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Risky Business of
Shorting
The Motley Fool - December 03, 1997 17:04
VIFL STRL HFI CS COMS NRCI V%MFOOL P%TMF
December 3, 1997/FOOLWIRE/ -- A week ago Tuesday, a poster
to the Fool's "Shorting Stocks" message folder on America Online
breathlessly offered a new short idea, "One of the best candidates I've
ever seen," he said. He ran down a list of reasons for the stock being
wickedly overvalued at just under $7 a share and made the bold
prediction that it would fall below $1 a share within the next 12
months.
He forgot to actually name the company, but by the weekend, the folder's
short-selling sleuths had uncovered the mystery. By Monday evening, some
had done preliminary due diligence, with one poster agreeing the stock
was indeed "a stinky little dog." Others regretted that they couldn't
find shares to borrow; rumor had it that someone was already
aggressively shorting the stock. In the three days since the poster
recommended it, this "dog" had already taken on more fleas, having sunk
24% to $5 3/16. Not bad.
Twelve hours later, the dog in question, Food Technology Services
(Nasdaq: VIFL), was running toward a close of $11 11/16, up 125% on the
day (though it did fall back to $8 1/4 today). Food Tech is in the
business of irradiating food, a process that kills bacteria such as E.
coli. Yesterday, the Food and Drug Administration (FDA) acted on a
proposal submitted three years ago by the meat industry and Isomedix
Inc., now a unit of Steris Corp. (Nasdaq: STRL), and approved the
irradiation of beef. As the only pure-play food irradiator, Food Tech
had investors glowing. Meanwhile, the shorts were losing their
appetites, their shirts, and probably some small fortunes.
Although this dramatic episode highlights the inherently greater risk of
going short a stock rather than going long, it also suggests the general
risk of investing in stocks and the need for us to take that risk
seriously. To do so, it's first necessary to evaluate yourself,
including your reasons for investing, your time horizon, your comfort
level with market volatility, your desire to actively manage your own
investments rather than have someone else do that for you, your
investment philosophy or style, and your intellectual and emotional
capacity to make that style work for you.
The Fool's core mission is to educate investors in matters financial so
that they will be able to make their own decisions and profit handsomely
from them. For people who conclude they don't have the time or the
desire to actively manage their own investments, that may mean one of
two decisions: selecting a mutual fund indexed to the S&P 500 or putting
money into some variation of the Dow Dividend Approach, a high-yield,
super-charged variation of the S&P 500. Ultimately, though, the Fool
aims to prepare and assist investors who wish to run their own
portfolios.
While some investors may err on the side of caution, it's far more
common to see people fail to adequately weigh the risks of an
investment. Looking at a company's rapid earnings growth, optimistic
analyst estimates, hot new products, or a period of rapid stock price
appreciation, it's easy to begin to fantasize about your potential
return. But don't be seduced by your own fantasy, often a collective
fantasy. Just as you should be able to write out at least one solid
paragraph explaining why you've bought a stock, you should be able to
add another paragraph laying out the challenges facing the company,
evaluating the chances that things could go wrong, and listing the
developments that would make you consider selling your shares.
If you can't make a strong devil's advocate case against an investment
decision, you probably don't know the company or its industry well
enough to take the plunge. Some of the world's greatest investors have
an almost obsessive need to understand the other side of the story.
George Soros, for example, has said he was only satisfied with an
investment thesis when he knew its flaw. As a trader, he was interested
in playing the thesis. Yet because he assumed it was flawed, he was
always on the lookout for an "inflection point" where the flaw
decisively reared its head and the market would reverse course. It is a
boom/bust theory that's quite apt when investing in cyclical stocks or
hot technology companies. Good short-sellers are equally paranoid since
they want to be sure not just that a company is overvalued, but that
market forces will not carry an issue to an even more wildly overvalued
level before it retreats.
Investors with a time horizon of three years or more don't need to
obsess over market forces in this way, but all investors do need to know
the risks that might cause a company's business to falter and stock to
fall and to understand which of these potential problems are important
given one's investment horizon. A great place to start is with a
company's annual 10-K filing with the SEC or with the prospectus for any
new stock registration. Investors should study the section outlining
risks.
While many of these so-called "boilerplate" warnings are less than
helpful (what industry isn't highly competitive?), others will highlight
crucial issues, such as the possible impact of government regulation,
the company's reliance on a few customers or suppliers, potential
currency exposure, liquidity concerns, price pressures that have
historically been a part of an industry's cycles, and so on. The public
filings should give you some general clues as to what one should explore
in more detail when you compare the company to competitors and conduct
further research. Of course, an investor's best friend is an articulate,
well-informed critic of his company who can highlight the possible flaws
in his investment thesis. You know the gods are shining on you when you
find such a critic on the Fool message boards.
Of course, all of this is easier said than done -- but sometimes not by
much. Food Technology's public filings, for example, depicted a fairly
threadbare business that churned out less than $200,000 in trailing
sales and had posted substantial losses. As of September 30, the company
had merely $4,554 in cash but over $3 million in convertible debt. The
filings as much as said that the company's future depended on the FDA's
approval of meat irradiation and on the continued largesse of its
Canadian sugardaddy, MDS Nordian, which had the right to convert Food
Tech's debt into a controlling stake of over four million shares.
Assuming these shares were issued (and they would be if things went
well), Food Technology was valued at about $50 million Monday night. The
stock had run up from $0.62 a share to a high of $13 1/8 on the Hudson
Foods (NYSE: HFI) bacteria scare and support for irradiation from public
officials. It was being barely supported by the expectations that the
FDA would act soon. That expectation was at least as reasonable as the
short position on valuation because the new Congressional bill on FDA
funding had mandated that the agency act on this issue within 60 days.
While one can usually handicap FDA decisions, the agency is essentially
a black box. At least in hindsight, it's clear that the FDA's possibly
imminent approval of meat irradiation should have represented an
unappetizing risk for a short-seller. Even if one thought the chances of
approval were slim or that the company still faced enormous challenges
even if approval came, Tuesday's rally was the likely outcome if the
agency said yea.
Foolish readers have many opportunities to get a painfree education in
such material risks -- both to a company and to its stock -- by way of
the daily Foolish deconstructions of stock collapses, such as the
"Goats" of the Evening News, the Daily Trouble, and columns like
yesterday's Fool on the Hill on Cabletron Systems (NYSE: CS) or today's
Lunchtime News piece on 3Com (Nasdaq: COMS). Can an overreliance on one
customer be risky? Look at what happened to yesterday's "Quick Cuts"
disaster National Research Corp. (Nasdaq: NRCI).
In theory, a company's stock price discounts the firm's future return to
shareholders in the form of earnings/dividends. Because those earnings
could be diminished if things go wrong, the stock ought to reflect the
danger that they might. The goal of assessing risks isn't to scare you
out of the market. Rather, it's to make you cognizant enough of a
company's potential troubles and the likelihood of them happening that
you put a fair value on its stock price. It's also to help you set up
some parameters, based on your own investment time horizon, of what
kinds of troubles might alter your decision to own part of a company --
and to be prepared for them should they develop.
-- by Louis Corrigan
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