Category: Microcap

Why short selling is risky

I often write about companies I dislike and companies that I have sold short. I have made a good return on my short sales. Yet I have always recommended against short selling. Why I recommend against short selling was amply demonstrated by the stock of microcap Noble Roman’s (OTC BB: NROM) yesterday. The stock shot up 46% on no news. What happened? My bet is that the critical article on Noble Roman’s that I posted on Monday encouraged some people to short the stock and it encouraged some momentum longs to sell. That drove the price down 30% over the next two days. Yesterday some short sellers started to cover and that drove the stock price up a bit. Momentum players jumped back in long and soon the stock was back up to where it was Monday. Of course, this is just my idle speculation, but the effect on the stock price is quite real, no matter how it happened.

If someone shorted the stock at its low yesterday, that person would now be out a lot of money. They might even blame me for their losses. Yet for any stock, the short term is not indicative of the long term. In the short term the stock market is a voting game. Especially for small, illiquid stocks, prices fluctuate greatly depending upon supply and demand. But in the long term, the stock market is a weighing mechanism, and poor companies’ stocks will inevitably flounder. Most people have a hard time holding on to stocks they have bought (long) despite swings in short term prices. It is even harder to hold on when, with short selling, losses can theoretically be infinite. So stay away from short selling.

Disclosure: I am still short NROM and have not traded it since my first article on it last Monday, as per my disclosure policy.

Yet more junk from the OTC BB

I just received some OTC stock spam on behalf of Ido Security (OTC BB: IDOI). The company has 34.3 million shares outstanding (see the most recent 10Q for details), and at a recent price of $2.02 per share it has a market cap of $69 million. This despite a book value of $2 million, no revenues, and a loss of $9 million over the last nine months. The company has spent only $200,000 over the last nine months on R&D and yet it hopes to compete in the field of metal detectors.

Send this pumped-up penny stock into the trash can. Do not pass Go and do not collect $2 million (for those of you playing the updated Monopoly).

Following is the text of the spam email I received regarding this stock. I love the last paragraph:

Find out today, it will rock tomorrow IDO Security INC (IDOI.OB) Last Trade: Tuesday December 4th: $ 2.02

LOOK OUT Read this Great news about IDIO, and watch it trade on Wednesday!

The Honorable Tom Ridge Teams with IDO Security

IDO Security (OTC Bulletin Board: IDOI), a provider of innovative solutions for the homeland security market, today announced that The Honorable Tom Ridge, the first Secretary of the Department of Homeland Security, will provide special consulting services for the company. Governor Ridge will work with the company to accelerate U.S. implementation of the MagShoe high speed shoes-on portable footwear weapons detection system.

IDO Security, (OTC Bulletin Board: IDOI ) the provider of MagShoe(TM) high speed shoes-on portable footwear metal weapons detection system, commented on a joint assessment issued on October 24th by the Federal Bureau of Investigation and the Department of Homeland Security’s Office of Intelligence and Analysis that terrorists may be stepping up their shoe bombing efforts. The report was prompted by the capture of a suspect with a metal blasting cap concealed in a shoe.

IDO Security Inc., (OTC Bulletin Board: IDOI ) a provider of innovative detection solutions for the homeland security market including the MagShoe(TM) high speed shoes-on portable footwear metal weapons detection system, today announced the sale of additional MagShoe(TM) units from Port Lotniczy Gdansk Spolka z.o.o., the operators of Lech Walesa International Airport’s terminal facilities. This sale expands a prior installation of MagShoe(TM) units at the airport providing the capability to quickly and accurately screen all passengers for metallic weapons.

Information within this report contains forward looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21B of the SEC Act of 1934. Statements that involve discussions with respect to projections of future events are not statements of historical fact and may be forward looking statements. Don’t rely on them to make a decision. Past performance is never indicative of future results. We own 400,000 shares of IDOI, and intend to sell these share. This could cause the price to go down. Un-affiliated Third parties may own stock and will sell those shares without notice to you. This report shall not be construed as any kind of investment advice or solicitation. If you are not a savvy pink or bully investor we suggest you sit back and watch. You could lose all your money.

