One way to know what you are good at is to identify those things you are bad at.
I'm bad at recognizing the dislocative disruption of new players and new trends. I see the trends but I don't extrapolate their likely diffusing effects very well. At the same time, I tend to give to much credit/strength to the incumbent(s), eg. Nokia.
Another area I am not particularly good at is identifying who the next big thing is going to be, ie. emerging leader. Part of the reason is that the market has already given the name a huge multiple and I can't bring myself to join in the party (late). Of course, if something is the next big thing, then its addressable market is a multiple larger than it is at the front end and it warrants the high multiple (that in hindsight now looks like a great price).
I'm a sucker for discounted relative value plays. Currently, CALL, ESI, ACI and OUTR are on my radar. But there is usually some good reason why they traded at an apparently steeped discount to their peers. If it is too good to be true, then it is probably too good to be true. I can't tell you the number of times I've been attracted to a name (sometimes bought it) only to find out there were shenanigans going on that I didn't know about (but the smart money did).
I am good at buying companies when the market has thrown the baby out with the bath water. This is an incredibly dangerous strategy, but it is in keeping with my own investing personality (DNA).
I don't have great vision for choosing the next great growth stock, but I have the courage to buy when/after the market has thrown something on the trash heap.
Tuesday, July 29, 2014
Friday, July 18, 2014
What Is Value?
Value is in the eye of the beholder...value is ethereal...value is a moving feast (non-stationary)...value is real...value is relative.
What is MSFT worth? What is INTC worth? What is GOOG worth? What is AAPL worth? What is ORCL worth? What is CSCO worth?
After years of multiple compression, things are looking up for the mega-cap techs. I don't know what level their multiples bottomed at but they are slowly seeing an expansion. Most are currently trading around 10x EBITDA. This seems crazy to me when they all exhibit a little growth, have monster margins, strong market positions and competent management. Still technological disruption threatens to undercut all of them and so some level of discount should be applied. But given their premium performance characteristics I would suggest the technological disruption discount should cancel the quality premium out and they should trade at a market average multiple. Given that they are essentially the market (given their size) this could of course be a tautology. Nevertheless, it is not difficult for me to see the market warm to these names and see their EV/EBITDA multiple move out to 12x or 13x. That is another 20%-30% upside tacked on to 10% earnings growth and a 3% yield. Not a bad return.
We have seen a massive move out of the smalls into the large and I don't see that changing anytime soon. The smalls got way out ahead of the game and are now mean reverting.
What is MSFT worth? What is INTC worth? What is GOOG worth? What is AAPL worth? What is ORCL worth? What is CSCO worth?
After years of multiple compression, things are looking up for the mega-cap techs. I don't know what level their multiples bottomed at but they are slowly seeing an expansion. Most are currently trading around 10x EBITDA. This seems crazy to me when they all exhibit a little growth, have monster margins, strong market positions and competent management. Still technological disruption threatens to undercut all of them and so some level of discount should be applied. But given their premium performance characteristics I would suggest the technological disruption discount should cancel the quality premium out and they should trade at a market average multiple. Given that they are essentially the market (given their size) this could of course be a tautology. Nevertheless, it is not difficult for me to see the market warm to these names and see their EV/EBITDA multiple move out to 12x or 13x. That is another 20%-30% upside tacked on to 10% earnings growth and a 3% yield. Not a bad return.
We have seen a massive move out of the smalls into the large and I don't see that changing anytime soon. The smalls got way out ahead of the game and are now mean reverting.
Wednesday, July 16, 2014
Buyer Beware
In my journeys around the asset management industry I sometimes come across fairly large ($2b in AUM or so), well respected asset managers with no marketing and no sales (or at least none that is in evidence).
These are firms that have found an audience for which there is no need to sell or market their services, ie. affinity marketing, and are not active in selling or marketing on a broader basis, ie. competing in the broader institutional marketplace.
The owners are fat and happy doing what they love doing - investing - and are not interested in growing or developing their business further. Their websites are atrocious, their resourcing levels low, and oftimes they have lots of family working in the business.
I can't imagine any (or many) of them are frauds. But they show the signs and have the capacity to carry out shenanigans if that is their predilection.
These are firms that have found an audience for which there is no need to sell or market their services, ie. affinity marketing, and are not active in selling or marketing on a broader basis, ie. competing in the broader institutional marketplace.
The owners are fat and happy doing what they love doing - investing - and are not interested in growing or developing their business further. Their websites are atrocious, their resourcing levels low, and oftimes they have lots of family working in the business.
I can't imagine any (or many) of them are frauds. But they show the signs and have the capacity to carry out shenanigans if that is their predilection.
Tuesday, July 15, 2014
Contrary investing - the trapdoor and the panic
Two good strategies. Both require tremendous patience and discipline. One is a micro approach, the other a macro angle.
The first is the trapdoor spider strategy. You keep your powder dry waiting patiently for the market to throw you a prize. The prize is a great company that is overowned and has stumbled. Problems and concerns have arisen, but there is no fundamental rearranging of the deck chairs. Just a misstep. These things happen. Could be a 1 to 2 year workout. Don't buy too soon. The stock will bottom before the worst of the information comes out. When you see it holding fast or rallying on bad news. That is a good sign. But it can take some time for the stock to find its legs again.
The second is a general market panic. Could be a country. Could be an industry. Could be the whole market. Everything is marked down. Fear is rife. Buy the country or industry champion. These are too big to fail, too deeply entwined in the fabric. Again, another 1 to 2 year workout.
The first is the trapdoor spider strategy. You keep your powder dry waiting patiently for the market to throw you a prize. The prize is a great company that is overowned and has stumbled. Problems and concerns have arisen, but there is no fundamental rearranging of the deck chairs. Just a misstep. These things happen. Could be a 1 to 2 year workout. Don't buy too soon. The stock will bottom before the worst of the information comes out. When you see it holding fast or rallying on bad news. That is a good sign. But it can take some time for the stock to find its legs again.
The second is a general market panic. Could be a country. Could be an industry. Could be the whole market. Everything is marked down. Fear is rife. Buy the country or industry champion. These are too big to fail, too deeply entwined in the fabric. Again, another 1 to 2 year workout.
Monday, July 14, 2014
Behind The Numbers - Unsustainable Boosts To Earnings
Given the importance of choices among accounting treatments, look first for any accounting changes. Management can hide behind them to manipulate earnings quality.
Accounting treatment changes almost always change comparisons of apples to apples to comparisons of apples to kiwi fruit, obscuring reality and earnings quality.
Lengthening of depreciation period boosts EPS in the short term and hurts it in the long term. Track D&A as a percentage of fixed assets. If the percentage declines, the company may have extended the D&A period.
In mergers, the reporting entity changes. This offers management a way to consign all sorts of expenses and charges to the past. Acquisitions are tougher because the reporting entity doesn't change.
Manipulating the allowance for doubtful debts affects receivables, and it carries across the financial statements. If the percentage of allowance for doubtful accounts drops sharply relative to gross AR, it may indicate an artificial boost to revenues and therefore earnings.
Note: businesses just don't see their customers' payment quality increase faster than the rate of new receivables.
When a company makes an acquisition, it is allowed up to 12 mos to adjust the purchase price for the acquired company's carrying value of assets and liabilities. As a result of the purchase price reallocation within a year, expenses are kept off the income statement, artificially boosting earnings in the period of adjustment.
The most conservative treatment (of intangibles) is to immediately expense acquired in-process research and development, patents and licences, direct response marketing, and other R&D.
Software companies may capitalize software development (at their discretion) once technological feasibility is reached (whatever that means).
The frequence of capitalization, the items capitalized, and the relative size of those items tells investors whether capitalization is a serious concern or not.
Deferred revenue - revenue a company receives before it delivers the product or service.
