Here is a summary of my motivation and approach in selling short beaten-down stocks.
In his popular book "What Works on Wall Street," O'Shaughnessy backtested many different stock screens from the 1950's till now. While he was mostly interested in finding schemes that have high returns, his results are also instructive for short sellers.
The scheme he found that had the very poorest return was selecting the 50 stocks with the lowest one-year price performance among all the stocks in his universe. This scheme had a positive return of about 2%, compared with 10% or so for the universe as a whole.
A positive return of +2% is hardly good enough for a short portfolio, though, so I've been working on schemes to narrow the stock selection further, to identify stocks that will have negative returns.
I do this by analyzing the financial statements and management discussion the in the annual reports (10k) and quarterlies (10Q) in the SEC database.
First of all, I only look at really small companies. If you look for the lowest RS stocks, they are all small caps anyway. Really small companies can have a lot of trouble staying afloat when things go wrong.
One profile I look for is an especially nasty liquidity situation: if the cash position is low and the cash flow is negative, then the co. is facing a cash crisis. It isn't necessary for them to actually go bankrupt for the stock to collapse, though.
I make sure that I am not looking at a beaten-down value stock by eliminating stocks with a low PSR or p/b.
Another profile I look for is a stocks with very low shareholders equity and big negative earnings. When this continues, the shareholders equity will eventually go negative, and this will violate the exchange listing requirements. Companies actually do get delisted for having too low a net tangible assets (NTA, defined as shareholders equity minus goodwill). This situation can be win-win for shorts. If they get delisted and start trading on the bulletin board or pink sheets, the stock price will respond badly. If they succeed in beating the delisting, it is often by selling more equity in a hurry to raise their NTA, typically in a private placement, and this can be highly dilutive.
This brings me to a favorite type of broken stock: the one that has been forced to seek a Reg. S private placement. These offshore private placements are highly unfavorable for existing shareholders. The co. sells convertible preferred or convertible debentures, which convert into common stock at a discount of 8% - 25% from the prevailing market price for the common. This assures the holder a profit, regardless of what the market price does. The convertible typically yields only 5%, which is insignficant, so the holder flips into common as soon as possible, typically within a couple of months of making the deal, then and sells the common immediately, thereby locking in a profit from the discount. This selling of the common stock by the offshore institition can severely depress the stock price. Moreover, it is predictable in its timing, because you can tell from the SEC filings, particularly the S-3 prospectus that must be filed, approximately when the selling will commence. This a predictive capability that is hard to come by in most any other situation. Yet another factor that makes these deals interesting is that firms will only do them as a last resort. So, when you see a new discounted convertible deal, it means the co. was too messed up to raise capital any other way. |