I love bicycling and reading and anything to do with animals. In Japan I grew up with baseball so I know a lot of the players over thereAt this point, only the radical third cam lobe actuated the valves for timing and liftWhen we saw some of her portfolio shots we knew we needed her–so much that we sent a photography team out to the backwoods of the Sunshine State to capture herWhat’s the best part of modeling?Choosing a radiator and a cap is only the beginning when it comes to upgrading your cooling We wanted them to leave! They were yelling out things like, “We know you can smile; just smile damn it!” We had to give the guys some Polaroids to make them go away. Not to mention it looks pretty dope on your crusty-ass ride.In conjunction with a variable-length intake manifold, the advanced VTEC engine anticipates having a 13-percent increase in combustion efficiency over current i-VTEC powerplants. After removing the OEM cat, we welded and bolted up an OBD II Magnaflow ceramic-core catalytic converter in place of the stock one. In early 2004, Ueo began designing AE86 suspension products under his label Desukara Desune With the Magnaflow cat installed, the Honda turned the rollers to the tune of 150hp and 107 lb-ft . The difference between the Laptop Dyno and the inertial dyno were negligible at best, with a difference of less than 2 hp and lb-ft of torqueWhat do you listen to?Additional mods include extending the arms into the rear cabin and welding brackets, making this kit better suited for the serious enthusiast.However, if you are running a rich mixture, the metallic cat is still your best bet.For me, the simple stuff is better: nice jeans, nice top, no braEvery girl wants an honest manIn addition, an advanced VTEC engine is slated to be released, sporting continuously variable-valve lift control and phasing of valve switchover timingWhen he starts talking about how great he is-like where he lives, what he drives, what he does after a few dates-you will know what kind of person he is.So if you could chose to live anywhere …How do you like being romanced?.

Disclosure: I have no interest in IDOI. I have a disclosure policy that has a $480 billion dollar contract with Homeland Security to produce a thought-control device with a range of 800,000 miles . However, I plan to subvert the government’s plan for imperial domination by using the device to encourage people to vote for Ron Paul.

Noble Roman’s Strategy Falls Flat

Noble Roman’s (OTC BB: NROM.ob, $2.48, market cap: $45 million) is a company that franchises two fast-food concepts: Noble Roman’s Pizza and Tuscano’s Italian Subs. You can see a bit more about what they do on their website. The company provides a perfect example of what I call operating accruals and why they are bad for companies. (Note–this is probably not the correct term. If there is a better term for what I discuss, please tell me.) By operating accruals, I mean that the business is operating in such as way that earnings today are coming at the expense of poor earnings (or even losses) in the future. The obligations that go along with today’s earnings accrue in reality, but not on the financial statements. Accounting accruals are different but no less bad. Just google ‘Sloan accrual anomaly‘ and you can learn more about why accounting accruals can be bad.

Strategy Problems

I have thought about franchising from both the selling and buying sides. There are two benefits to franchising from the buyer’s side. The first benefit is that the franchisee gets training / products / a system. Otherwise it can be very hard to start anything from scratch. For example, a restaurant is not just about good food, but choosing the right kind of food and food that is high margin (has a high ratio of price to raw material and labor costs) . (Watch Gordon Ramsey’s Kitchen Nightmares a few times and you will get a feel for how important non-quality aspects of a restaurant’s food are.) Secondly, franchising gets you instant credibility and name recognition. It is for this reason that McDonald’s can charge more for its franchises than can other franchisors. It is this name recognition that helps the average McDonald’s franchise to achieve annual revenues of $1.9 million versus $500,000 for the average Noble Roman’s franchise (according to some estimates, although my estimates are significantly lower). Because of this extra name recognition McDonald’s can charge an initial franchise fee of $45,000 (plus 4% of ongoing sales) versus an initial franchise fee of $6,000 (plus 7% of sales on an ongoing basis) at Noble Roman’s.

The problem with Noble Roman’s is that it does not do any significant advertising. Its product is in a highly competitive industry and it is not differentiated from its competitors. The one advantage to choosing to franchise a Noble Roman’s concept is that it is cheap. While this is advantageous for the franchisees, it is not good for Noble Roman’s. The low capital requirements and low initial franchise frees likely draw many inexperienced and poor restaurant operators to the franchise.

