Short Selling -- Research and Destroy

If you had not noticed, or if you have not participated, there is a technique I call "research and destroy."

A stock researcher finds a short sale candidate. This stock may have some hidden fraud, or weak holders, or some other vulnerability. He does his homework and if he does not have his own short fund, he tells those who do.

They all short the stock and once they have a good position, with great fanfare they publish the hit piece on the stock with huge publicity.

The stock craters and the shorts have one of the best trades in the world -- a sure thing and a short term sure thing at that.

Never mind the merits of the company or that the research of the shorts is questionnable, the important thing is scaring the weak shareholders into dumping the stock.

With a fast hit like this, a drive by shooting, no one has a chance to dig into the real facts.

The media, hungry for news, and loving stories that invalidate things and people, give the researcher's claims a wide distribution.

This starts the stampede of the longs to the exits and with the resulting short term imbalance in supply and demand the price goes into free fall.

Only after a month or two can the stock recover if the selling is unwarranted.

But who cares, the shorts have their fast profits and time to cover at leisure.

Risk to the shorts = almost zero. The only question is how far the stock will go before it is time to close out the trade.

Now it helps if the stock is that of a Chinese company traded in the United States as these companies are under a cloud and they do not know how to defend themselves from short sellers.

The big shorts have someone else act as the front man in the media. The big boys like privacy and why put yourself out there to be sued when you can pay someone else to be the public mouthpiece and take the heat.

Where else are you going to find a short term sure thing like this? You put up 50% of the price to go short. If the stock drops about 50%, so you have a 100% profit in a few months. What is the worst that can happen? The stock does not drop on the hit? So you cover even and lose nothing.

Research and destroy.

Herbalife - HLF - conflict wastes time

Much news this week on Herbalife (HLF).

The New York Times put up a well written piece covertly criticizing Ackmann for lobbying and revealing the million of bucks spent  by HLF on counter-lobbying : The Herbalife War

Both sides are hiring people who are connected in an attempt to influence the regulators.

Ackmann scored a big win when the FTC opened an investigation, yet HLF's allies say the result of this FTC action will not be very expensive to HLF. 

Here is the chart showing the surprise hit, the eventual comeback to higher prices that caused Ackmann to take a huge loss, and the recent hit when the FTC investigation is announced.

HLF -- Chart courtesy of Stockcharts.com

Missing the Point 

I maintain that both sides are missing the point.

The idea is not to expend massive resources for huge battles. These resources are expensive. Expensive advisers, even though they may be people of great reputation and integrity, have a built in interest in keeping the battle going, do they not?

Huge battles between two well financed adversaries are seldom conclusive; they just wound both sides.

Continuing the battle is expensive for the company as it continues to be under a cloud, stifling its survival.

Continuing the battle is expensive for the short as he has to pay interest on the money to carry his position,, has to pay to borrow stock, and still has to make a return for its investors. This all adds up.

The trick is to find that one point that causes the enemy to lose power and collapse like a balloon stuck with a pin.

This is why you look for air bubble stocks to short, they are easy prey. Chinese companies have been fun shorts as they do not know how to defend themselves and there has been a number of scams that inflict the reputation of the whole sector. One wonders if anyone is enthusiastic about protecting Chinese companies trading in the U.S. given these past scandals.

This is why you do not short stocks that have many millions in cash flow. While you may get a fast win that feels good, like the attack on Pearl Harbor, the enemy becomes enraged and comes after you with all their resources, like bombing two cities with nukes. See the chart above. Notice that Ackmann had his fast drop from his surprise attack, and then HLF came back and caused him huge losses.

Now if you are locked in one of these battles, you still need to find that one point that will deflate the enemy instantly.

You will know you have found it when the enemy runs away so fast you cannot folllow him.

Then it is not a war any more than stepping on a cockroach in your kitchen is a war.

Yet you had better find this attack point fast or you will be slowly losing energy while you expend big bucks holding your position while the enemy gains strength.

I am not going to tell you any more valuable trade secrets in public. If there are those expending many millions to fight these battles, hiring the smartest and most powerful people out there, and they still have not found it, it must be rare and valuable information, yes?

This may give you food for thought -- what type of thing could this be, how do I find it, how do I exploit it?

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?