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Danger Signs Danger signs In a great book “Short Selling”, by Tom Taulli, there are some signs on what to look for in shorting a stock. “Imagine that over the past few months, you have been tracking Plunge Corp. The stock has seen a tremendous run-up in the past few years, becoming a Wall Street darling. But, there has been some recent bad news. Last quarter, the company reported a loss that was unexpected. You also notice that the company’s management has been selling many shares of their personal holdings. The company has been in a fast -growth industry. But is it the end of the fad? Short sellers try to look at all types of information when making their decisions. It is not surprising that short sellers are often called information junkies. The process can range from studying overall industry trends to even having a discussion with a customer of a company. For a short seller, there are two types of information. First, there is information that shows that a business is having problems-these are known as “danger signs.” While this sounds very simple, short sellers try to delve very deeply into a company’s internal workings. They constantly question the business model, the industry, the management, and so on. Short sellers want to find the weak links. However, these weak links may not necessarily be apparent to institutions, analysts, or individual investors. Perhaps the danger signs are too opaque. In some cases, it seems investors do not want to see bad news. They have an inherent interest for the stock to go up. So they often will try to rationalize the danger signs. It is no surprise that a seemingly weak company can continue to see its stock price rise more and more. Short selling requires very good timing. The question for short sellers is, when will the stock fall? It is not uncommon for it to take several years-despite many danger signs-for a company’s stock to fall. Or in some cases, a company may even be bought out, preventing you from profiting from the short sale. If the danger signs continue to pile up, a short seller may decide to take a risk and start shorting a stock. However, it is likely that the short seller will not take a big position at first. Short sellers will look at another type of information: “trigger events.” A trigger event is some type of bad news that makes investors skittish. They begin to wonder: Is the stock headed for a fall? Are there more problems in the offing? In many cases, the trigger event is the first time the stock price has fallen based on bad news. Chances are good that the initial bad news will not be the end of the bad news. Short sellers call this the www.capitalideasonline.com Page - 1 Danger signs “cockroach theory.” If you see one cockroach, there are likely to be many more. We will first look at common danger signs. These danger signs will alert you to a potentially good short sale candidate. Next, we will look at trigger events. This provides some validation that the danger signs are, in fact, real. Now, just like anything in investing, there is not always a clear-cut difference between a danger sign and a trigger event. Actually, as you spend more time analyzing potential short sale candidates, you will start to develop your own system. Keep in mind that danger signs are often found in a company’s financial statements. Danger Sign 1: Fads Fads in the financial markets recur and typically last a few years. Inevitably, people lose interest in the fad. When this happens, the fad can quickly turn into a bust. For a short seller, this is very good news. However, sometimes the mania is not a fad, but a true long-term trend. When McDonald grew in popularity in the 1960s, many investors thought it was a mere fad. Of course, the company continued to climb as it established itself as the leader in the emerging industry of fast food. The challenge is in separating hype and fads from reality. There are certain industries that are prone to fads. Here’s a look: Restaurants. The restaurant industry is extremely competitive. People’s tastes can change quickly and a once- hot restaurant can become a dud almost overnight. Restaurants will often be based on a theme that hopefully will resonate with customers. A classic example of a theme restaurant is Planet Hollywood. No question, the restaurant had tremendous glitz. Owners included such high-profile stars as Demi Moore, Bruce Willis, and Arnold Schwarzenegger. The Planet Hollywood IPO was strong. In 1996, the stock went from $18 to $28. However, the food was not great and people soon grew tired of the theme. The company eventually went bust, filing for bankruptcy in 1999. Another fad was bagel mania. During the mid-1990s, Americans could not get enough of this snack food. In www.capitalideasonline.com Page - 2 Danger signs 1996, Einstein’s Bagels went from $17 to $36. But the bagel mania fizzled and so did the stock. The stock was selling for 5 cents per share in 2001. Toys. Kids drive fads. Fads can be intense and then evaporate at lightning speed. In fact, it is rare for a toy not to be a fad. There are, after all, few Barbies in the toy world. A classic fad was the Cabbage Patch doll from Coleco. It seemed that every kid in America wanted at least one. The company had difficulties manufacturing enough to satisfy the demand, which only served to turn up the heat on the frenzy. But when kids moved on to newer toys, the fad disappeared, and Coleco quickly went into bankruptcy in 1988. Let’s also consider Happiness Express. More than 80 percent of its revenues came from the red-hot Mighty Morphin Power Rangers, based on the popular children’s cartoon. Even though the company saw a surge in demand, it was still losing about $1 million per month. The fad fizzled and so did the company, which filed for bankruptcy in 1996. Technology. Remember the Betamax? It was cutting-edge technology, but was overtaken by VHS technology. Technology companies are subject to short swings in product cycles. After launching a hit product, it is very difficult to come up with an encore. For example, in the early 1980s, Lotus grew fast because of its innovative spreadsheet software called 123. But it could not follow this up with another blockbuster product, and the stock price languished. Eventually, the company sold out to IBM in 1995 because the competition was too intense. The Internet has proved to be very fruitful for fads. In the mid1990s, the conventional wisdom was that we would all shop online. But even this was not an entirely new idea. During the mid-1980s, the conventional wisdom was that everyone would shop from their TVs. As a result, Home Shopping Network soared in value. From 1986 to 1987, the stock zoomed more than 1500 percent. But by late October 1987 the company had troubles and the fad was wearing off. The stock fell to $5 as the number of people shopping via television dropped. A symbol of the dot-com e-tailing frenzy was eToys (Fgure 1) www.capitalideasonline.com Page - 3 Danger signs Figure 1- The eToys.com Fad Fizzled In 1999, eToys stock went from $20 to $86. It even had a bigger market value than stalwart toy seller Toys “R” Us. But eToys could not sustain this sky-high valuation for long. Every quarter, the company’s losses mounted. Simply put, the company was selling its goods below cost; it would never make money. By March 2001, the company had lost all its value (see Figure 1). What are the danger signs that indicate a fad is losing momentum? While there is no exact science to it, there are some signs to look for: Ø The company is dropping its prices. This indicates that demand is falling off. Increased inventory and receivables also indicate falling demand. Ø Competition is entering the industry. This is what happened to Snapple. Although the all-natural ingredients approach was fresh at the time, it did not take long until the major soft drink companies entered the marketplace, increasing competition and reducing Snapple’s market share. www.capitalideasonline.com Page - 4 Danger signs Ø Earnings start to drop. Danger Sign 2: No More Big Growth One common strategy for growth is acquisitions. This is especially the case for a maturing industry. In this situation, a company is motivated to buy other companies to try to continue its growth rate. This mergers and acquisitions strategy can work for several years. But eventually the successful acquirer will start to see its growth slow, as it becomes the leader in the industry. Let’s consider this example: Dominance Corp. is in the drug store industry. This is a mature industry and it is growing-but slowly. Currently, Dominance has 10 percent of the market with $1 billion in sales and $100 million in profits. In the next five years, Dominance buys five competitors and expands its sales to $7 billion and profits to $600 million. Now, the company has 70 percent of the market. While the company is currently very profitable and has a dominant market position, where will new growth come from? True, Dominance could try to buy the rest of the industry, but, of course, this could be difficult because of antitrust concerns.
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