gasification facility can only import liquid natural gas, not export it).  Cheniere actually managed to pull it off.  Unfortunately, the industry started to figure out shale gas technology and the US was flooded with cheap natural gas.  Contango is very fortunate is having sold its investment in time, as it looks like the US should be exporting natural gas rather than importing it.  Cheniere is in the process of trying to convert its facility to export LNG (they might succeed).

Hedging

Ken Peak used to be a proponent of hedging.  The problem with fluctuating natural gas prices is that losing money can seriously affect the rate of return.  If the company were to lose half its value, it would have to double its value just to break even.  And if the company has a small chance of going to 0, then it eventually will go to 0.  This is also why Ken Peak does not like leverage, as he has seen too many E&P companies go bankrupt throughout his investment banking career. 

By hedging its output, Contango is able to avoid huge drawdowns in its value.  It does give away some upside but over time the rate of return is arguably superior.  Ken Peak is also well aware that it is dangerous to short futures (and to take short positions via swaps).  If there is a hurricane, Contango may be forced to shut production.  Lower production across producers will raise natural gas prices.  Contango would have zero production while it is obligated to deliver natural gas, which is now at very high prices!  This is why Contango bought call options to protect itself from its swap positions / natural gas shorts.  The overall position is very similar to buying put options and being long volatility*.

(*On the other hand, it may not be a perfect hedge as one set of risks was traded for another.  There are likely differences in delivery location, sulfur content/penalties, mix of natural gas liquids in the natural gas, etc.  Buying put options outright has fewer of these risks… though there may be a spread in price between delivery locations.)

Contango currently does not hedge.  And it probably will not hedge unless gas prices are much higher and volatility is cheap.

Contango’s current strategy (as I understand it)

Other than the onshare shale partnership, Contango is going to stick to its bread and butter: wildcat exploration.  In the wake of the Deepwater Horizon accident, there has been significantly less drilling activity in the Gulf of Mexico because it is harder to get permits, the environmental liabilities are higher, and because gas prices have stayed stubbornly low (most companies cannot economically drill).  Ken Peak is incredibly excited about the GOM as drilling costs have come down significantly and the economics for Contango are extremely attractive.  It has always been able to find gas cheaply and should be able to continue to do so.

In an ideal world, he would probably sell all of Contango’s producing assets and invest it all into wildcat drilling.  Contango should be able to achieve a higher rate of return on wildcat drilling than sitting on its developed assets.  Presumably there are reasons why this hasn’t happened (presumably the private market for gas assets is not very good right now with stubbornly low gas prices).

Contango seems to be having a lot of delays in getting its drilling permit as they were supposed to spud one of their prospects in Sept/October and they still haven’t done so.  In the meantime, they are buying back shares.  Contango should be able to acquire natural gas (or oil) assets cheaper by drilling than through share repurchases.  Its rate of return is being hampered by its inability to drill drill drill.

Outlook

I’m pretty bullish about natural gas.  The current prices are unsustainable as few sources of natural gas are economic at these levels.  Also, Fukushima was a very good thing for natural gas as power generation will shift away from nuclear.  China is starting to recognize its pollution problems and this should reduce its reliance on coal.  This points towards natural gas as being the fuel of choice for baseload power generation.

What I’m actually doing

Trading in and out of Contango.  I recently sold all my shares and am trying to buy them back at $59.  Is this a great idea compared to buy and hold?  Maybe not.

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My quick take on PRXI (Premier Exhibitions)

I just don’t think it’s deeply undervalued.  (VIC writeups here and here.)

1- In theory, its Titanic assets are worth a lot.  However, you should read the court filings for yourself.  If Premier Exhibitions wants to sell the Titanic artifacts, it has to sell all of them together.  It cannot sell them separately.  This will make them difficult to sell.  On top of that, Premier will want to lease/rent back the artifacts that it is using for its successful Titanic exhibition.

Premier for a long time has been trying to get permission to sell the artifacts piece by piece.  The judge is NOT happy with them for trying to do this.  I suspect that the judge’s emotions will rule the day and Premier will not get what it wants.

