Everyone !!! Got this from the Fool.
FOOL ON THE HILL
An Investment Opinion by Louis Corrigan
Risky Business
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 - news) , 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 - news) , 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 - news) 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 - news)
or today's Lunchtime News piece on 3Com (Nasdaq:COMS - news) . Can an overreliance on one customer be risky? Look at what happened to yesterday's "Quick Cuts" disaster National Research Corp. (Nasdaq:NRCI -
news) .
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.
Regards
Sri. |
