Herbalife and the Short Sellers

Herbalife (HLF) has been under attack for months by short sellers but the stock has performed well, urged on by long traders like Carl Icahn. 

It is now announced that Senator Mackey of Massachusetts has written to the SEC and the FTC asking them to investigate HLF.

California Atty. Gen. Kamala D. Harris' staff has agreed to meet today Friday in Los Angeles with a coalition of critics who believe that Herbalife Ltd. preys on poverty-stricken immigrants with false hopes of easy money.

When you have predatory or activist short sellers, you can expect a public relations battle to begin.

Just as the lion kills its prey by grabbing the prey's throat in its mouth and squeezing off blood to the brain, a predatory short seller will gradually cut all supp0rt for its victim.  

We have in HLF an interesting situation because the company's case is flawed at best -- 88% of its distributors do not make a dime, because the company has almost $800 million in EBITDA, and because we have an investor with relatively unlimited resources, Carl Icahn, buying up the stock with the intention of squeezing the lead short seller, Bill Ackman, with whom he has a grudge.  Carl is an expert at using the media to publicize his investments. 

We see the resources each side has, we can expect an excellent public relations contest.

The shorts, with almost 20 million shares short as of the end of the year, are probably pushing these latest two announcements. 

In retaliation, HLF has said it is "eager" to address the Senator's concerns at his earliest convenience. This is a good reply by a competent staff that is used to defending the company and its business.

The shorts seem intent on recruiting powerful allies in the government, both in California and with two federal agencies. 

As a short you want the attack vectors focused on the target. You want force multipliers from entities that are more powerful than your target. 

These attacks come at a good time for the shorts as the stock seems to have been high priced even if its business model is a valid one.

Chart courtesy of Stockcharts.com

Thus we see a lovely move from over $80 to almost $60. I am sure the shorts are hoping this will start some momentum on the downside. No doubt they would like to panic and institutional holders into seeking a safer stock and one that is not accused of preying on the public. In fact I doubt that the stock will ever see $80 again. I believe the shorts will eventually bring it down but the battle will take years and be very costly. 

What seems unusual to me is that the shorts would attack a company with billions in revenues and almost $900 million in cash to protect itself. 

After all, lions, crocodiles and other predators all go after the weakest member of the herd, not the strongest. In war, you attack where the enemy is weak. You do not make a frontal assault on a heavily defended position. 

As a short seller, you want stocks that tank fast after a big hit, not a long, drawn out expensive war. 

There are many tools left for both sides to use. I believe it is a mistake not to use them all at once. 

The power of Herbalife is that it can recruit new distributors. All this publicity cannot be helping. While it is good to try to recruit the government, to rely on that as your only attack is a big mistake as you cannot control it. 

On the other side, the longs just seem intent on talking up their position. I do not see them directly attacking the shorts, other than making the price go up.  As we saw this week, it is a mistake to rely only on this. 

In a life or death battle, shorts only stop attacking when you are almost dead. 

We look forward to being a spectator on this one. 

Shorting Pump and Dump Stocks

One of the wonderful things about shorting stock promotions, or pumps and dumps, is the chance that the regulators might come in and nail them while you are short.

This makes for instant profits.

Let's take the example of Life Stem Genetics, Inc.  LIFS.

I received in the mail a promotional brochure telling me that buying LIFS is like owning stock in the fountain of youth.

Checking the chart, I found that the stock was making a steady climb, indicating a successful promotion.

However, things seemed to have gone astray:

SECURITIES EXCHANGE ACT OF 1934

Release No. 70933 / November 25, 2013

The Securities and Exchange Commission ("Commission") announced the temporary

suspension, pursuant to Section 12(k) of the Securities Exchange Act of 1934 (the "Exchange Act"), of trading in the securities of Life Stem Genetics Inc. ("Life Stem"), of Beverly Hills, California, commencing at 9:30 a.m. EST on November 25, 2013, and terminating at 11:59 p.m. EST on December 9, 2013.

The Commission temporarily suspended trading in Life Stem because of questions regarding the adequacy and accuracy of information about Life Stem, including, among other things, its business operations.

_____ 

Oops!

Here is the chart, courtesy of those nice folks at Stockcharts.com:

Naturally, an aggressive, professional short seller will be happy to inform the regulators of the fruits of its research. 

However, this does not always work. In fact, it may be more often that it does not work. Regulators are overloaded and may not feel motivated to attack your particular stock. Companies fight back and will be ready to counter any presentation you may make. You may even be sued by the company for slander. 

Nonetheless, informing the regulators of a documented fraud is a good thing to do. It serves the public good and your pocketbook. There is little downside risk and the profit potential is enormous. 

Economic Shorts

There are two basic unannounced theories of short selling, or indeed long investing.