From the buyer’s point of view, the demand may be questionable.  You have to pay ~$200M to buy the artifacts and you are obligated to maintain them (if you cannot maintain the artifacts, you will not be allowed to buy them).  And what is their utility?  I only see somebody buying them for the same reason they buy a piece of artwork.  However, to exhibit these artifacts in your house… you will have to rotate the artifacts in/out to prevent damage associated with exhibiting them (as is the case with the Titanic exhibit).  Is there a market for this?  Maybe.  But figuring out the market for this asset is too hard for me.

2- Management: The old management was very good at running an exhibitions… the new one not so much.  That is why Premier will not be able to maintain its historically high returns on equity.  This is a business where Premier doesn’t have any special advantage or economic moat.

Investing frameworks II: Dealing with uncertainty

Here’s my way of dealing with uncertainty:

1. Avoid blow-up risk.
2. Stick with I-can’t-believe-this-exists situations where the risk/reward is riduclously distorted.

If I am wrong, I don’t want to lose all my money.  With particular instruments, you can even lose more than all your money.  Historically it has happened to people who write options contracts and are short volatility.  It can also happen if you take on mortgage debt or take on debt to finance a business.  If you don’t sell common stock short and if you never sell options, then your portfolio can never go below 0*.  You also won’t make a killing by short selling stock and by writing options contract, so there isn’t a lot of sense in doing it.
*On the other hand, I may not necessarily practice what I preach because I short sell very small amounts of common stock and options.  At the end of the day, we cannot avoid all risk and shouldn’t worry about extremely small risks.

Secondly, stick with situations where the risk/reward is distorted.  There is nothing wrong with holding onto cash.  If you simply saved a lot of money and held cash, you would lead a worry-free life without financial worries.  Nothing wrong with that.  And if you take risk, you might as well have your cake and eat it too.  Find situations where there is little risk and a lot of reward.  Because these situations exist.*  You simply have to wait for them.
*Remember to think for yourself: this is my opinion and I’m not sure I could prove it.  The problem I see with this theory is that it goes hand in hand with loading the boat on your best ideas.  If you’re wrong about a situation being high reward and low risk, then you’d be taking on a lot more risk than you intended.  And this may work badly for most human beings because we tend to be overconfident about our abilities.

Investing frameworks I

Trying to beat the market involves predicting the future.  This is not easy.  One needs to find theories that can be applied in the real world to predict the future.  A useful theory makes predictions that can be tested and falsified.  If a theory can’t be proven wrong, then how do we really know that it’s right?  We don’t.  Avoiding unprovable theories weeds out hokey bull**** stuff out there.

The problem with the stock market is that it is run by human beings and human beings often change.  If people get burned by some fad that loses them money, then they probably won’t get sucked into the same exact fad again.  Like .com stocks, tulip bulbs, and so on and so forth.  So sometimes when we come up with theories, everybody will know that theory (or market inefficiency if you want to call it that) and then the theory might not work so well anymore.  A great example would be the classic Ben-Graham techniques of buying stocks below liquidation value and buying stocks with long track records of profitability.  These situations are much rarer than they used to be, since almost everybody is familiar with these techniques.  That being said, human beings often make the same mistakes repeatedly.  Casinos have a lot of repeat customers, there have always been numerous real estate bubbles in the same areas, etc. etc.

That being said, let’s dive into some theories/frameworks about how to make money in the stock market.

Simple math

Yes, in some cases there are almost risk-free ways to make money.  These are generally called arbitrage trades.

One type of arbitrage trade is where a stock trades in two different currencies.  In theory, you could buy the stock in one currency, sell it in the other currency at a higher price, pay for the currency conversion, and then profit.  Nowadays, all sorts of high-frequency trading computers are all over this type of trade.  For the retail investor, there is no opportunity due to higher transaction costs and not having a super fast infrastructure ($$$).

Almost risk-free arbitrage trades

One type of arbitrage trade that is sort of available to retail investors is in special situations where the computer-wielding players aren’t looking.  Companies may announce tender offers to buy back shares (they will buy at a certain price), usually because they think that the shares are undervalued.