Days in Deferred Revenues (DDR) = (91.25 x deferred revenue)/quarterly revenue.
Reducing reserves for warranties boosts EPS.
Know your company's debt intimately:
Assuming too high returns on pension investments understates pension liabilities and overstates tangible book value.
Remember. It is normal for gross margins to vary. Be suspicious of any that were unchanging.
Price changes in cost of goods sold inputs are not sustainable as a source of earnings quality, but a dramatic increase in consumer demand and increased volume could make up for it.
To detect problems in input costs requires industry and company specific knowledge.
Recurring one time charges are a bright red flag wrt earnings quality. Serial one time charges may allow a company to establish reserves or bundle normal operating costs, making future results look better than they are.
The long investor should run from those companies with serial restructuring charges. They are not worth the effort to figure out.
Another way for management to manipulate earnings unsustainably is through taxes. The value of net operating loss carryforwards (NOL - a deferred tax asset) depends on what profits and tax rates management estimate it will have in the future. Investors should compare the expected tax rate indicated by management and forecast by Wall St with what is actually reported in the quarter. An artificially low tax rate may indicate that the tax allowance was reversed, benefitting current EPS.
Accounting treatment changes almost always change comparisons of apples to apples to comparisons of apples to kiwi fruit, obscuring reality and earnings quality.
Lengthening of depreciation period boosts EPS in the short term and hurts it in the long term. Track D&A as a percentage of fixed assets. If the percentage declines, the company may have extended the D&A period.
In mergers, the reporting entity changes. This offers management a way to consign all sorts of expenses and charges to the past. Acquisitions are tougher because the reporting entity doesn't change.
Manipulating the allowance for doubtful debts affects receivables, and it carries across the financial statements. If the percentage of allowance for doubtful accounts drops sharply relative to gross AR, it may indicate an artificial boost to revenues and therefore earnings.
Note: businesses just don't see their customers' payment quality increase faster than the rate of new receivables.
When a company makes an acquisition, it is allowed up to 12 mos to adjust the purchase price for the acquired company's carrying value of assets and liabilities. As a result of the purchase price reallocation within a year, expenses are kept off the income statement, artificially boosting earnings in the period of adjustment.
The most conservative treatment (of intangibles) is to immediately expense acquired in-process research and development, patents and licences, direct response marketing, and other R&D.
Software companies may capitalize software development (at their discretion) once technological feasibility is reached (whatever that means).
The frequence of capitalization, the items capitalized, and the relative size of those items tells investors whether capitalization is a serious concern or not.
Deferred revenue - revenue a company receives before it delivers the product or service.
Days in Deferred Revenues (DDR) = (91.25 x deferred revenue)/quarterly revenue.
Reducing reserves for warranties boosts EPS.
Know your company's debt intimately:
- Avoid all companies whose business models depend on securitizations or consistent access to credit markets.
- Debt used to fund dividends and/or stock buybacks must pass the most stringent of tests - and usually fails.
- Carefully monitor the uses of debt to determine adequate returns on capital raised.
- Only buy companies with large debt to assets where you can model interest coverage, maturity dates and other terms.
Assuming too high returns on pension investments understates pension liabilities and overstates tangible book value.
Remember. It is normal for gross margins to vary. Be suspicious of any that were unchanging.
Price changes in cost of goods sold inputs are not sustainable as a source of earnings quality, but a dramatic increase in consumer demand and increased volume could make up for it.
To detect problems in input costs requires industry and company specific knowledge.
Recurring one time charges are a bright red flag wrt earnings quality. Serial one time charges may allow a company to establish reserves or bundle normal operating costs, making future results look better than they are.
The long investor should run from those companies with serial restructuring charges. They are not worth the effort to figure out.
Another way for management to manipulate earnings unsustainably is through taxes. The value of net operating loss carryforwards (NOL - a deferred tax asset) depends on what profits and tax rates management estimate it will have in the future. Investors should compare the expected tax rate indicated by management and forecast by Wall St with what is actually reported in the quarter. An artificially low tax rate may indicate that the tax allowance was reversed, benefitting current EPS.
Behind The Numbers - Aggressive Inventory Management
Inventory is the second most important factor for earnings quality analysis.
The longer inventory ages, the greater the possibility that the company is misallocating cash, misjudging the market and may have to write down inventory.
Inventory affects profitability via gross margin on the income statement and shows demand for a company's products.
Days Sales in Inventory = (91.25 x Inventory/Quarterly Cost of Goods Sold).
Days Sales in Raw Materials = (91.25 x Raw Materials/Quarterly Cost of Goods Sold).
Days Sales in Work in Progress = (91.25 x Work in Progress/Quarterly Cost of Goods Sold).
Days Sales in Finished Goods = (91.25 x Finished Goods/Quarterly Cost of Goods Sold).
In addition to inventory on the balance sheet, the company also records deferred income to distributors, to whom it affords rights of return and price protection for products they don't sell. While deferred income represents some future revenue, in some company's cases it also represents inventory sitting in the sales channel that has yet to be sold and is at risk.
Tracking inventory component divergence gives the investor advance notice of good and bad performance. Focus on negative divergences wherever you find them and understand the business.
Positive divergence occurs when a company knows that business ahead is good, so its raw material inventory picks up while work in progress and finished goods either lag or do not increase at the same rate.
Investors want to avoid negative divergence when finished goods pile up in excess of sales while raw material inventories and work in progress are flat or declining absolutely or relative to sales.
Charlie Munger on technological advances bring products and favorable declining prices that benefit consumers and not shareholders of the producers.
Rising inventory by itself is no indicator of problems. What matters is inventory buildup relative to other factors.
If aging inventory is a greater percentage of total inventory, then mark-downs, write-downs, and obsolescence have a more servere impact. This is especially toubling with consumer products.
LIFO reserve changes - Changes from one method to another for any purpose, such as valuing reserves, are cause for concern. When a reserve is reversed, its a credit to the income statement. Essentially it is 100% margin, so the EPS boost is significant.
The retail method of inventory valuation recognizes markdowns as the products are sold, while the average cost measures markdowns when made. The change from average cost to retail method stretches out the period between markdown and actual reduction in inventory value.
The longer inventory ages, the greater the possibility that the company is misallocating cash, misjudging the market and may have to write down inventory.
Inventory affects profitability via gross margin on the income statement and shows demand for a company's products.
Days Sales in Inventory = (91.25 x Inventory/Quarterly Cost of Goods Sold).
Days Sales in Raw Materials = (91.25 x Raw Materials/Quarterly Cost of Goods Sold).
Days Sales in Work in Progress = (91.25 x Work in Progress/Quarterly Cost of Goods Sold).
Days Sales in Finished Goods = (91.25 x Finished Goods/Quarterly Cost of Goods Sold).
In addition to inventory on the balance sheet, the company also records deferred income to distributors, to whom it affords rights of return and price protection for products they don't sell. While deferred income represents some future revenue, in some company's cases it also represents inventory sitting in the sales channel that has yet to be sold and is at risk.
Tracking inventory component divergence gives the investor advance notice of good and bad performance. Focus on negative divergences wherever you find them and understand the business.
Positive divergence occurs when a company knows that business ahead is good, so its raw material inventory picks up while work in progress and finished goods either lag or do not increase at the same rate.
Investors want to avoid negative divergence when finished goods pile up in excess of sales while raw material inventories and work in progress are flat or declining absolutely or relative to sales.
Charlie Munger on technological advances bring products and favorable declining prices that benefit consumers and not shareholders of the producers.
Rising inventory by itself is no indicator of problems. What matters is inventory buildup relative to other factors.
If aging inventory is a greater percentage of total inventory, then mark-downs, write-downs, and obsolescence have a more servere impact. This is especially toubling with consumer products.