The first you might call cheap investing. The investor buys something that is under-priced. He is looking for a value, a cheap stock.

In this method, you run the risk of having false information from the company.

The second depends on predictions of the future, usually based on some economic analysis.

Now there is nothing wrong with economic analysis. I have nothing against those who struggle with inaccurate government reports, sudden surprises, unforeseen developments, and all the twists and turns of fate. However, somehow economists have developed a reputation for being mostly wrong, like long term weather forecasts.

The effects of losing your capital are so crippling that exposing it to the risks of economic forecasts is a very brave act that is well known to many hedge fund managers who have large losses.

There are just too many imponderables in the future to be betting your money on it.

Even when you buy $1 for fifty cents, you may find nasty surprises. There are investors who have purchased stock in a company at a price below the cash per share that is in the company, only to find that they still lose money.

However, these losses are very rare compared to the losses to those who predict the stock market or the economy.

We are often told that market timing is a losing game. In fact, it may be.

Now when you go short, you want to be shooting fish in a barrel, not stabbing blindly into the ocean.

The truly aggressive short seller is not content to take position and wait for the future to happen, he makes it happen.

At the least the short makes a big public announcement of his discovery so that the long holders will be stampeded out and new shorts may come in to assist.

He may go further than that and try to start government or media investigations, inform customers, employees, suppliers, sources of finance and those who assist the victim.

In doing so, he risks suits for slander, interference with business relations, and securities law claims.

A wise victim investigates the accusers and any dirt found may be used against the short.

So some shorts have developed the strategy of using fronts or attacking from a hidden position.

The allegation has been made that the people who were short mortgage securities for large profits financed various seemingly independent entities to expose mortgage problems.

So these are the three positions in the game, bet on the future, buy cheap, or make it happen.

Short Selling Bubble Stocks - Looking for weak holders

In the old pre-1929 days, the bears would find an overpriced stock and slam the bid hard, driving the stock down and causing the bulls to panic and sell out cheap.

In modern times, the bears would follow a stock up and when they felt it was vulnerable they would go gunning for the stops. The bulls would follow the trend up and put sell orders, stop loss orders, below the market to get out fast if the stock declined. Suspecting the presence of a large grouping of stop orders below the market, the bears would know the stock down through the price of the stop loss orders and then mop up cheap stock when that stock hit the market.

Many of the bulls used stock price charts and by drawing the same lines as the bulls, the bears knew where the bulls were likely to have their stops and went hunting accordingly.

In last few decades, one of the methods used was to find a bubble stock, usually a small cap manipulation, dig up and document the dirt using a private investigator, and give the dirt documents to financial columnists who released it while you blast the bid.

Then came the naked short sellers, shorting more than the outstanding stock and driving the company to oblivion.

Now we have blogs that release the results of their investigations.

Here is stock that just suffered from a negative research report, OMEX. See the drop from $3 down to almost $2.  The company has tried to invalidate all the alleged negatives, but so far without much result.

 Chart courtesy of Stockcharts.com

The bears, good predators as they are, look for signs of weakness.

If they see small public investors jumping in on an overpriced bubble, they know the stock can be driven down.

Recently, the Facebook IPO was done at a high price, the company put a ton of stock on the market at the last minute, and the small investor, aka "the public" was hot to get in on the deal.  Great opportunity for the shorts.

Chart courtesy of Stockcharts.com

When a stock drops that fast from the opening, it is hard to get anyone brave enough to fight the trend.

No doubt driving the stock down into the 20s caused a lot of small holders to sell.

That, is what the predatory shorts are looking for.  A large discrepancy between price and value, a bubble, caused  by small, timid public investors paying too much.

Institutional investors can be more brave, but they also can fear having a loser on their books when they have to report for the period and sell beforehand to avoid being embarrassed.

In fact, having a huge percentage of institutional investors in the stock in very often a sign of impending doom. if you see 85% of the stock owned by institutions, you have to suspect that they may be overdoing it and can be stampeded by bad news.

Look for weakness, but the basic pattern is to prey on the small investor who has been carried away with enthusiasm.

Shooting Fish in a Barrel - Shorting Penny Stock Promotions

The worst nightmare of the short seller is to take a position in an obviously overpriced stock only to find that the darn thing is actually a real company and it keeps growing, with the stock price going up continually.

They say that you can boil a frog if you raise the temperature in the pot slow enough. 

Well, the sensation you have as a short seller who has shorted a real high growth company is the sensation that the frog must have – you know that you are more and more uncomfortable, but the distress is not strong enough to get out until you suddenly realize that you have been boiled alive.

To avoid this distress, we look for stocks that can never make it, that have huge hidden issues like  undisclosed criminal convictions of the principals or worse.

The problem of shorting a real company that looks like a promotion will rarely if ever occur if you stick to shorting penny stocks.

