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.

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:

1. All insurance companies are required to file annual financial statements with the state insurance department (filed in March).
2. 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. 
3. 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.

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).

I've Got A Feeling

I don't think the market is ready to give up its gains. I think we have an upward bias at least until September. October is setting up to be a time when a greater ask is made.

Existential Angst

You can really begin to doubt yourself and your understanding of things when you sit here day after day reading ZeroHedge, Rick Ferri, Ben Carlson, Mebane Faber, The Reformed Broker and Barry Ritholz wondering what do I know and why would I want to compromise my integrity in such an industry.

When I reflect upon the last five-six years with all the things that have transpired (Greek/Southern Europe crisis, Sandy, Abenomics, anemic growth, Iraq/Afghanistan, Ukraine, Syria, China slowdown) and then I match it against the market (which has gone vertical in the last 18 months) I am flabbergasted.I know nothing. I understand nothing.

Where Does The Biggest Risk(s) Lie?

In reflecting upon the many doomsayers prognostications regarding systemic risk in the system and their attempts to make the case that it is worse now than in 2008, I see their points but struggle to see the timing. Sure, we are likely to see a cyclical decline or recession. The markets no doubt will be hamstrung by that, but I don't get the sense of a systemic risk event predicated upon a Minskian leverage moment. To be true, corporate balance sheets are not as strong as the aggregate numbers may propose. Much of the cash outstanding is concentrated among a small number of mega sized firms, and that is quickly being netted off against debt issuance to fund stock buybacks. A troubling development in my book and one for caution. There are many who point to the "too big to fail" banks having grown even bigger. There are many who point to the economic recovery being anemic. There are many who point to ZIRP and QE as creating an artifice for asset prices. There are many who point to China. Many who point to the potential for hyperinflation. Many who point to the obesity of the Fed's balance sheet. The global financial system is connected and interconnected. It is a tightly coupled complex system prone to collapse. But I think it takes significant time to build imbalances via increasing leverage brought about by growing confidence leading to complacency and hubris. I don't think we are there yet. The greatest accumulation of debt/leverage has taken place on central bank balance sheets and country debt. I think that is where the next crisis will arise from. But until confidence is punctured, central banks and countries can continue to issue bonds and increase their liabilities. The puncture is likely to be an "emperor has no clothes" moment and will forever re-shape the global financial system as central banks become ground zero for fear and contagion.