LIFO reserve changes - Changes from one method to another for any purpose, such as valuing reserves, are cause for concern. When a reserve is reversed, its a credit to the income statement. Essentially it is 100% margin, so the EPS boost is significant.
The retail method of inventory valuation recognizes markdowns as the products are sold, while the average cost measures markdowns when made. The change from average cost to retail method stretches out the period between markdown and actual reduction in inventory value.
Saturday, July 12, 2014
Patience Is A Virtue - Sitting Tight
I have essentially been sitting tight on my positions (with the exception of being stopped out of my high momo shorts earlier this year) for the better part of a year. If I had held my high momo shorts I would have made a killing (30%-40% returns). I don't feel bad about that because you have to enact a limit loss discipline in the short realm. Fortunately, I didn't panic when the market took its little dive in February. The main reason was that I didn't think my holdings warranted being sold. I put a long mega-cap tech position on last year based on what I considered to be a significant undervaluation for the space (relative to the high growth momos and the rest of the market). That thesis has played out over the period and I expect it to continue to play out (which is likely to provide an upward bias to the indices). In fact, many of those names (INTC, QCOM, MSFT, ORCL, GOOG, AAPL, EMC, CSCO) still look very attractive on a valuation & yield basis relative to alternative investments. I have price targets set for each name and will begin reducing my exposure as those targets get hit. INTC = $36-$38, QCOM = $90-$100, MSFT = $45-$48, ORCL = $48-$52, GOOG = $620-$650, AAPL = $120-$130, EMC = $34-$36, CSCO = $34-$36. I also have a kind of net-net barbell on with KLIC, QLGC, GENC, TST & WSTL. I'm eyeing RELL but expect to pick it up when the market pulls back. I have a stodgy contrarian core with BP, RDSA, CHL, SYT, BEN and JPM, and two contrarian plays in BBRY and SGI and a speculator in ARO.
I think patience is the most important part of investing. At least it is for me. I feel that it is my weakness - my achilles heel. I cannot count the number of times I was in the right position, but failed to hold, either through lack of conviction or pulling the trigger too quick or reacting to macro events. With the market continuing to march higher, I am feeling pressure to take profits and put some money in the bank, even as my thesis hasn't played out. And when those names reach their target levels there is a good chance I'll re-evaluate and decide they are still the best option from a value, yield and alternative valuation perspective. In which case, I may trade around those positions. Right now, I am hitting my one year holding period and so the temptation to lock in long term gains is definitely there.
I think patience is the most important part of investing. At least it is for me. I feel that it is my weakness - my achilles heel. I cannot count the number of times I was in the right position, but failed to hold, either through lack of conviction or pulling the trigger too quick or reacting to macro events. With the market continuing to march higher, I am feeling pressure to take profits and put some money in the bank, even as my thesis hasn't played out. And when those names reach their target levels there is a good chance I'll re-evaluate and decide they are still the best option from a value, yield and alternative valuation perspective. In which case, I may trade around those positions. Right now, I am hitting my one year holding period and so the temptation to lock in long term gains is definitely there.
Thursday, July 3, 2014
Behind The Numbers - Aggressive Revenue Recognition
Revenue is the top line of the income statement for a reason: it is the lifeblood of any company.
Management persist in massaging revenue in numerous ways to mask underlying weakness because they can. Because the rest of the financials depend on revenue, it deserves the most scrutiny. Any doubt about the quality or sustainability of revenue throws the rest of the financial model into question.
Accurate revenue is crucial to confidence in cash flow, because the bottom line of the income statement is the top line of the cash flow statement.
Revenue is recognized when it is earned, but the timing is open to interpretation. Revenue can be "realized", "realizable", and "earned" - allows for wiggle room.
The top metric to determine the quality of a company's revenue is days sales outstanding (DSO). DSO = 91.25 x (AR/Quarterly Revenue). We want to compare the quarter's DSO both year-over-year (to account for seasonality) as well as sequentially (quarter-over-quarter). The practice we want to catch is a change in payment terms that borrows revenue from the future to make this quarter look better than it is. Higher DSO has nothing to do with collections but everything to do with revenue recognition.
If management alludes to a "heavily back end loaded quarter" it may mean the company signed deals at generous terms near the end of the quarter in order to feed the Street. Raise your eyebrows if you hear "hockey stick growth" or "non-linear growth" for anything but a hypergrowth company.
Anytime discretion enters into the equation, there is the opportunity to manipulate the numbers. Management my underestimate costs incurred or overestimate the proportion completed in a given period, providing a boost to current results at the expense of future reporting periods (watch out in Percentage of Completion accounting).
When a company derives an increasing portion of its revenue from affiliated entities (related parties of some sort), investors should be concerned.
Keep an eye on the deferred revenue number (liability on the balance sheet offset against a cash asset received but revenue not yet realized).
Watch out for nonmonetary transactions as a boost to reported revenue (barter).
Watch out for bill-and-hold revenue - vendor invoices the customer and recognizes the transaction as revenue, but the products aren't shipped until later.
Watch out for one time gains reported as revenue or interest income falsely counted as regular income. One time revenue events can obscure real underlying growth or organic growth. Strip them out.
Look for growth in sales-type leases (where a company can lease a product but treat it as a sale).
Be wary when a company purchases a distributor - it can slip by some double counting.
Any change in revenue recognition policy should raise eyebrows and warrant increased scrutiny. Even a change to a more conservative policy can boost results by double counting revenue.
Wall St has a nasty habit of seeing write-offs as one time events and forgetting about them, when in fact they are prima facie evidence of weakness in accounting systems.
Management persist in massaging revenue in numerous ways to mask underlying weakness because they can. Because the rest of the financials depend on revenue, it deserves the most scrutiny. Any doubt about the quality or sustainability of revenue throws the rest of the financial model into question.
Accurate revenue is crucial to confidence in cash flow, because the bottom line of the income statement is the top line of the cash flow statement.
Revenue is recognized when it is earned, but the timing is open to interpretation. Revenue can be "realized", "realizable", and "earned" - allows for wiggle room.
The top metric to determine the quality of a company's revenue is days sales outstanding (DSO). DSO = 91.25 x (AR/Quarterly Revenue). We want to compare the quarter's DSO both year-over-year (to account for seasonality) as well as sequentially (quarter-over-quarter). The practice we want to catch is a change in payment terms that borrows revenue from the future to make this quarter look better than it is. Higher DSO has nothing to do with collections but everything to do with revenue recognition.
If management alludes to a "heavily back end loaded quarter" it may mean the company signed deals at generous terms near the end of the quarter in order to feed the Street. Raise your eyebrows if you hear "hockey stick growth" or "non-linear growth" for anything but a hypergrowth company.
Anytime discretion enters into the equation, there is the opportunity to manipulate the numbers. Management my underestimate costs incurred or overestimate the proportion completed in a given period, providing a boost to current results at the expense of future reporting periods (watch out in Percentage of Completion accounting).
When a company derives an increasing portion of its revenue from affiliated entities (related parties of some sort), investors should be concerned.
Keep an eye on the deferred revenue number (liability on the balance sheet offset against a cash asset received but revenue not yet realized).
Watch out for nonmonetary transactions as a boost to reported revenue (barter).
Watch out for bill-and-hold revenue - vendor invoices the customer and recognizes the transaction as revenue, but the products aren't shipped until later.
Watch out for one time gains reported as revenue or interest income falsely counted as regular income. One time revenue events can obscure real underlying growth or organic growth. Strip them out.
Look for growth in sales-type leases (where a company can lease a product but treat it as a sale).
Be wary when a company purchases a distributor - it can slip by some double counting.
Any change in revenue recognition policy should raise eyebrows and warrant increased scrutiny. Even a change to a more conservative policy can boost results by double counting revenue.