Most penny stocks are unvarnished promotions with no merit.  Pump and dump penny stock promotions.

If there is any problems with these stocks, it is (1) you can never tell when the promoters will pull the plug so it is hard to pick the peak and (2) you might not be able to short enough.

As to not predicting the peak, that will limit your profit but not give you a loss. Most of these promotions will go to oblivion, so no matter where you shorted them, you will inevitably profit. The question is only how much.

The way penny stock promotions work is that the promoter gets control of a shell company or one with very little business. This can be a Form 10 shell, or a Footnote 32 shell, or just a nearly defunct company.

The promoter and his associates may buy aged debt – convertible debt that is old enoughto qualify under the Rule 144 holding period.

After that, cheap stock is issued to the promoter and his friends.

To set up the trading, a reverse split may dilute out the prior existing shareholders.

Then a sexy company is merged in the promoter starts developing the market in the stock. More and more promotion is introduced. This stage is called the “pump. When the promoter has had a chance to “dump” his stock, he will pull the plug and stop spending on promotion.

The stock will then crash for lack of new demand.

In your short position, you will find that you are helped by the market makers. 

They know which way the wind blows and will be shorting the stock on the way up and bear raiding the stock as it collapses. A well capitalized market maker will be licking his chops when he sees a rich penny stock promotion. He can just keep shorting all the way up, knowing that his whole position will be profitable eventually, whatever the price.

Usually, these penny stock promotions are wildly under-capitalized. Why spend money on developing your business when you can spend it on stock promotion? Selling stock is a lot more profitable than selling products.

I have seen $4 million spent on stock promotion (on which the promoters made $12 million reportedly) and less than $1 million was raised for the company. The company was lucky to get that. The stock, a former Form 10 company, started trading for real below 60 cents, hit over $2.20 and now, a year or so later is at three cents.

The company is not always to blame. In this case, it was the reverse merger promoters who took advantage of a legitimate start up effort.

Now consider, there was enough volume out there on this one to sell $12 million in stock from 60 cents up to $2.20 and now you can buy it back at three cents -- about a one year round trip. 

Does that roughly 97% profit in a year with little risk that the stock will go higher sound like it might be of interest?  

Naked short sellers seek protection from short squeeze

This year, the SEC brought a civil action against Harbinger fund manager Philip Falcone for creating a short squeeze. The SEC alleges that Falcone and two Harbinger investment management entities he managed manipulated the market in distressed high-yield bonds issued by MAAX Holdings Inc.

The SEC alleges that Falcone and the Harbinger entities orchestrated an illegal “short squeeze” – a market manipulation scheme in which an investor constricts the supply of a security, through large purchases or other means, with the intent of forcing settlement from short sellers at arbitrary and inflated prices.

The SEC’s complaint alleges that at Falcone’s direction, Harbinger purchased a large position in the MAAX bonds during April and June of 2006. After hearing rumors that a Wall Street financial services firm was shorting the MAAX bonds and also encouraging its customers to do the same, Falcone decided to seek revenge. In September 2006, Falcone directed the Harbinger-managed funds to buy every available bond in the market, often purchasing the bonds from short sellers. Ultimately, Falcone owned 13% percent more than the supply of the bonds.

At the time of these purchases, Falcone locked up the MAAX bonds the Harbinger funds had purchased in a custodial account at a bank to prevent his brokers from lending out the bonds to short sellers.

When he had control of the supply of the MAAX bonds, Falcone then demanded that shorts settle their outstanding short sales, but did not disclose that it would be virtually impossible to find bonds for delivery. The Wall Street firm bid daily for the bonds, which quickly doubled in price.

Falcone then engaged in a series of transactions with certain short sellers at arbitrary, inflated prices, while at the same time valuing the funds’ holdings on his books at a small fraction of the prices he charged the covering short sellers.

To re-state the pattern here, the SEC found it unlawful to (1) buy up more than the outstanding issue, (2) put the bonds out of reach of the short sellers so they could not borrow the securities, (3) execute a buy in, and (4) demand much higher prices than the value of the securities.

We do not defend Falcone or this pattern of actions. However, this case raises several interesting issues, mostly issues of how to determine what conduct is prohibited. These are questions of degree – how far can you go?

First, do not see any mention by the SEC of a case against the short sellers in this case who were obviously knowingly executing illegal naked short sales. Do these illegal shorts have the right to sue Falcone for manipulation and get damages? Are not Falcone's actions a form of poetic justice on the shorts?

Second, Falcone clearly had the right to buy securities – is it the SEC's viewpoint that buying more than the outstanding issue is improper? Would buying more than the outstanding issue be improper by itself or are more actions needed to create an actionable case? Can you buy the 100% and then quit? Wouldn't buying a large amount of the outstanding, for example 80% create a squeeze? If it did create a squeeze, would that be illegal?

