by Amit Kumar
FIGURE 10.2 Key news flow for Tesla stock. 1, Tesla schedules press conference to reveal financing program; 2, analysts are skeptical that the financing will invigorate demand; 3, Tesla posts adjusted first-quarter profits, 5,000 Model S vehicles sold in the quarter; 4, Tesla makes $1 billion follow-on offering to repay DOE loans; 5, Goldman analyst downgrades Tesla, says stock defying gravity; 6, Tesla reports second-quarter results, 5,150 Model S vehicles beat its own target of 4,500; 7, Tesla rises 6 percent on filing trademark for a Model E name; 8, Deutsche Bank analyst upgrades price target to $200. Source: Tesla press releases, Bloomberg.
I was speaking on a short-selling panel at the New York Society for Securities Analysts on May 9, 2014 (what would have been Ben Graham’s 120th birthday). Tesla stock had just hit a low on the ongoing concerns on that day and my co-panelists laid down their case for shorting Tesla. One of them had initiated a small short position on Tesla in 2013 and believed that Tesla had now become an attractive short.
I disagreed with my co-panelists because the biggest risk to Tesla’s short thesis was betting against Elon Musk, who has a spectacular record of delivering on every big risk he took. Musk was directly involved with six multibillion dollar companies that he founded or co-founded. While a couple of these companies went through near-death experiences, they ultimately prevailed. Simple Bayesian math would point to the low odds of successfully betting against Musk, and my only point was not to bet against him.
Failing Ship, Star Captain: Management Star Power Can Revive Stocks
We have seen in previous examples that even star captains can fail to turn around their ships when their industry enters a declining period and products lose relevance amid emerging alternatives. However, their star power has high odds of success when the issues are endemic to the company and not the broader industry. Let us consider the technology industry in particular.
The technology industry has the most dynamic competitive landscape of all industries. It is rare to find tech companies holding a monopolistic grip on their markets for long periods, while it is common to find them losing their dominance to disruptive technologies. Some tech companies spend on innovation (which shows up as research and development expenses on the income statement), while others buy innovative companies (which shows up as capitalized items on the balance sheet). Both strategies are critical to staying ahead or even staying in the race!
Tech companies usually generate a lot of cash, which they constantly reinvest in core research and expensive acquisitions of innovative concepts, but they are often left floundering with their cash after they lose key executives. They can end up as value traps after burning cash in a string of poor acquisitions and failing products; however, it can be dangerous to short them after they have dashed market expectations. Markets can place renewed hope in their salvage if they can hire a star captain.
CASE STUDY:
YAHOO! (YHOO)
Executive turnover, fifth time is the charm
Yahoo! is probably the most fitting example of a fallen angel since it lost the dominance in search engines to Google and failed to acquire them in 2002. Since then, Yahoo! missed out on many key acquisitions, such as Facebook, and made poor acquisitions, such as GeoCities. Yahoo! stock dropped after rejecting an unsolicited bid from Microsoft in 2008, and it remained a value trap for the next four years.
Yahoo! probably saw everything go wrong that could go wrong since then, while the rest of the tech industry witnessed home runs from many startups and rivals. Yahoo! replaced five CEOs in the next four years, lost its grip on its valuable stake in Alibaba, and failed in executing restructuring plans. Yahoo! stock stemmed the decline in 2012 after resolving its dispute with Alibaba and announcing stock buybacks; however, its real tailwind came from hiring Marissa Mayer, a Google alumni. Market expectations lifted on the announcement of her appointment as the new Yahoo! CEO.
Mayer pursued her alma mater’s core strategy of aggressive acquisitions, buying more than a dozen companies, including the big-ticket acquisition of Tumblr. Analysts expressed skepticism of her strategic goals, while investors placed hope in her Google pedigree. Yahoo! stock rose more than 70 percent within Mayer’s first year as CEO, even as Yahoo! showed dismal growth in revenues or profits.15
Hidden Options: Value Waiting to Be Unlocked
Hidden options in a company’s business model can sometimes unlock value that is worth many times the stock price. Such options are even more valuable when the company has a strong distribution network to render its products or services. In such a case, a company’s speed to deliver new products and services is only constrained by the time needed to develop or acquire new products. Markets can undervalue the distribution network and other hidden options when investor sentiments about the stock turn sour.
CASE STUDY:
NETFLIX (NFLX)
Netflix stock had risen ~7× to $295 since 2009, steamrolling short sellers (including a few reputed ones). In July 2012, Netflix announced price hikes and new subscription plans as part of the plan to separate their DVD rental and online streaming services. Netflix customers were outraged by the price hike and the inconvenience of logging onto two separate websites. Media and analysts launched a series of tirades over this announcement for the next couple of months, forcing the Netflix CEO to apologize; however, the apology seemed too little and too late. Netflix had basically shot themselves in the foot, causing the stock to drop more than 70 percent in a span of four months.