There may also be opportunities in stub stocks, where one company (call it the parent) owns shares in another company (call it the child).  If you want to own stock in the child company, it may be cheaper to buy shares in the parent company and get the parent company’s other businesses and liabilities thrown in for free.  You can buy shares in the parent company and short sell shares in the child company.

There may also be odd situations such as Medquist Holdings where you could have bought MEDQ shares and sold MEDH shares short.

In practice, these trades aren’t 100% risk-free.  If it’s a tender offer, there may be a limit as to how many shares get tendered (though I am not aware of any situation where this has happened).  If you are selling stock short, you have to:

1. Pay interest to borrow the shares (this interest rate can shoot up)
2. Get bought-in on your shares (other people will engineer buy-ins to profit from short sellers)
3. You are exposed to margin (liquidation) risks (where you can lose more than anticipated because your broker can liquidate your account however it wants and some try to profit from that situation).

Other arbitrage trades are risky

You may read about other types of trades that are labelled “arbitrage”.  Make no mistake about it, many of these trades are risky.  This includes merger arbitrage and trading futures and derivatives against the underlying.

The stuff we are less certain about

Moving away from situations that only require simple math, we get into the world of:

• Predicting human behaviour.
• Valuing businesses.
• Market structure. / Fleecing retail and institutional investors.
• Other.

Incentives drive behaviour

Throughout history, this has almost always been the case.  It’s pretty rare to find human beings who go against their self-interest to do the right thing.  Whenever people are faced with the wrong incentives, they usually figure out the behaviour that serves their self-interest.

If a school’s funding is dependent on standardized testing, you will usually find teachers helping their students cheat or cheating on behalf of their students / their school.  When it comes to stocks, you usually find that insiders and the boards of directors pay themselves a lot of money.  They have a mutual interest in keeping their pay high and will usually work together to maintain the status quo, even though they are supposed to be working for shareholders.

When management does not own a significant amount of stock in a company, they don’t really have skin in the game.  If stockholders are getting a raw deal, management isn’t really affected.  So management may do things such as empire building, where they make the company grow even if it doesn’t make money for shareholders.  This increases their social standing and tends to increase their paycheques (because it’s easier to justify higher pay for larger companies).  They may also do deals with investment banks and pay ridiculously high investment banking fees in return for kickbacks.

When it comes to accounting, management will often use overly aggressive accounting to inflate their reported profits and drive the share price higher.  I tend to call this fraud, but I throw the f word around too much.  This increases their pay since it’s usually tied to the share price, especially if they own options.  In rare situations, management will switch to overly conservative accounting to drive the share price down.  This is because they haven’t been granted their options yet and they want to get their options when the share price is low.  And then they switch to overly aggressive accounting.  It’s dangerous to buy into stocks with overly aggressive accounting so it pays to figure out the insider’s incentives.  Some people are really smart and the accounting trickery that they use may be difficult to figure out.

What are the incentives?

Human beings are not always driven by money.  Bernie Madoff committed a massive fraud even though he didn’t really need the money.  He had a profitable market making business (though its profits were declining).  He could have used his smarts and his connections to continue making money legitimately.  I would say that his pride led him down the path of fraud as he didn’t want to admit that he wasn’t making a lot of money for his clients.

On the flip side of this, there are rare situations where management pays themselves too little as a matter of pride/ethics.  Warren Buffett of Berkshire Hathaway is the best example as his salary is $100,000 and the use of the company jet.  He could easily get paid a salary that could buy multiple company jets every year.  As a hedge fund manager he could probably rake in a billion dollars a year, if not more.

Valuing businesses

See my posts on value investing for my opinions.

Market structure

Trading is a zero-sum game.  If somebody is making money, somebody else is losing it.

So let’s play follow the money.

The various stock exchanges derive a lot of their revenue from market makers.  In return, market makers get special advantages that allow them to profit from skimming from investors.  (If market makers add value for an exchange’s customers by “providing liquidity”, then I would expect that the exchanges would pay market makers instead of the other way around.)  This stuff doesn’t go on with the futures exchanges, so you don’t have to worry about this type of skim there.