Even worse, Noble Roman’s has tried to expand quickly by introducing a second level of franchising. Area developers pay the company for the right to develop franchises in a geographic area. They then receive a portion of the initial and ongoing franchise fees of new franchises in their area. This leads to what I call an operating accrual. Noble Roman’s reports strong earnings in the present and by selling more areas to area developers it can grow its current earnings. But Noble Roman’s will receive a much smaller chunk of money from new franchises than it does from current franchises and it will still be responsible for training the new franchisees. And soon enough there will be no more area developer rights to sell. So the company is essentially giving up future revenue to gain revenue now. This type of strategy rarely works.

I am not the only one to criticize Noble Roman’s strategy. See the following article on the Franchise Blog, where Kevin Murphy, a franchising lawyer widely known as Mr. Franchise, comments quite negatively on Noble Roman’s area developer strategy.

Valuation

Let’s say that the whole area developer thing goes well and all the new franchises get built. Noble Roman’s signs over 30% of the initial franchise fee and 2/7 of the continuing franchise fee of 7% of sales. Considering that the company has a timetable for its new franchises and the average franchise brings in $500,000 per year, I can do a simplified discounted cash flow analysis on the extra revenue from those franchises. Noble Roman’s will receive $4,200 of the initial franchise fee and approximately $25,000 each year from each additional franchise (if you buy the $500,000 per year in sales, which I do not). See the attached Excel spreadsheet for four different valuations of the company using different assumptions. I discuss the assumptions and valuations below. I discuss below the assumptions of the different valuation models.

First, for all the valuations I use earnings as a proxy for free cash flow. It is not that bad of an assumption considering that Noble Roman’s does not have much in the way of depreciating assets. I separately value new stores and existing stores. All the valuations use a discount rate of 10%, which is reasonable for a highly competitive business like fast food.

The first and rosiest valuation is as follows: For the existing stores, I assume that sales remain flat and that revenues remain at the same (high) level as they were in the most recent quarter. This gives us $2.8 million per year in FCF from present stores. For a terminal valuation I use book value. I assume that all new planned stores get built and that they achieve $500,000 in sales in the first and all subsequent years. For the terminal value of the new stores I use 5x the previous two years’ revenues. I also assume that the new franchises have zero cost for Noble Roman’s and that Noble Roman’s cut of the sales goes straight to the bottom line. This analysis yields a value for the company of $146 million, or 220% of the company’s current market cap.

One problem with the first valuation is that a lot of the current revenues (that I have modeled as existing stores) come from area developer fees and initial franchise fees. Eventually there will be no more areas to develop and initial franchise fees are accounted for in my model in the new store valuation. Subtracting out those revenues from the current store revenues leaves a current annualized profit run rate of only $256,000. This lowers the valuation to about $100 million, or about 121% above the current market price (this is shown on the second worksheet of the valuation spreadsheet).

However, this second valuation assumes over-optimistically that each new franchise will generate $500,000 annually in revenue. A 5% cut of this gives Noble Roman’s $25,000 per franchise per year. Rather than using estimates, I should use actual royalties received from current franchises to estimate what the average franchise gets in revenues and gives to Noble Roman’s in royalties. In the most recent 10Q, Noble Roman’s breaks down its royalties into the various types, including area developer royalties and initial franchise fees. For the most recent quarter continuing royalties totaled $2.044 million. Multiply that by four to get the annual run rate (because pizza is not seasonal) and we get $8.18 million annually in royalties from 1,033 franchises. This averages out to $7,920 per franchise per year. Multiply that by 14.3x (the inverse of the royalty rate of 7%) and we get average revenues of $113,143. For the new franchises under the area developers Noble Roman’s only gets 5% of revenues, so we can expect Noble Roman’s to receive $5,650 in revenue for each new franchise per year.

One important note–a lot of the current and new franchises are dual-concepts–a Tuscano’s Subs franchise and a Noble Roman’s franchise. Even though these are usually within the same restaurant they are counted as two franchises, which explains the low per-franchise revenues. Still, $230,000 sales per restaurant is horrid. Now, I will be charitable and assume that the new franchises produce 50% more revenues than the current stores. But even with this rosy assumption, the valuation of Noble Roman’s falls dramatically. The company is then fairly valued at $42 million, 7% less than its current valuation.

