by Amit Kumar
In the case of IPOs and spin-offs, the initial owners and insiders are not allowed to sell their shares during an initial lockup period (typically 90 to 180 days preceding the public offering), and the lockup expiration calendar is publically available. The expiration dates are watched very closely because stock prices are expected to drop as a result of new supply entering the market.
Mostly, stocks react negatively to an exit of marquee or strategic investors and forewarnings from prominent short sellers. It is important to pay attention to float (shares available for trading) and short interest ratios (the number of shares sold short in the market as a percent of the float). Low float (concentrated ownership by a small number of investors) or a high short interest ratio (heavily shorted stocks) reduce the stock liquidity (ease in trading the stock) and cause wider swings in the stock price, or a short squeeze.
Short sellers are not required to disclose their stakes in the United States; however, they may choose to disclose their short position and make their pitch through public interviews and presentations. Most successful presentations point out clear flaws in a business model, accounting irregularities, or impending threats to the company’s prospects to the extent that the short thesis seems to be a no-brainer. However, short sellers do not always expect such stocks to go to zero (even famous shorts on Enron and Lehman), and it is important to ensure that the current valuation allows a margin of safety for a short trade.
Short selling requires a contrarian mindset. Therefore, when a prominent investor takes a large long position in a cheap stock, it may be worthwhile to examine if the stock is a value trap. Finding a value trap is probably the hardest task. Not only do you need to deeply analyze the company’s financial statements, but you also need to predict adverse demand trends for its product, broader industry, or macroeconomic indicators.
Last but not least, downgrades by sell-side analysts mostly result in a down day for stock. Short-term tactical calls are often based on channel checks or surveys conducted by the analysts. In some other cases, analysts might downgrade a stock on the heels of a poor earnings report or poor product launch, or after the stock is near their target price. It is usually difficult to source short ideas based on short-term tactical calls; however, longer-term calls that point to structural problems with a business can lead to good short ideas every once a while.
Loss of a Key Client, Product, Executive, or Subsidy
A company with revenues derived from the sale of one key product or sale to a key client naturally has a higher risk of mishaps and failure, akin to putting all of its eggs in one basket. The most common examples are biotechnology and pharmaceutical companies with a single drug. Among the many things that can go wrong for these companies, the drug may be coming off patent, insurance companies or Medicare reimbursement plans may drop coverage of the drug, the drug may cause unexpected side effects, clinical trials may not be successful, and alternative drugs may enter the market. In general, the risk in shorting companies with commercialized drugs is always much less than shorting companies with drugs in the pipeline.
CASE STUDY:
QUESTCOR PHARMACEUTICALS (QCOR)
In August 2007, Questcor Pharmaceuticals adopted a new pricing model for Acthar, its sole drug, used for the treatment of multiple sclerosis (MS) and infantile spasms. Questcor effectively raised the price of Acthar in 2007 from $1,650 per vial to $22,222 per vial. Questcor’s revenues doubled over the next three years, from $49 million in 2007 to $115 million in 2010; the stock soared multifold, from $0.5 to approximately $15 by the end of 2010.5
Questcor was noticed by short sellers after the health care reform law required pharmaceutical companies to provide rebates to cover a portion of the Medicare Part D coverage gap, the so-called donut hole. Twenty-five percent of Questcor’s sales came from Medicare-insured patients. Questcor responded by doubling its sales force to boost Acthar prescriptions for MS patients whose treatment was covered by commercial insurance companies. Consequently, prescriptions for MS increased to 3,090 from 1,212, boosting annual sales by 87 percent to $217 million in 2011 and doubling the stock price in 2011.
Short sellers were out of luck on this stock, and the tug of war between longs and shorts continued into 2012. In July 2012, a noted short seller argued that Acthar’s active ingredient could be replicated in a generic version, sending the stock 23 percent lower. However, Questcor stock recouped its losses after it became eligible for lower Medicaid rebates in September 2012 (figure 1.2).
FIGURE 1.2 Questcor revenues, stock price, P/S, P/E 2010–2012. Source: Questcor SEC filings.
The story was not over. Two weeks later, on September 18, 2012, Aetna published a clinical policy bulletin on Acthar to limit reimbursements to treatment of West syndrome (infantile spasms). QCOR fell nearly 50 percent on the news as the market worried that other insurers would follow suit. On the heels of this news, the SEC announced an investigation into Questcor’s marketing practices. With a heavy short interest of 40 to 50 percent, QCOR was a hot stock. QCOR stock continued to remain depressed until it announced on June 12, 2013 that it would acquire the development and commercialization rights to Synacthen and Synacthen Depot from Novartis. On April 7, 2014, Mallinckrodt Pharmaceuticals announced that it would acquire Questcor for approximately $5.6 billion in cash and stock.
High-priced drugs often run into reimbursement issues from commercial insurers or Medicare, and their problems compound when a cheaper rival drug enters the market. In other cases, high-priced drugs may catch the attention of lawmakers. For example, Gilead Sciences faced scrutiny over its pricing strategy for Sovaldi, a hepatitis C drug that was approved only four months earlier on December 6, 2013. Although companies with diversified drug portfolios are less risky, single-drug companies are prone to getting out of businesses; the risk in their business model makes them more attractive candidates for short sellers.
