clearing out the inbox (part one)

Once again, I’d like to thank everyone who has emailed, messaged, or tweeted at me since my book Dead Companies Walking came out. I’ve tried to reply directly to as many folks as possible but running my fund has taken up most of my time and attention, so I thought I would post my responses to a few interesting questions, comments, and criticisms I’ve received in recent weeks here. Unfortunately, I couldn’t fit everything into one post, so I had to break my responses up into two parts. I’ll post the second half on Wednesday.

First up, an email from a reader named Greg:

“I am a private investor who has been investing on the long side for most of my career. I’ve almost finished your excellent book, ‘Dead Companies Walking,’ and it has inspired me to start trading the short side as well. My immediate question is: Where do you find all the good ideas? It’s fairly easy to find long ideas in places like Value Investor’s Club (of which I am a member), or the published portfolio lists of hedge fund managers. But where do you get quality short ideas? Thanks for your help with this!”

The best resource to find potential shorts is the 52-week low list. It’s in Barron’s every Sunday. Every single stock that goes to zero spends months on that list. When a stock winds up there, it’s almost always a signal that something is severely wrong. You can also run very simple screens looking for companies that have excessive levels of debt relative to their total assets or excessive levels of interest payments relative to their net income.

These methods will easily produce 50-150 names that you can use as a first cut of companies to study further. Then you have to start doing the real work of sorting out the best opportunities. For instance, Apple just had a bad quarter, but Apple’s probably not going to be a profitable short in the long term, because it’s not going anywhere. It’s going to be around forever, or at least a long time. Twitter on the other hand? There is a good chance Twitter is simply not a viable business. Even before it put out last week’s terrible earnings report, analysts had been slashing revenue estimates. What happens if it has a down year in revenues? It could go to zero.

The key is to get your head around the logic of finding shorts among stocks that have already lost a considerable amount of value. If a stock is at $10 and it drops to $5, it’s probably a better short at $5 than it was at $10. That’s because people often don’t realize how hard it is for falling stocks to recover. When you short a stock that gets cut in half, you make 50 percent on your money, right? But for that very same stock to get back to where it started, it has to gain 100 percent.

Next up, Kevin Kaiser (@HedgeyeENERGY) tweeted at me:

“I enjoy your blogs, but why are you always citing “EBITDA/share”? That’s not a meaningful metric, esp for those levered cos.”

I believe Kevin was referring to two posts in particular where I cited EBITDA per share numbers, one on gaming companies Eldorado Resorts and Monarch Casino and one on undervalued Christian-focused companies, particularly Salem Media. He makes a good point. EBITDA (or Earnings Before Interest, Taxes, Depreciation, and Amortization) can definitely be a risky way to value a company, because it allows you to overlook its capital structure. I wrote about this exact issue in Dead Companies Walking. The example I used was the old Yellow Pages company Idearc, which went bankrupt and became Supermedia, which also went bankrupt and became Dex Media, which is about to file for bankruptcy. No matter how much cash they generate, highly leveraged companies like these will have a ton of interest expense, something that EBITDA numbers fail to capture.

However, one thing I didn’t go into when I cited EBITDA per share numbers for Eldorado, Monarch and Salem is the way private equity firms and other investors are increasingly relying on that metric for businesses in cash-rich industries. These days, private equity firms always buy companies at a multiple of EBITDA. That wasn’t true 15 years ago, but it is now, and that definitely went into my decision to purchase those stocks. Also, in the case of Salem Media, it’s going to be able to pay down its debt load considerably over the next few years.

And finally, for today, a reader named Aleks sent me this message on my Yahoo Finance contributor page:

“I’d be very interested to hear your thoughts on short selling stock vs. buying put options in general, as well as with these companies in distress that tend to have sky-high implied vol (making options expensive but also a short potentially risk). Would you typically hedge your short sales?”

I’ll start with the second question, because it is the easiest to answer. I don’t hedge my short sales.

I did trade options for a brief period when I was an undergraduate in college. I wrote about it in Dead Companies Walking. Let’s just say, it was an expensive but educational experience. I made a few bucks initially but I wound up going broke, so as a rule I have never utilized options as an investment strategy in my career as a money manager and it’s not something I would recommend.

The good thing about options is you don’t pay negative rebate fees and you don’t have to worry about whether or not you can get a borrow from your prime broker. The bad thing about options is that there is almost always a premium that dissipates as you get closer to the expiration date. Ninety percent of all options expire worthless, so if you’re buying a lot of puts or calls over a long period of time, it’s highly likely you’ll end up with no money.

Okay, that’s all the space I have for today. As I said, I’ll post more responses on Wednesday of this week, including my thoughts on a couple of tickers and my advice to a young finance student. Thanks again to everyone who contacted me. Please keep the emails and messages coming. I’ll do my best to answer them directly or in a future blog post. And if you haven’t had a chance to buy a copy of Dead Companies Walking yet, it’s still on sale. All of the profits I earn go to help disabled children.


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