What is worse is that even this valuation involves optimistic assumptions. It assumes that current franchises do not close. It assumes that all the proposed stores get built (which the management just admitted will not happen). It assumes that revenues are 50% greater at new stores than at existing stores. It does not account for the discount that multiple-franchise stores get (saving $2000 on the initial franchise fee). It does not account for the extra training costs (however small) that each new franchise entails. If only half of the projected 868 new franchises are built and new franchises have only as much revenues as old franchises, then the company’s stock should fall 47% to a market cap of $28 million.

Disgruntled Franchisees

Another problem I see with Noble Roman’s, though I cannot quantify it, is that there are a few very disgruntled franchisees out there. The reason I can tell this is by looking at all the negative posts about Noble Roman’s on the Yahoo! stock message boards. Those boards are usually not informative, but in this case they are. Normally, most negative posts on such boards are written by short sellers. But judging from the short interest in NROM, it appears that I am the only one who has sold the company’s stock short. So that means that Noble Roman’s really annoyed a few people. I should add that this is only icing on the cake for my case against Noble Roman’s: I never put much weight on such subjective information. In the case of these ‘disgruntled franchisees’, it could be all the work of one lunatic who may not have even been a franchisee and may just hold a personal grudge against Noble Roman’s management.

Conclusion

All in all, things do not look good for Noble Roman’s stock or for its business. In my realistic scenario, the company is priced at over twice its intrinsic value. In a worst-case scenario most of the new franchises will never be sold, the area development agreements will flop, and Noble Roman’s will struggle to earn $1 million per year. In this scenario the company’s stock price could easily fall 75%. Considering management’s past failures to expand Noble Roman’s, the company’s lack of advertising and product differentiation, and the untested strategy of going with area developers, I think it likely that Noble Roman’s will fall far short of achieving its goals for growth.

Lessons

While I do love bashing companies, there is a broader purpose to the above analysis. I wanted to show how a cogent analysis of financial statements and business decisions can help an investor avoid problems. I knew months ago that Noble Roman’s would never build all the new stores they planned to build. I knew that the company’s current earnings were inflated by non-recurring charges (area developer fees and initial franchise fees). I knew all of this just by thinking hard about its business and looking in depth at its financial statements. I did not need any inside information. Yet still I knew enough to avoid the company’s stock and even to take a large short position in the stock.

Many companies are willing to cut corners to improve current earnings. Whether this involves accounting tricks (such as inappropriately capitalizing expenses) or poor business decisions (such as not re-investing enough money in the business to maintain earnings), the individual investor would be wise to beware.

Disclosure: I am short NROM. See my disclosure policy.

Barron’s Slams Parkervision

This is not news for those of you who subscribe to Barron’s, but this morning’s Barron’s had a great article on Parkervision [[prkr]]. I suggest buying the paper and reading the article. If you are an online subscriber you can see the article here after logging in.

Parkervision is another of those companies that sell nothing but hopes and dreams that short sellers like myself love to hate. Another such company is Research Frontiers [[refr]], which I have previously panned. Parkervision’s dream is wireless technology. While the Barron’s article does not bring up any new information it did point me towards PVnotes.com. That website, run by the founder of Rambus and other technology companies (who is also a Parkervision short seller) archives just about all the negative news and opinion on Parkervision. It also contains original opinions on Parkervision’s technologies and patents.

While I have no intention of shorting Parkervision, I will bet my reputation that the company will never produce significant profits and will eventually go bankrupt.

Disclosure: I have no interest in PRKR or REFR. I have no connections to any current PRKR short sellers. I previously sold short both stocks and managed to lose money despite both stocks falling over 30% between when I started shorting them and the present. My disclosure policy has not lost over $160 million over its lifetime, unlike Parkervision.

$134 million for this?

Seriously, I do not understand how anyone can read the following and still believe the company from which it comes should be worth $134 million:

We may compete for the time and efforts of our officers and directors.