There was no end to the bad news for the stock. Netflix decided to raise $400 million in fresh capital in November 2011 by selling convertible debt at a strike price of $85.8. The stock continued to swing up and down in the following months and ended up trading around $60. Netflix was a consensus short by July 2012. Threats to the Netflix business model from Amazon, CoinStar, and Walmart were a hot discussion topic. News show guests were highlighting how content owners wielded power and Netflix had struggled to renegotiate their video content deals. The popular view seemed to be that content owners had rendered the content aggregation business model useless. Netflix seemed doomed.
I had followed Netflix for a number of years. It piqued my interest when market bears thought the Netflix business model was broken and the stock was going to head even lower after it had swooned 70 percent. Bears were basically arguing that Netflix was a value trap and their subscriber base of 23 million members was now on the path of secular decline.16 I began evaluating the short thesis on Netflix to find any catch with this value trap argument: Did Netflix not have any hidden value with its 23 million subscribers?
Beware of the Hidden Option in Netflix: Hulu17”
I had a Netflix online subscription for $9.99 a month at home and I had just signed up for Hulu Plus. I was watching The Daily Show with Jon Stewart on Hulu Plus and was irritated by the fact that Hulu served me with advertisements every few minutes. I was paying $7.99 a month and was expecting a Netflix-like commercial-free treatment.
I became curious about how much Hulu earned from advertisements. While Hulu was a private company owned by Disney, Fox, and Comcast, the Hulu CEO regularly posted its revenue and subscriber numbers in his company blog. It was interesting to note that Hulu users were complaining about advertisements in response to the blog posted by Hulu’s CEO.
Hulu made $420 million in 2011, with an average of 1 million paid subscribers, and had ended the year with 1.5 million subscribers. Their revenue math seemed simple, with an $8 per month subscription plan, and subscription revenues came to $96 million (12 months × $8/month × 1 million subscribers). Where did the remaining revenues of >$300 million ($420 million—$96 million) come from? The answer was in-video advertisements, sold on a cost per impression or cost per mille basis.
YouTube had effectively built the in-video advertisement market, although Google, its parent company, had not separately disclosed YouTube’s revenues. Street analysts had estimated that YouTube held a lion’s share (more than 80 percent) of the $3 billion online video a
dvertisement market. This market was expected to grow 50 percent for the next three to five years.
What Did In-Video Advertisement Mean for Netflix?
In-video advertisement was a real option for Netflix, and it was important to evaluate the value of this real option to determine whether Netflix was a value trap. If Netflix could launch new tiered ad-based pricing for 2 million subscribers (<10 percent of 23 million current subscribers), it could easily generate $600–800 million of incremental advertisement revenues based on Hulu’s historical results. Netflix would not need a sizeable investment to launch such a plan and they could generate 50–60 percent in incremental operating margins (~$400 million in incremental net income). At a price-to-earnings ratio of 15–20, the value of the advertising option was >$6 billion. The stock could easily double.
Netflix had two other real options: venturing into in-house content production and introducing a pay-per-view model to watch movies. Both options had the potential to boost Netflix’s content library. While Netflix had reported slowing subscription growth in their online streaming business, there were no alarming signs of a decline in the subscription base.
Netflix did not seem like a value trap from any angle. I recommended that my clients buy Netflix in August 2012.
How Did Netflix Play Out?
On October 13, 2012, Hulu borrowed money to buy back 10 percent of their shares for $200 million, valuing them at $2 billion, which implied a valuation of more than $1,000 per subscriber. The transaction seemed expensive, probably because the deal did not involve an outside investor. However, the economics of this transaction implied a valuation of <$200 per subscriber for Netflix, which had a much larger subscription base of 23 million.
On October 31, 2012, Carl Icahn announced in a Securities and Exchange Commission filing that he had recently bought Netflix stock and call options that could give him control of 9.98 percent of the company. Netflix stock soared 20 percent on the news. Five days later, Netflix adopted a poison pill, limiting noninstitutional investors to a 10 percent stake in Netflix shares.
Markets shrugged off any concerns of a tug of war between Carl Icahn and Netflix management and became increasingly optimistic about a possible turnaround. Netflix stocks continued to rise amid optimism about their upcoming earnings on January 22, 2013. Netflix announced surprise positive earnings, an increase in subscribers, and positive earnings outlook. Netflix shares jumped ~40 percent on the news to $146.86 and continued to rise for the next six months, closing at $257.26 on July 12, 2013.
Recap
• Optimal allocation and prudent risk management limit downside, whereas analyzing developments since the initial investment is critical to making allocation changes and risk management decisions.
• Hold on to your position when the story does not change materially. Fold when the story unfolds with unexpected material developments. Revisit thesis when a material catalyst appears. Stay away from crowded shorts: hot stocks with high short interests.
• Do not underestimate the ability of a star CEO.
• Do not get in the way of an early-stage growth stock run by a star CEO when you cannot handicap growth.
• Management star power can move stocks when issues are endemic to the company and not the broader industry. Beware of hidden options that companies can exercise to unlock value.
11
The Mechanics of Short Selling
Knowledge is better than practice without discernment.
