Wealth with Risk
- Prices of businesses vary from intrinsic values as fads linger in the markets as institutional investors are too averse to risk and too aware of short-term relative performance to bet against the fad and sell
- Short-sale candidates cluster in 3 categories: companies where management lies to investors, companies with tremendously inflated stock prices (bubbles), companies that will be significantly affected by changing external events
Mechanics of Short-Selling
- Must put up 50% of the balance in cash or 100% in stock collateral in a margin account
- Institutional investors can earn interest (short interest rate) on their short balance or short equity pledged
- Investors must meet margin calls to match their 50% equity pledged
- Stock is borrowed from other margin accounts or from other broker-dealers
- A buy-in can occur if the borrowed securities are moved to a cash account, returned to the issuer, or sold.
What to Look for on the Short Side
- Doing your own work will get you a long way in evaluating a business
- Look for assets that may have a true value less than their carrying value on the balance sheet: inflated real estate, obsolete inventory, aggressively booked receivables, bad loans, securities not marked to market
- Looks for red flags in financial statements: receivables and inventory growing faster than revenue or COGS, nonrecurring earnings included in operating income, capitalized expenses and deferred expenses, changes in depreciation schedules, and off-balance sheet liabilities.
- Determine the motivation of management: is management more focused on increasing the wealth of themselves or the business? Read the proxy to determine how the executives are compensated relative to the shareholders and whether compensation depends on the performance of the business. Look out for shady intercompany dealing where subs are owned by company insiders.
Short Comings of Short-Sellers
- Laziness; Not doing enough work or research
- Timing; it could take years for the market value of the business to match the intrinsic value. There is always a greater fool to finance a failing business
- Commodity cycles; it’s difficult to be a stock and commodity analyst. Focus on businesses that aren’t dependent on commodity cycles
- Technology stocks; avoid tech stocks as their valuations are unpredictable
- Small floats; high risk of buy-ins and short squeezes
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