 

Some of our officers and directors are also officers, directors, and employees of other companies, and we may have to compete with the other companies for their time, attention and efforts. Other than our President, Mr. Nicholas Cucinelli, none of our officers and directors anticipate devoting more than approximately five (5%) percent of their time to our matters. Other than with our President, Mr. Cucinelli, we currently have no other employment agreements with any of our officers and directors imposing any specific condition on our officers and directors regarding their continued employment by us.

Yet that is the market cap of Octillion (OTC BB: OCTL). How can a company at which not even the officers spend time be a viable company? It can’t. Furthermore, the company does not even own what would be considered its sole asset:

We have yet to obtain a license and our intellectual property rights may not provide meaningful commercial protection for our interests in the UIUC Silicon Nanoparticle Energy Technology.

 

Our ability to compete effectively depends in part, on our ability to maintain the proprietary nature of our technologies, which includes the ability to license patented technology or obtain, protect and enforce new patents on our technology and to protect our trade secrets. Since we have not yet obtained a license to either the UIUC Silicon Nanoparticle Energy Technology, it is not clear what rights, if any, we may have under the UIUC Patents.

Not only do they not own the technology, they don’t even have a license. And the company does not have enough money to pay for a license should the technology be proved viable. (I should note that the company has a subsidiary with a similar ‘asset’ that it is about to spin off.) All of the above quotes come from the company’s recent 10K.

 

Anyone who invests his or her money in such companies is a fool. They would do much better to just stick their money in index funds or a target-date fund.

 

Disclosure: I am short OCTL. I was not short when I first wrote about this horrid little company. I have a disclosure policy.

Skins: Yet Another Silly Shoe Idea

I have to say that I do not like silly shoes. Crocs (the shoes) are dumb and overpriced and ugly. Heelys wheeled shoes are dangerous and faddish. Of course, that has not kept Crocs [[crox]] and Heely’s [[hlys]] the companies from making some nice money.

But seriously, Skins? At best it is a niche idea. With the price they are selling at they are never likely to go big. While the company is serious and has brought in some substantial outside talent this is a classic case where foolish investors bid up the price of the company to an absurd level. When it had a market cap of $100 million, Skins (OTC BB: SKNN) was priced as if it had already achieved niche status and was growing beyond that. Yet the company had no sales at the time. Reality has caught up with the stock and it has fallen 80% since its high last summer and almost 90% since its 52-week high last December.
Reality often catches up to those who unwarily speculate in ‘the next big thing’. Don’t let reality catch you off guard. Even with a market cap of $16 million I would not touch the stock. That being said, the company’s management is a welcome oasis of decency in the cesspool that is the OTC BB.

Disclosure: I have no position in any stock mentioned above. My disclosure policy loves wearing its Birkenstocks.

The Ethics of Bashing Stocks

My last post reminded me of Gary Weiss’ criticism of Mark Cuban’s website Sharesleuth. Cuban pays a reporter to dish up dirt on public companies, and to fund the venture he shorts the stock of those companies before the articles are published. Cuban calls it a new business model for investigative journalism, Weiss calls it unethical, and I think it is a good thing.

I have in the past been criticized by anonymous message board posters for writing critically about several companies in which I held short positions. I was even called “the scum of the earth” by one poster in response to my criticisms of Document Security Systems [[dmc]]. The coincidental and fitting end to the story of my involvement with Document Security Systems is that while I closed my short position at a loss, the stock later dropped 30%. So was it ethical because I lost money and would it have been unethical if I had made money?

But what is so bad about writing about stocks in which I have an interest? I always disclose a position, as does Sharesleuth. A similar website is CitronResearch.com, run by Andrew Left, who has a blanket statement on his website that he may short any of the companies about which he writes. Is this any different from a mutual fund manager who appears in the pages to talk up stocks in his portfolio? And yet such mutual fund managers get superstar treatment and short sellers like myself earn nothing but the enmity of a bunch of anonymous hooligans.

Is it Unethical to Withhold Information?

While I know that many people frown on writing about stocks in which the writer has a financial interest (at least if that interest is short), what about the opposite situation–someone shorting a stock and unwilling to write about what they know because they are attempting to build up a big short position at a high price or just because they don’t have the time? I have blogged about only a fraction of the companies whose stock I have sold short. I would argue that it is far more unethical for me to withhold my information about unknown companies that I have sold short from the public than it is for me to write about such companies. What do you think?