Third, investors clearly have the right to buy in those who do not deliver securities they have sold. Is it actionable to buy in the securities in pursuit of a short squeeze and if so at what point does this become a short squeeze? Do you have to own more than the outstanding issue of securities or is owning some vast majority enough to be a “short squeezer” and be denied the right to buy in?

Fourth, property owners generally have the right to sell their property at whatever price they choose. At what point is it improper for Falcone to charge high prices to short sellers? Could he sell at at 5% premium to the market? At a 25% premium? Did he have to sell at all – can he be forced to sell his own property? What if he had simply sold in the market instead of making private deals with the shorts?

Fifth, the squeeze hurt those firms that made improper naked short sales. Presumably, any bond holders other than Falcone profited by his purchases and squeeze. Are his actions a fraud on the market or just on the shorts? Didn't the shorts know that they ran the risk of being squeezed?

Sixth, Falcone did not announce that he owned more than the outstanding issue, did not announce he was making the securities unavailable to borrow, or otherwise make public information on his actions. To what degree and under what rules is he bound to make such information public? If he had said, “I plan to buy up more than the outstanding, refuse to lend such securities, buy in the bonds and only sell at higher than market prices to punish illegal short sellers,” would he then be permitted to do so? Under what rules is such disclosure required and if generally required, what disclosure is sufficient? What if he bought up the bonds without thought of a short squeeze and then later decided to buy them in?

In summary, we are left without clear guidance as to what actually constitutes “manipulation.” This lack of guidance is deliberate and beneficial. If a bright line test is created, manipulators will find it easy to game the rules. Leaving it vague gives the regulators discretion to act in new cases.

In this case, Falcone's actions put the price of the bonds at unconscionable levels. That would seem to me to be manipulative.

Olam sues Muddy Waters over 'collapse' claim

SINGAPORE (AFP) Wed Nov 21 2012 09:03:25 GMT-0800 (Pacific Standard Time)

Roslan Rahman/AFP/File
The sun rises over the high-rise financial district of Raffles place in Singapore. Global farm commodities supplier Olam International on Wednesday sued a US-based research firm and its founder for saying the company was in danger of collapse.

Global farm commodities supplier Olam International on Wednesday sued a US-based research firm and its founder for saying the company was in danger of collapse.

In a filing with the Singapore Exchange after trading closed for the day, Olam said it "today initiated legal action in the High Court of Singapore against both Muddy Waters LLC and Carson Block".

"The grounds are basically slander, libel and/or malicious falsehood," Aditya Renjen, Olam's general manager for investor relations, told AFP. He declined to respond when asked if Olam was seeking damages.

In an emailed reply to AFP about the lawsuit, a Muddy Waters spokesman said: "Should we have to defend ourselves, we will do so vigorously."

Block, the founder of Muddy Waters and an influential short-seller, told an investment conference in London on Monday that Singapore-based Olam could collapse due to its debt load and other factors.

This sparked a 7.5 percent plunge in the value of the firm's shares on Tuesday but the stock recovered on Wednesday, rising more than five percent to close at Sg$1.6950 in heavy trading.

As the shares recovered, Muddy Waters issued an open letter to Olam chief executive Sunny Verghese and his board, after they threatened legal action and accused the US firm of deliberately sowing panic among investors.

"Olam's disproportionate reaction is extraordinary in our experience," Muddy Waters said, adding that "you and your investors should note that attempting to silence critics is not a plan of corrective action".

Eugene Ng, an investment analyst at UOB Kay Hian Research, said the absence of a full report from Muddy Waters allayed investor panic nand allowed the stock to recover.

"Currently they only issued a letter to Olam and I guess after people have read the letter, they don't think it's anything substantial," he told AFP.

"So now, some of the panic and fear that was experienced by the market yesterday, I guess that has reversed and that's why probably (Olam stock) came back today," he told AFP.

Olam sources 44 products from 65 countries and supplies them to more than 11,600 customers. Key products include cocoa, coffee, cashew, sesame, rice, and cotton and wood products.

Singapore's state investment firm Temasek Holdings is one of Olam's biggest shareholders, owning 16 percent as of March 31.

Block's assessments of companies have been closely monitored, especially after Chinese timber supplier Sino-Forest Corp filed for bankruptcy protection after a 2011 Muddy Waters report questioned the value of its assets.

Olam listed in Singapore in 2005 and is one of the 40 largest companies on the city-state's index in terms of market capitalisation.

Olam was originally established in 1989 in Nigeria and began with the export of raw cashew nuts from Nigeria to India, the company website says.

This article, Olam sues Muddy Waters over 'collapse' claim, is syndicated from AFP and is reposted here with permission. Copyright 2012 AFP. All Rights Reserved

AFP (http://s.tt/1ujC3)