At the retail brokerage level, some of the retail brokers will sell order flow to companies such as Knight Capital Group (NITE).  Knight then goes on to skim from the retail broker’s customers, and in return the retail brokerage gets a kickback (the euphemism for this is “payment for order flow”).  Nowadays the market landscape has changed as the retail brokers sometimes move this activity in house, or they sent retail orders to Knight’s competitors (sometimes these practices fall under “broker-dealer internalization”).

The whole system is fairly complicated and there are various methods and techniques to stealing (e.g. collecting the spread, NBBO manipulation, NBBO exceptions, opening price gap, market orders, all-or-none orders, stop orders, margin liquidation, etc.).  This makes it difficult for investors to catch on as to how they are being cheated.

But remember to think for yourself

Look, there are exceptions to some of the frameworks I already mentioned.  Sometimes fraud/shadiness works against you, and sometimes it works for you.  Maybe it’s not so easy to figure out where insider’s incentives lie.  Or if they are really smart, then they may be good at concealing their accounting fraud and you will get burned even if the company didn’t look shady (see Cynthia Cooper’s book on Worldcom).  And therefore you have unexpected losses.

And if a particular criteria is subjective (e.g. shadiness), then maybe it’s an unprovable theory that isn’t so helpful in real life.

And even I admit that “incentives drive behaviour” (my favorite framework) is not true for all human beings.  There are whistleblowers and martyrs out there.  And in other contexts, human beings can be incredibly kind and generous.  Most strangers will help you (and/or give you money) if you ask for their help, even if it’s highly unlikely that you will reciprocate.

Most investment returns are bull****

More often than not, you’ll hear about people beating the market or otherwise doing really well.  But a lot of them are misleading and/or overstated.  Here’s why.

People are more likely to report great returns than crappy ones

Most people have egos and/or want themselves to look good.  If their investment returns suck, then they are highly likely to keep their mouth shut because they don’t want to look dumb.

Sometimes, it’s in the speaker’s self-interest to promote themselves or their companies.  And it’s almost always that case that behaviour follows incentives.

Here are some ways to overstate returns.

Cherry picking

Suppose you flip a coin 10 times and it lands heads 5 times and tails 5 times.  The first two flips are tails.  So, you start counting from the third flip.  Lo and behold, your coin flipping record is 5 heads and 3 tails.  It gives the impression that you’re good at flipping heads.  But the actual track record (5-5) is simply average.

Mutual funds do this by reporting the 3-month, 1-year, 3-year, 5-year, 10-year, since inception, etc. return… whichever happens to be better.  If a mutual fund really stinks it up, it will usually end up being merged or shut down.  Which leads us to…

Survivorship bias

If all the poor/unlucky performing mutual funds are taken out, then the survivors will be stacked towards having good track records.  So you end up with a world where it looks like most mutual funds are able to “beat” the market.  But this might not be the case.  (The reality is that most mutual funds charge way too much in fees.  On average, they will lag the market a lot because of these fees.)

Not actual returns

Sometimes people report returns based on backtesting historical data.  It’s not based on actual returns.  The problem with backtesting is that it often suffers from data mining.  If you look at enough data, you will find correlations that won’t predict the future.  For example, if you categorize stocks based on the first letter of their name, you will find that some letter will outperform all others.  However, a company’s name will have little to do with how well that company will perform in the future.

Simply lie about it

Some people like Bernie Madoff just make stuff up.  Is this really news?

My investment returns 😉

2008-2009 combined  +22.1%

2010  +25.8%

Yes, my penis is bigger than yours*.

(*Just kidding.  It probably isn’t.)

Value investing

Value investing is trying to buy companies for less than their intrinsic value– what they should be worth.  There are different ways to value a company.

Liquidation value

If you sold off all its assets and paid off all its liabilities you would be left with a pile of cash.  If you buy companies at half their liquidation value, then you would theoretically make money.  I generally don’t like this style of investing because I am greedy and like strategies with higher rates of return.  The problem with trying to find companies like this is that this kind of analysis is easy to do, almost everybody knows about it (thanks to Ben-Graham and Warren Buffett), and so people buy these stocks and the price goes up.  So you don’t have a lot of room for profit.  Yes, these types of stocks still exist.  You can find them on shady exchanges like the TSX Venture exchange.  Institutional investors won’t touch those stocks and they can be overlooked.  But, I don’t like them.