Use of the single-product theme to identify short candidates applies to many other industries, such as smartphone makers. I want to quickly compare this industry with drug makers to point out additional issues with sustainable profitability for smartphone makers. Products such as smartphones are not as strongly protected by long-term patents as drug makers, and the design cycle for phones is much shorter than that of pharmaceuticals (drugs go through multiyear clinical trial processes).
A shorter product shelf life, design time, upgrade cycle, competition, and shifts in consumer trends make it hard for phone makers to profitably grow market share for more than two years. Once a phone maker loses luster for its hit product in the market, there seems no end to the decline in their revenues, such as in the cases of Motorola (unit sales fell 85 percent after their RAZR fallout in 2006), Nokia (unit sales fell more than 20 percent in 2010 as rival smartphones entered the market and Nokia entered a product recession), RIMM (unit sales fell more than 30 percent after product missteps in 2010), and HTC (unit sales fell more than 20 percent in 2011 on pricing missteps and competition).
Other Product Issues
Markets do not like uncertainties and they do not welcome negative headlines on profitability or growth prospects for a company, namely production and capacity expansion issues, supply chain disruptions, delays with product launch, excess inventory, input cost inflation, and so on. Sometimes, these headlines can point to broader and longer-term issues with the company.
CASE STUDY:
PILGRIM’S PRIDE CORPORATION (PPC)
Prices for corn and soybeans (key inputs for chicken farms) began rising in 2007 and hurt the margins of chicken producers. Their shares were down 20–30 percent from the peak in 2007. My fund manager had taken a long position in PPC and asked me to research the company.
Chicken producers had not hedged corn prices, and corn futures indicated more trouble coming for them. In particular, this was not good news for PPC, which had acquired Gold Kist for $1.3 billion, funded entirely by secured credit and bridge loans. Based on its 2007 earnings, PPC would have been required to pay a
higher interest rate on its long-term debt because its debt/EBITDA ratio of 3.2 was above the restrictive covenant of 3.0.
Pilgrim’s Pride spent approximately $2.4 billion on corn and soybean feedstock in 2007. If prices increased another 20–30 percent, as suggested by commodity futures, their cost of sales would have increased by an additional $400 million to $600 million. PPC could pass some of the cost to customers through price increases; however, historical data suggested that chicken prices rarely rose above 5 percent because consumers often shifted to beef. The chicken industry was already cutting production through 2007 after an oversupply in 2006. With plant utilization at 85 percent in 2007, drastic production increases seemed unlikely at PPC.
Pilgrim’s Pride would have posted losses of at least $100 million in the best-case scenario of a 5 percent price increase, and they still could have risked breaching their debt covenants. They were also facing other cost issues related to fuel prices, labor shortages, and an increase in their interest rate on long-term debt. PPC seemed like a good short candidate; we sold our stake and went short. PPC posted significant losses in 2008 (figure 1.3) and filed for bankruptcy protection.
FIGURE 1.3 Pilgrim net income, stock price, corn price increase 2007–2008. Source: PPC SEC Filings, U.S. Department of Agriculture.
Industry Trends: Cyclical and Secular
When an industry begins to show signs of decline, it is important to understand whether the decline is secular, cyclical, or short term in nature. This aspect of investment research or analysis is an art, and there are no magic frameworks to understand and predict the nature of such trends. Industry experts, sell-side analysts, market research firms, and news media dedicate considerable resources to researching and publishing short-term and long-term themes and trends. Typically, short bets based on clear declining trends in an industry tend to be crowded trades that follow smart investors (or money).
When the advent of the Internet threatened traditional news dissemination, all newspaper stocks entered a multiyear decline period. Trends such as online delivery of content (video, audio, news, etc.) and outsourcing at the beginning of the twenty-first century have proved to be irreversible. Similar trends that promise cost benefits from comparative advantage can also last for many years. Other secular trends that emerge from shifts in consumer behavior, such as product obsolescence or substitution, disruptive technologies, and chronic overcapacity or oversupply (e.g., telecom bust), can also threaten long-term prospects of an industry or even lead to their demise.
Industries, just like companies, go through cycles of growth, maturity, or decline, and the profitability of companies within an industry is naturally correlated with the stage of the industry. During a growth phase, industries or companies can be financed by customers, capital markets, or government investments; these sources of funding eventually define their balance sheet characteristics. In general, hard-asset industries (e.g., airlines, banks, utilities) are heavily indebted, whereas soft-asset industries (e.g., services, software) tend to be financed by customers and remain free of debt.
The strength of a balance sheet or war chest can inject life into a company’s ability to renovate and survive when its industry enters a cyclical or structural decline phase. However, when products offered by an industry become commoditized (e.g., personal computers [PCs]), it becomes hard even for companies with great balance sheets to reverse the decline in profitability; they become value traps for investors. Good managers can sometimes spot the declining trends early and decide to completely exit the business, such as when IBM decided to exit the PC business in 2004.