—GITA
THE MECHANICS OF SHORTING STOCKS and buying stocks are different. Shorting a stock is a combination of borrowing shares and selling them in the market. Borrowing stock introduces additional consideration to the trade, such as borrowing fees, the lender calling back their shares, dividend payouts, short squeeze, voting rights, and regulatory restrictions. Most importantly, borrowing stock adds the margin and callable features to the short trade—the most critical risks that make shorting different from simply selling a stock that you own.
In general, the holding period of a short sale trade is shorter than that of a long trade. Short sellers sell stocks that they do not own and the trade is subject to the stock lender’s call. Consequently, it is important to identify near-term catalysts or events that can negatively impact the stock.
Simply put, buying a stock is like running a marathon where the finish line is the most important milestone. In comparison, shorting a stock is like a hurdle race, where short-term hurdles (getting called on the stock, merger and acquisition rumors, short-sale restrictions, etc.) are as important as the finish line.
It is also possible to enter a long (buy) or short (sell) trade without buying or selling the actual stock. Derivatives such as options, futures, and swaps offer alternatives to trading stocks or cash equities. Derivatives are geared toward more sophisticated investors because gains and losses involved in trading derivatives can be much higher than in trading stocks. I will cover some basics of options in this chapter as well.
Takeaway
Shorting is risky because it involves borrowing. When you short a stock, the lender can force you to cover (or close) your position on short notice and force you to realize losses at an inopportune time.
Key Differences Between Shorting and Buying
Opening the Short Position
You can open a long position and buy as many shares as you want, depending on the stock’s liquidity (volume traded). In comparison, a normal short sale requires you to locate and preborrow the stock so it can be delivered to the buyer within the standard three-day settlement period and avoid a failure to deliver. In other words, you cannot short sell a stock unless someone has first promised to lend it to you.
Short selling has long been blamed for stock market abuses, especially during the Great Depression. In 1934, Congress directed the Securities and Exchange Commission (SEC) to purge the market of short selling abuses. The SEC adopted restrictions on short selling in a stock while the price was falling. That rule remained unchanged for more than sixty years until the adoption of Regulation SHO in 2004 to curb naked short selling.1 Naked short selling refers to selling the shares without borrowing them first or ascertaining that the stocks are available to borrow.
Regulation SHO requires broker-dealers to close out all failures to deliver in threshold securities that exist for thirteen consecutive settlement days. Threshold securities are equity securities that have an aggregate fail-to-deliver position for five consecutive settlement days, total 10,000 shares or more, and are equal to at least 0.5 percent of the issuer’s total shares outstanding. Exchanges update information on the threshold securities list on a daily basis and on short interest (number of short-sold shares outstanding) on a biweekly basis.
You may have identified your best short idea, but you will not be able to short the stock if it is not available to borrow due to high demand or short sale restrictions. In such a case, costs can be abnormally high for stocks that are available to borrow. Derivatives may be the only alternative left in such a case, and puts are the most common derivatives used for shorting.
While it may still be possible to place derivative trades (options, swaps, or futures) on the underlying stock, such trades can be crowded as well, making the derivatives expensive and lowering the expected returns on short investments. The price of derivatives, such as puts, depends not only on the underlying stock price but on many other moving parts (time of expiration, stock volatility, and interest rates, etc.) that can further lower returns.
BUYING PUTS IS LIKE BUYING INSURANCE
Buying a put option is similar to buying automobile insurance. The insured pays a premium for automobile collision and liability and gets the right to claim for damages in the event of an accident. Similarly, when you buy a put option on a stock, you pay a premium to protect (or hedge) your stock investment.
How Does a Put Option Work?
Suppose you have 100 shares of Company X that is trading at $120 per share and you fear that X shares may fall by $10 to
$20 in the next six months. You do not want to sell your X stock at $120 per share; however, you want to protect your losses. In other words, you want the (put) option to sell X at $120 per share over the next six months if X falls. You decide to buy such an option (traded on the options exchange as a put option) at the prevailing market price of $2 per share or $200 for one contract (one contract is usually based on 100 shares).
A few months later, your fears come true: X is trading at $105 and you lose $15 per share on the stock; however, your put option compensates for this loss by allowing you to sell X at $120 per share. Alternatively, you can decide to keep X and sell the put instead for a premium of $15 per share ($120 minus $105). Had X stock traded above $120 per share, you would have lost the $2 premium.
Do You Really Need to Own X’s Stocks to Buy a Put Option?
Not really. Unlike automobile insurance, which requires you to own the car before you can buy the insurance, a put option does not require you to own the stock. In that case, you would actually profit from the falling stock, akin to shorting the stock.
Put Option and Shorting: Risk Versus Reward
The idea behind shorting or buying put options is to profit from falling stocks; however, the rewards and risks involved are a little different. As discussed, when you buy a put option, your maximum loss is the premium paid. The returns on a put option can be multifold. For example, you made $13 per share on a $2 per share put option (a whopping 6.5× or 650 percent return).