Wall St has a nasty habit of seeing write-offs as one time events and forgetting about them, when in fact they are prima facie evidence of weakness in accounting systems.
Wednesday, July 2, 2014
Behind The Numbers - The Real Risk of Stock Investing
Most stocks lose money.
Study (1983-2007): 39% of stocks had a negative total return (2 out of 5 stocks are money losing investments); 18% lost at least 75% of their value; 64% underperformed the Russell 3000 (most stocks can't keep up with a diversified index); a small minority of stocks significantly outperformed their peers.
The best performing stocks (top 25%) accounted for all the gains. The bottom 75% collective had a total return of 0%.
It is obvious that a few stocks are responsible for all the market's gains. This shows why it is essential to avoid the losers - and that there are valuable opportunities to profit from shorting.
Beating inflation is likely an accident of birth.
Graham called "firmness of character" - the ability to keep your own emotional counsel.
To buy any individual stock, let alone take any contrary market position, you have to be able to identify earnings quality concerns in your companies financials, and you have to stay away from anything you don't understand well enough to do so.
Indexes are the best of poor alternatives for anyone not investing in individual stocks. The minute that investors choose stocks, they have to learn about earnings quality.
Poor bases for shorting: Overvaluation (can continue indefinitely); fads (can do very well against the odds for a long time); frauds (hard to identify until after the fact); identifying business models that will fail (when they will fail is all but impossible to know); the short seller who "needs to be right". Short selling on those bases is simply too hard, too risky, and unnecessary.
We recommend waiting until there is aggressive revenue recognition, weakening balance sheets, and deteriorating cash flow trends. Wait until there are negative catalysts for profits in the near future.
Finding a fad and simply shorting it can never be called risk management. It adds risk because it increases the chance of margins calls and being stopped out.
Does it hurt to wait until a stock has cracked before shorting? Ans. No. And this is one fundamental thing about short selling that is so obvious that it is confounding-and ignored. You make as much money shorting a stock that falls from $70 to $5 (93%) as one that falls from $100 to $5 (95%). Waiting for the right time isn't going to cost you money. The time to short will be only when accounting analysis shows that the revenues aren't real or aren't sustainable.
Short sellers take an unnecessary risk by focusing on fraud because frauds are preceded by accounting issues that can be identified. The problem is that constantly looking for fraud can cloud your judgment.
Our process focuses on revenue. Until we see revenue problems-revenues that may be falling while inventories build and credit terms lengthen-we won't bet on whether a company is a fraud.
It is rational to want to short a fraud, but the correct focus is not on whether a manager is lying, but on whether a company is practicing financial chicanery.
Short sellers rightly look for business models that can fail, but they can't know when to short without a specific catalyst that, if it materializes, will kill the company's model and let them profit from a short.
When the money tap is turned off, a business model that depends on huge leverage suddenly dries up and becomes unsustainable. That's the catalyst.
The time to short is not when you think a business model can't survive. The time is when the numbers suggest that management is covering up poor performance and when the stock has already begun to fall.
When buybacks are not opportunistic, they mask options grants or - worse - raise the question of whether they are specifically to transfer shareholder wealth to option holders and insider sellers.
Days Sales Outstanding (DSO): the time between when the company makes a sale and receives the revenue.
Earnings quality analysts don't short without analyzing short interest and days to cover in order to avoid the squeezes that lead to margin calls, covering at any cost, and catastrophic losses.
If a lot of shares are sold short and the stock is thinly traded, the slightest good news could be very bad.
Float means the shares that can be freely traded any given day, excluding restricted shares, insider holdings, and shares held by those with more than 5% ownership.
Instead of needing to be right, wait for the obvious indicator of accounting trouble and act then. You have your negative catalyst.
Financial analysis prevents the mistake where an investor unearths an accounting issue but does not understand whether it matters or not in the real world.
The BEST SITUATION IS AGGRESSIVE REVENUE RECOGNITION MASKING SOFTENING DEMAND.
Study (1983-2007): 39% of stocks had a negative total return (2 out of 5 stocks are money losing investments); 18% lost at least 75% of their value; 64% underperformed the Russell 3000 (most stocks can't keep up with a diversified index); a small minority of stocks significantly outperformed their peers.
The best performing stocks (top 25%) accounted for all the gains. The bottom 75% collective had a total return of 0%.
It is obvious that a few stocks are responsible for all the market's gains. This shows why it is essential to avoid the losers - and that there are valuable opportunities to profit from shorting.
Beating inflation is likely an accident of birth.
Graham called "firmness of character" - the ability to keep your own emotional counsel.
To buy any individual stock, let alone take any contrary market position, you have to be able to identify earnings quality concerns in your companies financials, and you have to stay away from anything you don't understand well enough to do so.
Indexes are the best of poor alternatives for anyone not investing in individual stocks. The minute that investors choose stocks, they have to learn about earnings quality.
Poor bases for shorting: Overvaluation (can continue indefinitely); fads (can do very well against the odds for a long time); frauds (hard to identify until after the fact); identifying business models that will fail (when they will fail is all but impossible to know); the short seller who "needs to be right". Short selling on those bases is simply too hard, too risky, and unnecessary.
We recommend waiting until there is aggressive revenue recognition, weakening balance sheets, and deteriorating cash flow trends. Wait until there are negative catalysts for profits in the near future.
Finding a fad and simply shorting it can never be called risk management. It adds risk because it increases the chance of margins calls and being stopped out.
Does it hurt to wait until a stock has cracked before shorting? Ans. No. And this is one fundamental thing about short selling that is so obvious that it is confounding-and ignored. You make as much money shorting a stock that falls from $70 to $5 (93%) as one that falls from $100 to $5 (95%). Waiting for the right time isn't going to cost you money. The time to short will be only when accounting analysis shows that the revenues aren't real or aren't sustainable.
Short sellers take an unnecessary risk by focusing on fraud because frauds are preceded by accounting issues that can be identified. The problem is that constantly looking for fraud can cloud your judgment.
Our process focuses on revenue. Until we see revenue problems-revenues that may be falling while inventories build and credit terms lengthen-we won't bet on whether a company is a fraud.
It is rational to want to short a fraud, but the correct focus is not on whether a manager is lying, but on whether a company is practicing financial chicanery.
Short sellers rightly look for business models that can fail, but they can't know when to short without a specific catalyst that, if it materializes, will kill the company's model and let them profit from a short.
When the money tap is turned off, a business model that depends on huge leverage suddenly dries up and becomes unsustainable. That's the catalyst.
The time to short is not when you think a business model can't survive. The time is when the numbers suggest that management is covering up poor performance and when the stock has already begun to fall.
When buybacks are not opportunistic, they mask options grants or - worse - raise the question of whether they are specifically to transfer shareholder wealth to option holders and insider sellers.
Days Sales Outstanding (DSO): the time between when the company makes a sale and receives the revenue.
Earnings quality analysts don't short without analyzing short interest and days to cover in order to avoid the squeezes that lead to margin calls, covering at any cost, and catastrophic losses.
If a lot of shares are sold short and the stock is thinly traded, the slightest good news could be very bad.
Float means the shares that can be freely traded any given day, excluding restricted shares, insider holdings, and shares held by those with more than 5% ownership.
Instead of needing to be right, wait for the obvious indicator of accounting trouble and act then. You have your negative catalyst.
Financial analysis prevents the mistake where an investor unearths an accounting issue but does not understand whether it matters or not in the real world.
The BEST SITUATION IS AGGRESSIVE REVENUE RECOGNITION MASKING SOFTENING DEMAND.
What's Behind The Numbers - Intro
Every blow up avoided improves the performance of your portfolio.
Management faces crushing pressure to make things appear better than they are.