Exceptional managers can sometimes successfully retool the business. Steve Jobs steered Apple away from the PC business in 2004 to revolutionize digital music and the mobile phone industry. However, it is rare for even exceptional managers to be able to turn the tide of a secular decline. Dell was unable to reverse its decline despite its strong cash position and the return of its successful founder to the helm in 2007. Buffett probably saw many failed second acts from exceptional executives during his lengthy investing career. He captured this in one of his brilliant quotes: “When a management with a reputation of brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”
Financial Statement Issues
Uncovering accounting fraud is a dream job for short sellers, but it requires exceptional accounting forensic skills. Accounting forensics is no easy job; however, it is easy to pay attention to certain common issues, such as unusual divergence between sales and accounts receivable, high levels of inventory, asset valuations (changes in classification, mark-to-market assumptions, etc.), and major changes to accounting assumptions. Chapter 4 discusses some of the common accounting issues and related examples in more detail.
When a company discloses accounting problems, its stock is bound to fall as investors begin to question the integrity of its financial statements. Accounting problems can range from benign misclassifications to complex financial shenanigans. The most common scandals involve revenue recognition problems (to inflate sales), expense classifications (to understate costs), and masked liabilities (involving special-purpose entities and fake transactions).
Accounting is the language of business. Investing in a stock without reading its financial statements is akin to flying blind. Accounting issues are often symptoms of larger problems with the business model, and it is not enough to discover irregularities in financial statements. Good accounting short stories are also able to establish problems that the company is trying to cover up with financial shenanigans.
For example, when Jim Chanos looked at Enron’s 1999 10-K filing, his firm found that Enron generated 7 percent return on capital (below its cost of capital) and aggressively used gain-on-sale accounting practices to artificially boost profits. Chanos found Enron’s expansion in telecom to be a key mistake. He was also bearish on the telecom sector based on the glut of capacity developing in the sector, and Enron seemed oblivious to this when they announced their telecom initiatives. This belief, coupled with heavy insider selling (an example of insider selling as a leading indicator for a short idea), added conviction to his bearish view on Enron.
Company Events: Earnings, Investor Meetings, and Conferences
Markets closely watch scheduled company events, such as quarterly earnings announcements, investor meetings, management interviews, and industry conferences. The most closely watched events are quarterly earnings announcements, where companies release financial statements, forward guidance and outlook, profit warnings, and status on key initiatives, and management answers questions from analysts during earnings conference calls.
The SEC adopted Regulation FD in 2000 to prevent selective disclosure of material nonpublic information (information that would most certainly impact the stock price) by publicly traded companies. In other words, companies cannot provide sensitive information to a select group of investors ahead of the general public. Consequently, companies are mandated to release such information via press releases or public events, such as scheduled earnings calls. Companies enter a quiet period before such events; their management declines to discuss earnings-related topics and other material information during this time.
The most widely watched numbers in an earnings release are revenue and EPS. Markets can instantly vote down the stock if these numbers do not meet consensus expectations (median of Wall Street analysts’ estimates). In other cases, companies may meet or beat these expectations, but their stocks would still fall if the company’s forward guidance falls short of expectations or if it issues profit warnings. It is important to estimate revenue, earnings, and other key metrics and compare them with market expectations ahead of earnings.
Companies typically release certain industry-specific metrics only in earnings releases, which are closely watched by the markets as well. Some of the most commonly watched industry-specific metrics include available seat miles and load factors for airlin
es, book-to-bill ratio and capacity utilization for industrials and materials, comparable store sales for retailers, net interest margin and non-performing assets for banks, and subscriber growth for media and software companies. Chapter 4 provides a list of commonly watched metrics for each industry.
Companies also tend to announce major product launches, restructuring initiatives, and key strategies during annual or special investor meetings. These events build up expectations in the market, and stocks tend to fall when management fails to meet these expectations. Management changes at troubled companies can sometimes lead to good short candidates, especially when they are struggling with an industry slump, daunting competitors, poor acquisitions, or other specific issues. Investor meeting events for troubled companies are especially important as they give management a platform to clearly lay out their turnaround strategy.
When Meg Whitman, HP’s CEO, announced in the 2012 investor meeting that HP would not be able to recover and grow for another two years, the stock fell 8 percent on the news. Earlier, as CEO of eBay, Whitman had overseen a successful IPO of the firm and revenue growth for 10 years, from $4 million in 1998 to $8 billion in 2008. She was brought in as CEO to turn around HP.
HP had been struggling since ousting Mark Hurd, its star CEO, in 2010, and had subsequently fired Leo Apotheker, the incoming CEO, in 2011. Apotheker had failed to gain investor confidence amid declining PC demand and was criticized for his acquisition of Palm and Autonomy. The market had laid hopes in Meg Whitman to announce plans to turn around HP sooner than 2014, so her investor meeting was not well received.