I think investors in Skins (OTC BB: SKNN) would have wanted to hear a critical view of the company back before the stock dropped by 2/3. Even if they did not want to hear such negative information it probably would have done them some good. The same goes for YTB International (Pink: YTBLA), Hepalife (OTC BB: HPLF), Parkervision [[prkr]], and NNRF (Pink: NNRI). All of these companies I sold short over the last few months and yet I did not publish my analyses. In all cases these stocks have fallen very far since I chose not to write about them. So again I ask the question: which is worse, not writing about these companies or writing about them at the same time I was short?

If a critic says that I should have written about them without being short at all, then that critic misunderstands this blog. I am a trader. I make a portion of my living in the stock market. Nobody pays me to write this blog. Since I have started this blog I have put in hundreds of hours and I have received only about $7 in revenues from my Google Ads. If anyone wishes to pay me to investigate penny stocks, that is fine–I’ll adopt any code of ethics my employer wishes me to adopt. But the reality is that my choice is between me publishing information on some of these stocks (and being potentially biased) and no one but the hype-loving CEOs and shareholders publishing information on these stocks. I do not have the choice of doing this work just for the fun of it.

Is it the Order that Matters?

If it is unethical to write about a stock that I hold, would it be ethical for me to write about it and then after some delay follow my published advice? This is exactly what happened to me with Sun Cal Energy (OTC BB: SCEY). I wrote a negative article about the company and only later I found out that I could short sell the stock. I then sold it short and profited. I cannot imagine that anyone would find this to be unethical. And yet the only difference between this and taking the position before my article is how much profit I make from my work. So is it unethical to make money? Or is it only unethical to do so if I am not paid by a newspaper or financial magazine?

Is the world better off after I expose horrid penny stocks? The obvious answer is yes because I only write the truth and that is usually sorely lacking in the coverage of penny stocks. The good act of publishing the truth and countering untruth is not prevented or stopped just because I profit from it. And the act of profiting is not wrong in and of itself. So I see nothing wrong with profiting in my way from the information I promulgate.

Disclosure: I have no interest in any stock mentioned above. I have a strict disclosure policy. Please note that the last paragraph of this article was replaced after I published it because my first attempt at a closing paragraph was rather bad.

Bloggers behaving badly

Gary Weiss is a blogger behaving badly. He never published my insightful criticism of one of his arguments that I made in a comment on his blog two months ago. While he likes to dish out the criticism it seems that Gary cannot take it. Like too many journalists he thinks that he is somehow better than everyone else. Take it from me, Gary: there ain’t no such thing as impartiality. Journalistic ethics are not ‘right’–they can be useful sometimes and sometimes they are pointless or foolish.Let me reiterate that I publish all comments that could possibly contribute something and that are not obviously libelous, even if I think their authors are idiots and even if their authors insult me.

Disclosure: Gary Weiss, despite being pompous, rails like me against stock fraud and manipulation. He is one of the ‘good guys’. A previous version of this post criticized Clyde Milton of Cheap Stocks. He has since explained his action and apologized (see comment below). I see no reason to hold a grudge. I do find his blog interesting and useful.

The Reaper’s Guide to Short Selling Stocks

The point of this article is threefold: to associate the nickname “The Reaper” with me and my short selling activities so that when I become as famous as Jim Chanos or Manuel Asensio or at least Andrew Left, I can appear on the cover of Forbes magazine wielding a scythe (see picture below); to inform investors about short selling so that they realize the folly of buying into stocks just because of a so-called “short squeeze”; and to inform those crazy enough to actually try short selling about different strategies for doing it.

There are a number of websites dedicated to finding stocks that are prone to a short squeeze and recommending that traders buy those stocks. A short squeeze can occur under two different but similar situations. In each case, there is widespread negative sentiment about a stock in which short sellers have sold short a large percentage of the outstanding shares of the stock (leading to a high short interest ratio). In one case, routine speculative buying on the part of traders pushes up the price of the stock, which creates losses for the short sellers and this may lead some of them to cover their short positions (buy back the shares they borrowed and sold), and this buying on the part of the short sellers drives the stock price up even further.