Management tortures the numbers to "beat by a penny" and to keep the Wall St analyst predators and their dreaded downgrades at bay.
Aggressive accounting may not be illegal, but its chicanery. Sooner or later, hard and long aggressive accounting can try to entomb the bodies, they rise like zombies, until the company misses huge and the zombies suck management brains and investor profits through stock downgrades and selling.
The job is to analyze earnings quality.
The book may place revenue recognition and inventory management next, but every part of the financials connects with another. "Earnings" is the financial picture as a whole.
Rising days sales outstanding or days sales in inventory may be the two great single indicators of trouble in the next quarter or several.
Management faces crushing pressure to make things appear better than they are.
Management tortures the numbers to "beat by a penny" and to keep the Wall St analyst predators and their dreaded downgrades at bay.
Aggressive accounting may not be illegal, but its chicanery. Sooner or later, hard and long aggressive accounting can try to entomb the bodies, they rise like zombies, until the company misses huge and the zombies suck management brains and investor profits through stock downgrades and selling.
The job is to analyze earnings quality.
The book may place revenue recognition and inventory management next, but every part of the financials connects with another. "Earnings" is the financial picture as a whole.
Rising days sales outstanding or days sales in inventory may be the two great single indicators of trouble in the next quarter or several.
The Art of Short Selling - Six Pillars of Fundamental Short Selling
Short sellers get ideas from many sources. Some of the best ideas come from the most obvious of places - Barron's, WSJ, Forbes, etc. Short interest and stock float are important. A short seller should make sure the short interest is not so high that a short squeeze can increase the risk relative to return.
Franchises have extensive potential for financial stumbles; and once one franchise is analyzed, a group of them can be easily perused. A short seller should look for types of business that eat money - financial services and real estate - or companies with complex financial statements and blind pools of investments - the financial sector is another solid choice in this category. Once a company is targeted it should be analyzed with skepticism and curiosity every time a new financial document is published.
(1) The Pessimist's Guide to Financial Statements
The financial statements are always the first step for any serious student of stocks. Short sellers attempt to discover what is behind the numbers, what drives the company, what the business prognosis is.
Quality control - The first look at the financials is with the intent of breaking teh company into tiny pieces and checking to see if all those pieces are real. The most useful part of the financials will be the footnotes. The other consistent keys are what is not there and what cannot be understood. Start by looking for bogus assets. Then test accounts receivable and inventories looking at growth versus previous years and comparing growth to growth in sales and CGS. If the receivables growth is substantially greater than the growth in revenue, problems with earnings are likely. Growth in inventory vs growth in CGS is the single most reliable indicator that a manufacturer or retailer will stumble. A frequent area of abuse is deferred charges. Examples of deferred charges are prepaid advertising and deferred commissions or sales charges. Another category worthy of jaundice is goodwill and other intangible costs. Capitalizing routine expenses is another clue that a company is manipulating earnings. Accumulated depreciation is a sleeper balance sheet line that nobody watches much. If accumulated depreciation drops when gross PPE rises, the company might have changed the average life assumption and run the reversal through the income statement or might have simply reduced the depreciation expense in subsequent quarters. Look for off balance sheet liabilities, debt guarantees or recourse factored receivables. Make a subjective decision on what percentage of the business is stable and repeatable. Give it the buzz word test. Watch for auditor turnover - it is the one signal that is truly indicative of trouble.
(2) In Search of Greed and Sleaze
Form 4 - insiders purchases or sales.
Proxies - one of the best data sources for inurement and greed.
WRT salaries - compare salaries + bonuses to net income. Look at cash compensation relative to company earnings. Does the company pay a % of pretax profits to the primary officers in the form of a bonus? Are they paid a % of revenues? Does the company pay a bonus for taxes on options? Terms of retirement contracts? Unusual severance pay contracts? Arms length transactions??? Is the board a bunch of rubber stamps?
(3) The Bigger Puzzle
The research segment starts in the library, whereas the store check segment ends up watching the marketplace.
(4) Who Owns It?
High institutional ownership and high Wall St coverage can make for a quick collapse if something unexpected happens.
(5) Check The Water Temperature
Accumulate brokerage reports to provide the company think and Wall St attitude. Use analysts for indications of Street-think and as conduits of management information.
(6) Pay Attention
Keep paying attention. The date of the earnings release is also statistically relevant. The later they are, the worse the numbers. Keep watching - once a potential target, always a potential target. Do not cover just because of price movements; wait until resolution of the scenario. 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.
Recap
Wall St 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.
Do not genuflect in front of a business, an executive or an analyst. Keep your distance and your objectivity. The stock market is about people disagreeing over stock prices.
A short seller is a skeptic with a constructive, optimistic bent.
The rule of thumb when you study a proxy is that if you have to read it three times, you have struck pay dirt.
Franchises have extensive potential for financial stumbles; and once one franchise is analyzed, a group of them can be easily perused. A short seller should look for types of business that eat money - financial services and real estate - or companies with complex financial statements and blind pools of investments - the financial sector is another solid choice in this category. Once a company is targeted it should be analyzed with skepticism and curiosity every time a new financial document is published.
(1) The Pessimist's Guide to Financial Statements
The financial statements are always the first step for any serious student of stocks. Short sellers attempt to discover what is behind the numbers, what drives the company, what the business prognosis is.
Quality control - The first look at the financials is with the intent of breaking teh company into tiny pieces and checking to see if all those pieces are real. The most useful part of the financials will be the footnotes. The other consistent keys are what is not there and what cannot be understood. Start by looking for bogus assets. Then test accounts receivable and inventories looking at growth versus previous years and comparing growth to growth in sales and CGS. If the receivables growth is substantially greater than the growth in revenue, problems with earnings are likely. Growth in inventory vs growth in CGS is the single most reliable indicator that a manufacturer or retailer will stumble. A frequent area of abuse is deferred charges. Examples of deferred charges are prepaid advertising and deferred commissions or sales charges. Another category worthy of jaundice is goodwill and other intangible costs. Capitalizing routine expenses is another clue that a company is manipulating earnings. Accumulated depreciation is a sleeper balance sheet line that nobody watches much. If accumulated depreciation drops when gross PPE rises, the company might have changed the average life assumption and run the reversal through the income statement or might have simply reduced the depreciation expense in subsequent quarters. Look for off balance sheet liabilities, debt guarantees or recourse factored receivables. Make a subjective decision on what percentage of the business is stable and repeatable. Give it the buzz word test. Watch for auditor turnover - it is the one signal that is truly indicative of trouble.
(2) In Search of Greed and Sleaze
Form 4 - insiders purchases or sales.
Proxies - one of the best data sources for inurement and greed.
WRT salaries - compare salaries + bonuses to net income. Look at cash compensation relative to company earnings. Does the company pay a % of pretax profits to the primary officers in the form of a bonus? Are they paid a % of revenues? Does the company pay a bonus for taxes on options? Terms of retirement contracts? Unusual severance pay contracts? Arms length transactions??? Is the board a bunch of rubber stamps?
(3) The Bigger Puzzle
The research segment starts in the library, whereas the store check segment ends up watching the marketplace.
(4) Who Owns It?
High institutional ownership and high Wall St coverage can make for a quick collapse if something unexpected happens.
(5) Check The Water Temperature
Accumulate brokerage reports to provide the company think and Wall St attitude. Use analysts for indications of Street-think and as conduits of management information.
(6) Pay Attention
Keep paying attention. The date of the earnings release is also statistically relevant. The later they are, the worse the numbers. Keep watching - once a potential target, always a potential target. Do not cover just because of price movements; wait until resolution of the scenario. 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.
Recap
Wall St 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.
Do not genuflect in front of a business, an executive or an analyst. Keep your distance and your objectivity. The stock market is about people disagreeing over stock prices.