Peer/multiple comparison

You look at a company’s price to earnings ratio (i.e. its P/E multiple), EBITDA ratio, free cash flow ratio, or some other number.  You company that number to its peers’ number.  Usually there is a range.  You assume that your company should fall at the bottom of that range, the middle, or the top (based on how good it is).  And that becomes what they company “should” be worth.

The reason I hate this method is usually because it is applied with zero understanding of the industry and the companies involved.  There is usually a reason why the numbers are different between companies.  But if you are ignorant of those reasons, you might simply assume that your company should be “average” or fall at the bottom of the range.  This may be highly inappropriate if say you are looking at a mining company, and its mine will only make money for 1 more year while everybody else’s mine will make money for 10+ years.  The mine that is about to be closed may have a PE ratio of 1, while everybody else’s mine may have a PE ratio of 10 or higher.  And it could be that none of them are over/undervalued.

Discounted cash flow

One way to measure a company’s intrinsic value is to figure out how much cash it is going to make in the future.  A dollar ten years in the future is not worth as much as a dollar now, since money now can be used to earn interest and will be worth more in the future.  So, future income should be discounted to the present.  You factor out the interest so that the two are equivalent.  This is the discounted cash flow (DCF) method of valuing a company.

The obvious problem with the DCF method is that it is hard to predict the future.  And usually the problem with most value investors is that they get overly optimistic about a company.  And once you are optimistic about a company, you can easily make your DCF model make the company seem undervalued.  Because the new management will “turn the company around”, their performance will “revert to the mean”, or some other rationale is given that may or may not happen.

What I look for

To me, the most important factors to look for are:

1. Does the company earn a lot of money for every dollar it invests?  e.g. high return on invested capital.  Can the company’s earnings grow really fast over time?
2. Does the company have some sort of special advantage over its competitors?
3. Is management honest?
4. Is management trying to maximize shareholder return?

1- Suppose you put money in the bank and get 3% interest on it.  Suppose a company expands its widget factory and gets the equivalent of 15% interest on it.  Obviously, the higher return is better.

But this is before the magic of compounding.  Over time, the growth is theoretically exponential.  In 10 years, $1 invested in the bank account will be worth $1.34.  Whereas $1 invested in expanding the widget factory (and re-expanding it) will be worth $4.04.

Growth matters.

2- A lot of people have figured out that growth matters and will usually chase it too.  So whenever a company makes a high return on the money it invests, there will almost always be imitators that spring up.  The pattern is usually this: first there are the innovators, then the imitators, then the idiots.  More and more people flooding into a market tends to drive returns down, possibly until everybody is losing money.  I want to buy stocks where this won’t happen.  I want to buy growth stocks that will keep growing for a long time.  To me, value investing should be about buying these growth stocks cheaply.

Examples of special advantages that can’t be imitated or are very difficult to imitate:

In the railroad business, almost nobody will build a railroad to compete with yours because it would cost too much and the return would be low with competition.  So railroads only compete with other forms of transportation (e.g. air for passengers, trucks and ships for goods/materials).  Rail has a cost advantage over other forms of transportation, so it has an inherent advantage over the competition that is impossible for them to duplicate.

Microsoft Windows has an advantage over Linux and OS X because there is a huge amount of software out there that only runs on Windows.  Their competitors just can’t duplicate this advantage.

3- If management isn’t honest, then they may engage in accounting shenanigans to make their company look better than it actually is.  This is risky for investors because they may overpay for a stock.

There may also be fraud occurring.  If fraud is discovered and the company announces that it actually isn’t making any money at all, you will lose a huge amount of money.

Also, insiders may simply overpay themselves and/or skim money from the company.  Sometimes these shenanigans are disclosed in the Related Party Transactions section of the company’s financial filings.  This obviously reduces the amount of money that shareholders make.

I don’t want to invest in a company where dishonestly works against me.  (*I do speculate on companies where I think dishonesty works in my favour.)