The other case is where some good news comes out about the company which leads to the same outcome. In this case, a quick witted daytrader or momentum trader can easily make a lot of money. The trader might see the headline and quickly buy the stock at the same time the quickest shorts start covering, and by the end of the day there can be a whole lot of profit as mounting losses cause most of the other shorts to cover as well. I found myself on the wrong end of this kind of short squeeze in early February 2007 with Onyx Pharmaceuticals [[ONXX]] (see chart of squeeze). The market expected poor results from a drug trial, but the company reported outstanding results. Considering that the drug in question was one of only a few that the company was developing, this was incredibly good news for Onyx. Shares doubled from $12 to $24 in one day. I was quick and got out of my short position in the stock with only a 50% loss. A quick witted trader could have read the same headlines I read and bought as I was covering and realized a 30% profit in one day. Of course, I do not recommend such daytrading because most people are very bad at it, but I do recognize that some people do it well and they serve a purpose in the markets.

Non-news-driven short squeezes are much different despite looking very similar on the price charts. The problem with this kind of short squeeze is that there is no fundamental reason for the stock price to go up. As I have previously written (and written elsewhere), stocks targeted by short-sellers tend to do worse than the market as a whole, and people who buy a stock just because the short interest is high and just because there’s a possibility of a short squeeze would do well to remember that. Another thing to keep in mind is that if a company is bad enough, the short-sellers are very strongly convinced of their negative opinion of the company, and the short sellers have deep pockets, there is no reason why the short sellers need to cover just because of a temporary increase in the stock price. A good example of this is the various price increase in the stock of Home Solutions of America [[hsoa]]. The critics of the company are convinced that it is both fraudulent and insolvent and that the stock is worth nothing. So they will likely just hold onto their short positions and grit their teeth to withstand the short-term losses because they believe that within a few months or a year they will be sitting on a 100% profit.

Now, because I am a reasonable and conservative person, I feel obligated to warn you that short selling is highly dangerous, speculative, and for most people it is simply dumb to do it. In fact, we expect the return from selling short stocks to be about -10% per year because on average that’s about how much stocks go up per year. So unless a short seller has a lot of time, talent, guts, and knowledge, he or she should expect to lose money over time.

Short Selling for Fun and Profit

The one rule of short selling is this: don’t do it. If you ignore the rule you deserve what you get, whether it be fortune (if you have great talent and good luck) or poverty (if you have modest talent or great talent and bad luck). Consider yourself warned.

Now that we have that out of the way, there are two ways to profit from short selling stocks: momentum shorting and what I call steel-gut shorting.

Momentum shorting

As mentioned above, selling on negative news can be profitable. It is hard to tell what will continue to fall and what will bounce back. There are a few strategies to use. I have tried using certain influential blogs as my ‘news’ sources.

I receive emails of updates to those blogs or see the postings within an hour of them being published because I subscribe via RSS and I check my RSS reader often. If I see a negative comment about a stock I can quickly check to see if I can short it and then I can quickly short sell it.

This strategy has been a mixed bag and I have probably broken even. While Terra Nostra Resources (OTC BB: TNRO) gave me a nice profit, and Uranerz [[urz]] gave me a respectable profit, I saw small losses on several others, including Cellcyte Genetics (OTC BB: CCYG).

Steel Gut Short Selling

Imagine selling short a worthless company only to see the market double or triple its market value. You hold on. No–you don’t just hold on. You sell more. You borrow money and sell more. The company approaches a valuation that is absurd and crosses it. You sell more. You take out a loan against your house and you sell more. You borrow from friends and sell more. You sell your car and your house and you sell more of the stock. If the stock returns to only modestly overvalued you will make a fortune. If not, you lose everything.

This story ends in a couple ways. If you were unlucky and sold short Amazon.com or Yahoo or Lucent or any other overvalued tech stock in 1998 or 1997 then you were ruined. If you sold short in late 1999 or 2000 or 2001 then you made a fortune.

There are a few keys to making this work. First, be diversified in time and in stock. Make sure that no loss, no matter how incredible, will put you out of business. Second, stay liquid. Don’t get anywhere close to your margin limit. Have some backup cash or a credit line ready so that if the stock shoots up you can wire in some more money and short more. Third, don’t short a stock unless there is something that will force it down. In other words, don’t go against stock momentum or bet against a ‘high-tech’ company, even if the product is a rumor and the company’s sole asset is a promise and a ‘vision’. At the very least, if you do that, make sure that it is a small part of your overall portfolio.