A short seller is a skeptic with a constructive, optimistic bent.
The rule of thumb when you study a proxy is that if you have to read it three times, you have struck pay dirt.
The Art of Short Selling - Criticisms of Short Selling
Short sales established an inflated supply and cause price declines.
The laws of supply and demand cannot be contravened by laws artificially restricting marketing methods. Or, in the words of Bernard Baruch, "No law can protect a man from his own errors. The main reason why money is lost in stock speculations is not because Wall St 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 where this miracle can be performed."
The laws of supply and demand cannot be contravened by laws artificially restricting marketing methods. Or, in the words of Bernard Baruch, "No law can protect a man from his own errors. The main reason why money is lost in stock speculations is not because Wall St 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 where this miracle can be performed."
The Art of Short Selling - Shortcomings
The short sellers post price run-up exercise is to determine where the clues failed, why the price levitated, and why a normally accurate trail sign was misleading.
Three Short Sins: Sloth, Pride, Timing
Sloth
The first and biggest reason for failure in stock selection on either the short side of the long side is too little work. Usually, sloth is prompted by shorting someone else's idea.
Pride
Hubris is manifest in two primary analytical errors: (1) the sudden use of rigid formulas, and (2) the short sale of good companies.
Shorting a good company is always risky. A good company is a company with smart management who pay attention to business trends and customers and who have financial statements reflecting that unlikely blend. A valuation short is no different than a market bet.
Timing
The timing problem is the single biggest argument against individuals short selling - it throws off the risk/return relationships and suggests that individuals should use the discipline for selling or not owning stocks rather than for short selling. Investor ebullience can keep a stock price up for years in spite of no earnings, even no product. The second reason for the timing problem is the ability of investment bankers to sell another round of financing despite a seriously flawed corporate business plan. Continued flows of financing can keep a dead company on a respirator for years. In some instances, the lag time between the discovery of a fatal flaw and the demise of the company results in a change in the macroenvironment that bails out the troubled short sale candidate. Shorts all too often fail to realize how long debt takes to sink a company when the business environment is good. Almost every short position lasts too long for sellers.
One way to tweak timing is to wait until a stock cracks to short initially, after the first drop when the earnings and price momentum have slowed.
Commodities
It is easier to find fundamental balance sheet flaws than to trade grain prices. Make sure any short bet is on the company and not the commodity.
Tech Stocks
Tech inventories rise when a new product is in the works. Insiders own volumes of stock and sell often and without apparent regard for company condition. Margins can contract and expand with product cycles and the pricing curve.
Squeezes
The float of a stock is of paramount importance for a short position. Short slamming tactics do not work well for a company with a large float and a heavy Wall St following.
Complexity
Many short sellers fall in love with their own analysis, particularly if it is clever or extremely complex.
Lastly
The mistake is always shorting the company that's not that bad. The analyst has to be convinced that the core business will be overwhelmed by the problem and not just a hiccup. You can hide disgusting accounting practices with growth for a very long time.
Three Short Sins: Sloth, Pride, Timing
Sloth
The first and biggest reason for failure in stock selection on either the short side of the long side is too little work. Usually, sloth is prompted by shorting someone else's idea.
Pride
Hubris is manifest in two primary analytical errors: (1) the sudden use of rigid formulas, and (2) the short sale of good companies.
Shorting a good company is always risky. A good company is a company with smart management who pay attention to business trends and customers and who have financial statements reflecting that unlikely blend. A valuation short is no different than a market bet.
Timing
The timing problem is the single biggest argument against individuals short selling - it throws off the risk/return relationships and suggests that individuals should use the discipline for selling or not owning stocks rather than for short selling. Investor ebullience can keep a stock price up for years in spite of no earnings, even no product. The second reason for the timing problem is the ability of investment bankers to sell another round of financing despite a seriously flawed corporate business plan. Continued flows of financing can keep a dead company on a respirator for years. In some instances, the lag time between the discovery of a fatal flaw and the demise of the company results in a change in the macroenvironment that bails out the troubled short sale candidate. Shorts all too often fail to realize how long debt takes to sink a company when the business environment is good. Almost every short position lasts too long for sellers.
One way to tweak timing is to wait until a stock cracks to short initially, after the first drop when the earnings and price momentum have slowed.
Commodities
It is easier to find fundamental balance sheet flaws than to trade grain prices. Make sure any short bet is on the company and not the commodity.
Tech Stocks
Tech inventories rise when a new product is in the works. Insiders own volumes of stock and sell often and without apparent regard for company condition. Margins can contract and expand with product cycles and the pricing curve.
Squeezes
The float of a stock is of paramount importance for a short position. Short slamming tactics do not work well for a company with a large float and a heavy Wall St following.
Complexity
Many short sellers fall in love with their own analysis, particularly if it is clever or extremely complex.
Lastly
The mistake is always shorting the company that's not that bad. The analyst has to be convinced that the core business will be overwhelmed by the problem and not just a hiccup. You can hide disgusting accounting practices with growth for a very long time.
The Art of Short Selling - Crazy Eddie
The company caught the attention of shorts primarily because of valuation. The Street analysts were counting on growth. And that was when the prospectus began to fill in the blanks where the valuation exercise left off.
Crazy Eddie had all the trappings of a personal bank for the Antar family.
Crazy Eddie had all the trappings of a personal bank for the Antar family.
Quant Achilles Heel
Some quants systems no doubt focus on either one vector or one factor. Some are no doubt multi-factor. While the truly ambitious are no doubt seeking a unified theory of the markets, ie. try and incorporate all known anomalies.
Such a system would incorporate small cap bias, momentum bias, quality bias, value bias, broad diversification, red flags.
It is the red flags area where short sellers focus. Myriad changes reflected in a firm's accounts may point to warning signs. You can model those and you can model management quality (based on history), but identifying frauds or accounting shenanigans is an incredibly subjective endeavor when the data points you are working with are inconclusive (and they are always inconclusive).
I guess that is why "fundamental based", qualititative oriented investors are now getting caught with their hands in the cookie jar, ie. insider trading. Finding and getting an edge is extremely difficult.
On a side note. I am amazed when I look at so-called small and micro caps where the marketing material of managers in the space talk about inefficiencies due to lack of coverage, that the stocks are generally fairly valued. Now fairly valued is in the eye of the beholder, but there are few glaring mis-valuations from what I can see across the whole spectrum.
Now back to the quants achilles heel. The rigidity of their systems (whether is a static set of criteria or pattern recognition algorithms) or the backward looking nature of the learning systems mean that quants will always miss the nuance of something and/or miss the change in environment because they lack cognitive awareness. And they will never catch the subjective dimensions of not trusting management that comes from a visceral gut feeling.
Such a system would incorporate small cap bias, momentum bias, quality bias, value bias, broad diversification, red flags.
It is the red flags area where short sellers focus. Myriad changes reflected in a firm's accounts may point to warning signs. You can model those and you can model management quality (based on history), but identifying frauds or accounting shenanigans is an incredibly subjective endeavor when the data points you are working with are inconclusive (and they are always inconclusive).
I guess that is why "fundamental based", qualititative oriented investors are now getting caught with their hands in the cookie jar, ie. insider trading. Finding and getting an edge is extremely difficult.
On a side note. I am amazed when I look at so-called small and micro caps where the marketing material of managers in the space talk about inefficiencies due to lack of coverage, that the stocks are generally fairly valued. Now fairly valued is in the eye of the beholder, but there are few glaring mis-valuations from what I can see across the whole spectrum.
Now back to the quants achilles heel. The rigidity of their systems (whether is a static set of criteria or pattern recognition algorithms) or the backward looking nature of the learning systems mean that quants will always miss the nuance of something and/or miss the change in environment because they lack cognitive awareness. And they will never catch the subjective dimensions of not trusting management that comes from a visceral gut feeling.