4- A lot of the time, management is not actually trying to maximize shareholder return.  Some of them simply use their company to increase their status.  Oftentimes, they want to build an empire.  Or, they simply follow the herd.  Whenever they do these things, they aren’t figuring out how to get the best return on the money they invest (see #1).

Of all the stocks out there, probably >90% of the stocks out there don’t meet these criteria and <10% do.  By definition, not all stocks can meet the criteria for #2 (special advantages over everybody else).  If you think that more than 10% of the stocks out there meet these criteria, then you are probably doing something wrong.  They can’t all be the best.

Once you identify the best stocks, you simply wait for them to get cheap and then buy ’em.  If they aren’t cheap, it’s important to do nothing and wait.

Short selling shady stocks

*First see Risks of short selling in practice.

Things I look for:

1. Insiders selling massive amounts of shares.  Insider selling can sometimes be legitimate as insiders may want to reduce their risk (sometimes this is a BS excuse), support their extravagant materialistic lifestyle, or give money to charity (e.g. Bill Gates and Warren Buffett).  Legitimate selling usually occurs slowly and insiders don’t try to dump all their stock in say a single year.
2. Insiders are heavily promotional on their stock and project incredible growth, yet they are selling shares.  If they know that awesome times are ahead, it makes no sense to sell shares.
3. Secondary offerings.  A company will sell stock at a huge discount (I call this a fire sale) and pay massive fees to underwriters.  Companies will do this if insiders are smart and they know that their shares are overpriced.
   On the other hand, underwriters don’t want their clients to get burned all the time.  They will promote a stock after a underwriting (the share price will often go up) and they will try to find dumb CEOs who will do secondary offerings when their company is undervalued.
4. The company’s profits and numbers are way too high.  In commodity-like industries, every company can be expected to make around the same amount of money.  Unless the company has some crazy cost advantage or management is incredibly smart, they will be unable to generate incredible profits and extremely high return on assets figures.  If they report really good figures, they are probably lying.
5. (OTC Bulletin Board / Penny stocks only) There is no actual business.  If you read the SEC filings for pump and dump penny stocks, you can see that they spend money on stock promotion and if there is an actual operating business.  In promotional materials, promoters have to disclose how much they are getting paid.

Things I don’t put much weight on:

1. Aggressive accounting.  Such as improperly capitalizing expenses, choosing accounting rules that don’t make economic sense for the business (e.g. capitalizing interest on home communities that aren’t selling), aggressive recognition of revenue and not recognizing expenses right away, any company that reports non-GAAP earnings, etc.Most companies engage in this.   But most of these companies don’t strike me as good shorts.  And a lot of the really crafty insiders out there will do a good job of concealing their accounting shenanigans.

Things I don’t like to see:

1. The underlying business is a high-quality business like RIMM, CRM, NFLX, PCLN.  I don’t ever want to short good companies as they can grow 16-20X in the long run.
2. Ponzi stocks which continually hold secondary offerings.  Yes they are bad companies, but every time they hold a secondary offering the company is actually worth more.  The rate of return on shorting these stocks is poor.  For example, David Einhorn had a 5% IRR from shorting Allied Capital.
3. High borrowing costs.  These stocks are crowded by short sellers and ripe for a short squeeze or somebody to engineer a buy-in.  On the other hand, this is a characteristic of some really good short selling candidates.

What happens next

While a stock may be overvalued, I don’t want to short it right away.  Overvalued stocks can get insanely, unbelievable overvalued.  Sometimes this can occur because people start short selling the stock, then they get killed, then they cut their losses and create more buying demand at the top.

I want to be close to the turning point.  This usually coincides with the announcement of a secondary offering or an awful earnings release.  If a secondary is announced, there is a very good chance that the stock will start going up.  Analysts are all slapping a strong buy on the stock, there are crazy rumours about the company being taken over, and devious hedge funds may be buying the stock simply to squeeze the short sellers and force them to cover.  So wait for the rally, and then start shorting the stock.

How well does this work?

I don’t really know because I have an extremely small sample size.  So don’t take what I say too seriously.  Please do your own homework and thinking.