At the risk of repeating myself I will repeat myself: do not short stocks that are valued at a multiple of promises and dreams. My only significant losses in short selling have come from Research Frontiers [[refr]], Document Security Solutions [[dmc]], and Parkervision [[prkr]]. None of these companies has an operating business worth more than 10% of its market cap. Parkervision and Research Frontiers have great new technologies (that I think are totally bogus) and Document Security Solutions has a patent and a court case. If you take a look at Research Frontiers, you will find that it has been promising for decades that its great technology is just around the corner, and yet it never seems to sell anything (see my previous article on Research Frontiers).

Even after avoiding stocks that sell at a multiple of hope, it is important to avoid companies where there is no clear reason why the stock should go down in the short run. Short sellers of Imergent [[iig]] and Usana [[usna]] would do well to remember that. The sad fact is that companies with a bad business can last far longer than they should.

So what is left to short? There are wildly overvalued stocks that are overvalued only because no one knows about them. This is the type of stock that Continental Fuels (OTC BB: CFUL) was. I sold it short around $2.70 and rode it all the way down to $0.50. It is now trading at $0.60. When I shorted it, its diluted market cap was over $1.5 billion and yet it had maybe $10 million in sales, no promising technology, and a negative book value. However, it is very tough to find such stocks, and getting ahold of their shares to short is very hard.

Then there are the fading stars. These are once-highflying companies that run into problems and have little hope of evading them. Examples include Vonage [[VG]] and Krispy Kreme [[kkd]]. Krispy Kreme I just missed, while by the time I became active in shorting, Vonage was too cheap. This is also the category into which most housing-related stocks would fall. Everything from Countrywide [[CFC]] to New Century Finance (now bankrupt) to DR Horton [[dhi]] and E*trade [[etfc]] (didn’t realize they had a big mortgage operation, did you?). [Note: amusingly enough, when I first wrote about E*trade as a short it was weeks prior to its recent stock market crash. I did not actually short it, though it would have been quite profitable to do so.]

Trends, no matter what kind, tend to last longer than anyone thinks. So if you had waited until after the first mortgage problems had made themselves evident in January and February and after panic subsided, you could have shorted a large number of financial and house-building stocks at attractive prices.

If you short sell, good luck. If not, good luck. But even if you do not short sell it would behoove you to pay attention if short sellers target your favorite stock. Imagine the happiness of those few Enron shareholders that sold after hearing about Jim Chanos’ shorting of the stock.

Disclosure: I have no position in any stock mentioned. My disclosure policy makes for good reading. The picture of the grim reaper above is me. Yes, I do realize that I need to sharpen my scythe. No, I do not take myself too seriously.

Home Solutions of America Admits Problems, Delays Quarterly Report

See the press release at Yahoo. The stock of HSOA [[hsoa]] is down big on the announcement. The report is delayed because its auditors need more time to investigate related-party transactions. My bet is that some of them turn out to be sham transactions and much of HSOA’s so-called earnings go up in smoke. If that is the case it’s lender could call its line of credit (which is secured by receivables, some of which are from related-party transactions), forcing HSOA into bankruptcy.

This is another good example of why self-dealing is bad and why cash flow trumps earnings. The classic way to commit accounting fraud to pump up earnings is to make sham deals with pliant customers or related parties. The revenues are accrued, going into accounts receivable, and earnings are pumped up, but no cash is ever paid and the ‘earnings’ turn out to be non-existent. That is why I try to steer away from companies that have too many receivables and greater earnings than cash flows. In these cases, even if there is no fraud, the receivables may turn out to be noncollectable and the earnings are never followed by cash flow. So, even if there is no fraud at HSOA, shareholders will likely continue to be disappointed by the lack of cash the company can actually collect.

Disclosure: I have no position in HSOA, long or short. My disclosure policy committed accounting fraud back in 1984 but has since paid its debt to society and now speaks to corporations about the dangers of insider self-dealing.