Tuesday, July 1, 2014
I'm Here Because of My Father
When I went to college I had no idea what I was going to do. I asked my father and he said go into business. So I went into the business school. When it came time to decide a major. I asked him again, and he said go into finance. Now remember this was the mid-80s, New Zealand was just embarking upon a significant liberalization of its economy and financial sectors, and the future looked very bright.
When I graduated at the end of '88 and went home New Zealand was caught in a massive deleveraging spiral triggered by the '87 crash. Somehow I got a job in the markets and all was well. I was learning so much about the markets (things they didn't teach you in school) and really enjoying a birds-eye view of that time.
When I graduated at the end of '88 and went home New Zealand was caught in a massive deleveraging spiral triggered by the '87 crash. Somehow I got a job in the markets and all was well. I was learning so much about the markets (things they didn't teach you in school) and really enjoying a birds-eye view of that time.
The Art of Short Selling - Industry Obsolescence: Theme Stocks
Massive industry change can be triggered by macroeconomic events, by a specific product revolution, or by the death of a fad.
Wall St is much quicker to hype a new fad than to discard the old.
1980s Texas taught investors that when a region and its economy are built on growth, a slowing rate of change in the growth engine can pull the whole structure to the ground.
Banks are classic short candidates because the lending cycle is only as long as the credit experience of the current crop of bankers.
Betting on a real estate downturn means short the companies with big real estate exposure. Real estate always takes a while to work out because it is not marked to market every day.
How much damage can a wretched real estate environment do to a bank? The real estate pros knew that when it came, it lasted - three to four year minimum to clear out the overhang, with banks trading as low as 40% of book.
They knew that buying a bank stock or an S&L stock was like buying a blind pool. Buyers never knew what they had, so the macroenvironment had better be right.
When no one cares anymore, it is usually time to buy long or at least cover shorts.
Banks with their arcane and specialized terminology, are boring, to analyze, much like insurance companies. As a group, banks are perceived as sacred, inviolate, protected by the govt and the many insurance programs. They are in fact highly leveraged corporations. When equity is only 5% of assets, it does not take much to nibble through the base. So banks can be profitable and predictable on both sides, particularly if shareholders or stock sellers count cranes in their own backyards to determine how frenetic the pace of real estate expansion really is relative to the perceived economic growth in town.
Wall St is much quicker to hype a new fad than to discard the old.
1980s Texas taught investors that when a region and its economy are built on growth, a slowing rate of change in the growth engine can pull the whole structure to the ground.
Banks are classic short candidates because the lending cycle is only as long as the credit experience of the current crop of bankers.
Betting on a real estate downturn means short the companies with big real estate exposure. Real estate always takes a while to work out because it is not marked to market every day.
How much damage can a wretched real estate environment do to a bank? The real estate pros knew that when it came, it lasted - three to four year minimum to clear out the overhang, with banks trading as low as 40% of book.
They knew that buying a bank stock or an S&L stock was like buying a blind pool. Buyers never knew what they had, so the macroenvironment had better be right.
When no one cares anymore, it is usually time to buy long or at least cover shorts.
Banks with their arcane and specialized terminology, are boring, to analyze, much like insurance companies. As a group, banks are perceived as sacred, inviolate, protected by the govt and the many insurance programs. They are in fact highly leveraged corporations. When equity is only 5% of assets, it does not take much to nibble through the base. So banks can be profitable and predictable on both sides, particularly if shareholders or stock sellers count cranes in their own backyards to determine how frenetic the pace of real estate expansion really is relative to the perceived economic growth in town.
The Art of Short Selling - If You Can't Fix It, Sell It
Three categories of opportunity appear in a bull market (1) the restructured and heavily indebted company close to a stumble, (2) the "for sale" but not sold company, and (3) the company with deteriorating earnings that attempts to create the appearance of health with the sale of assets.
Assets are hard to value in a greater fool environment. Before a stock is shorted, the maximum buy-out value must be lower than the stock price.
Parkinson's Law of Short Selling: the stock price expands to fill the available short capacity and last iota of patience, particularly when it is a "no brainer."
From the Kay Jewelers example, the shorts concluded from the buy-out announcement frenzy that short speculation on "for sale" candidates was a less risky business than risk arbitrage - particularly if you could stand the news announcements and upward lurches.
Assets are hard to value in a greater fool environment. Before a stock is shorted, the maximum buy-out value must be lower than the stock price.
Parkinson's Law of Short Selling: the stock price expands to fill the available short capacity and last iota of patience, particularly when it is a "no brainer."
From the Kay Jewelers example, the shorts concluded from the buy-out announcement frenzy that short speculation on "for sale" candidates was a less risky business than risk arbitrage - particularly if you could stand the news announcements and upward lurches.
The Art of Short Selling - Money Suckers: Coining Money To Live
Some companies require great gulps of capital to stay alive, even during periods of economic expansion. When operations fail to prime the pump of free cash flow, financial markets irrigate the basic business. To fund a company that goes to the markets routinely, the debt or equity buyer must assume one of two things: that the company will either eventually earn enough money to pay back the obligation or will make a reasonable return on equity or that the assets on the balance sheet will appreciate enough so that the sale will cover the outstanding obligation.
When the market appetite for new debt and equity disappears, so does the company.
When a fundamental change occurs in the business environment, there are two strategies to follow for the short seller: short the marginal company or short the institutional favorite. The institutional favorite is the quality company with good growth, pretty financials and a large number of institutional investors. Insto favorites crash more quickly than marginal companies because the instos all head to the exit at the same time. The marginal company has shaky financials, bad management, and a history of aggressive but often poorly executed business strategies. Problems develop more rapidly when no support exists. The stockholder base is less sophisticated. They are slower to sell, they pay less attention, or even worse they are comprised of friends and family.
Prepaid acquisition costs are costs that the company decided to defer expensing until later.
The most important lesson from Integrated, one that should have been obvious, was that banks and other short term lenders control the destiny of a company that has negative cash flow.
Short maxim: wait to short until reality can be proved, ie. wait until actual earnings come in less than expected.
When the bulls start talking about takeovers - always a good sign for the bears.
The most prevalent mistake of short sellers is that they are often shortsighted about the duration of hope for a new industry and for concomitant stock price decreases.
When the market appetite for new debt and equity disappears, so does the company.
When a fundamental change occurs in the business environment, there are two strategies to follow for the short seller: short the marginal company or short the institutional favorite. The institutional favorite is the quality company with good growth, pretty financials and a large number of institutional investors. Insto favorites crash more quickly than marginal companies because the instos all head to the exit at the same time. The marginal company has shaky financials, bad management, and a history of aggressive but often poorly executed business strategies. Problems develop more rapidly when no support exists. The stockholder base is less sophisticated. They are slower to sell, they pay less attention, or even worse they are comprised of friends and family.
Prepaid acquisition costs are costs that the company decided to defer expensing until later.
The most important lesson from Integrated, one that should have been obvious, was that banks and other short term lenders control the destiny of a company that has negative cash flow.
Short maxim: wait to short until reality can be proved, ie. wait until actual earnings come in less than expected.
When the bulls start talking about takeovers - always a good sign for the bears.
The most prevalent mistake of short sellers is that they are often shortsighted about the duration of hope for a new industry and for concomitant stock price decreases.
The Art of Short Selling - If You Can't Read It, Short It
Most companies write reports that are comprehensible to a person with a fair knowledge of accounting terminology. Some companies write reports that are impossible to follow, even for accounting experts. Experience suggests that if you cannot understand a report, officers are hiding something worse than you expect. It is 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 got a live one.
The simplest form of financial obfuscation is detected by tracking the growth in receivables versus the growth in sales. Outsized growth leads the analyst to search out policies on booking revenues and collecting cash.
Any asset that does not have a ready market value is fair game for asset shuffling. The following are the most important points about insurance company financial statements:
The proper valuation of assets and liabilities is most important to the accuracy of the surplus total. Surplus provides the cushion for surprises and the funds for expansion. It is the heart of an insurance company. It also determines how much an owner can take out and whether the regulators take over.
Insurance companies have a lot of leeway on the carrying value of securities, particularly when the assets do not have a public market value. As a critical bystander, all you have to do is cast doubt on the quality of some of those assets to avoid owning the parent stock. If you question a significant number of assets relative to surplus, short the parent.
The simplest form of financial obfuscation is detected by tracking the growth in receivables versus the growth in sales. Outsized growth leads the analyst to search out policies on booking revenues and collecting cash.
Any asset that does not have a ready market value is fair game for asset shuffling. The following are the most important points about insurance company financial statements:
- All insurance companies are required to file annual financial statements with the state insurance department (filed in March).
- These statements require different accounting practices ("statutory accounting") so they don't match GAAP. The driving force of statutory accounting is liquidity. The spirit of the rule is the determination of solvency or of claims paying ability.
- All this fits together in one number called surplus (similar to net income).
The proper valuation of assets and liabilities is most important to the accuracy of the surplus total. Surplus provides the cushion for surprises and the funds for expansion. It is the heart of an insurance company. It also determines how much an owner can take out and whether the regulators take over.
Insurance companies have a lot of leeway on the carrying value of securities, particularly when the assets do not have a public market value. As a critical bystander, all you have to do is cast doubt on the quality of some of those assets to avoid owning the parent stock. If you question a significant number of assets relative to surplus, short the parent.
The Art of Short Selling - High Multiple Growth Stocks, Part 2: High Returns, Faltering Growth
The very backbone of a bull market is growth - new products, new sales, new technology.
There is almost always a bell ringing on the growth stocks that have one product. Shorts get killed trusting their intuition and common sense. Longs get killed with their belief that the company can always expand to one more market.
Two relevant concepts that define the shorts analytical task are pipeline fill and sustainable growth. Pipeline fill gives the revenue curve its shape. Sustainable growth rate sets the financing needs for that curve.
Cott Corp - going against Coke and Pepsi. Most corporate managers reproduce the errors of the past with remarkably regular frequency and inspire their corporate culture with the same consistence of mismanagement.
Pipeline fill refers to the process of filling the distribution channels' inventories - think drug companies getting out a new product. At some point the pipeline is full - every store has a shelf of product - and the growth rate is purely what the consumer consumes.
Cott paid sr employee salaries with stock and capitalized the expense as goodwill on the balance sheet. Watch when an analyst goes to work for a firm they covered. Top tick.
The Snapple story was a great lesson for growth stock players and short sellers alike. Store checks and valuation be damned, inventories are key in a one product company rolling out in a new era industry. If they build up, it is almost always because the product is not selling as planned.
Media Vision and Creative Technology - operate in an industry/sector that is characterized by short product life cycles and rapid change.
The bigger point on cash appetite in a growth company is a concept called sustainable growth rate. Sustainable growth rate says that a company can grow at the rate of return on equity times the retention rate without going to the capital markets. Growth companies with low ROE have to go to the market early and often and, if the prospects for eager buyers decline due to market conditions or failing financials, they have big trouble.
Growth is a good stock to own and a great stock to short if you can time both sides of the pyramid.
There is almost always a bell ringing on the growth stocks that have one product. Shorts get killed trusting their intuition and common sense. Longs get killed with their belief that the company can always expand to one more market.
Two relevant concepts that define the shorts analytical task are pipeline fill and sustainable growth. Pipeline fill gives the revenue curve its shape. Sustainable growth rate sets the financing needs for that curve.
Cott Corp - going against Coke and Pepsi. Most corporate managers reproduce the errors of the past with remarkably regular frequency and inspire their corporate culture with the same consistence of mismanagement.
Pipeline fill refers to the process of filling the distribution channels' inventories - think drug companies getting out a new product. At some point the pipeline is full - every store has a shelf of product - and the growth rate is purely what the consumer consumes.
Cott paid sr employee salaries with stock and capitalized the expense as goodwill on the balance sheet. Watch when an analyst goes to work for a firm they covered. Top tick.
The Snapple story was a great lesson for growth stock players and short sellers alike. Store checks and valuation be damned, inventories are key in a one product company rolling out in a new era industry. If they build up, it is almost always because the product is not selling as planned.
Media Vision and Creative Technology - operate in an industry/sector that is characterized by short product life cycles and rapid change.
The bigger point on cash appetite in a growth company is a concept called sustainable growth rate. Sustainable growth rate says that a company can grow at the rate of return on equity times the retention rate without going to the capital markets. Growth companies with low ROE have to go to the market early and often and, if the prospects for eager buyers decline due to market conditions or failing financials, they have big trouble.
Growth is a good stock to own and a great stock to short if you can time both sides of the pyramid.
The Art of Short Selling - High Multiple Growth Stocks, Part 1: High Risk, Low Return
Bubble stocks are the purest and easiest form of short selling.
The simplest form comes from a company with a fad product that is perceived to have a long life. The next level of financial complexity is a concept or theme stock, from companies that sell a product or service to fill a newly perceived need.
Wall St awards preliminary kudos to companies just for trying or just for hiring the right investment banker or public relations agent. And that is what makes shorting concept stocks chilling, palm sweating, white knuckle hard work.
Questions to ask about concept stocks: does it work? how soon will it run out of money?
Shorts almost always judge correctly if the business is dying. On the timing of the demise, they are seldom right. Someone is usually available to buy stock, loan money, offer short term bank debt long after the company's financials are in nearly terminal condition.
Add two years to a short's best projection, and you might only have a couple more years to wait.
Grizzled analyst wisdom says sell the stock of a company building a new headquarters that is owned, not leased. It is a top of the earnings cycle clue.
Cute tickers for fad/concept companies is another tell.
The patience required to track the trail of failure is a critical skill for short sellers avoiding the wrong stock or the wrong time in a growth company's price trajectory.
Cockroach theory: there is no usually just one bad quarter. Expect more to follow.
Concept stocks: cabbage patch kids, Coleco (home computers), Scoreboard (baseball cards), J. Bildner (yuppie/upscale grocery stores), Jiffy Lube (quick oil change franchises).
The simplest form comes from a company with a fad product that is perceived to have a long life. The next level of financial complexity is a concept or theme stock, from companies that sell a product or service to fill a newly perceived need.
Wall St awards preliminary kudos to companies just for trying or just for hiring the right investment banker or public relations agent. And that is what makes shorting concept stocks chilling, palm sweating, white knuckle hard work.
Questions to ask about concept stocks: does it work? how soon will it run out of money?
Shorts almost always judge correctly if the business is dying. On the timing of the demise, they are seldom right. Someone is usually available to buy stock, loan money, offer short term bank debt long after the company's financials are in nearly terminal condition.
Add two years to a short's best projection, and you might only have a couple more years to wait.
Grizzled analyst wisdom says sell the stock of a company building a new headquarters that is owned, not leased. It is a top of the earnings cycle clue.
Cute tickers for fad/concept companies is another tell.
The patience required to track the trail of failure is a critical skill for short sellers avoiding the wrong stock or the wrong time in a growth company's price trajectory.
Cockroach theory: there is no usually just one bad quarter. Expect more to follow.
Concept stocks: cabbage patch kids, Coleco (home computers), Scoreboard (baseball cards), J. Bildner (yuppie/upscale grocery stores), Jiffy Lube (quick oil change franchises).
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