(note: this post originally appeared last Thursday on my Yahoo! Finance contributor page.)
Last week, a longstanding short in my fund released one of the grimmest quarterly reports I’ve seen in three decades of managing money. The company’s most important sales metric dropped at a double-digit rate, meaning its near-term revenues are going to be abysmal (after all, today’s sales are tomorrow’s revenues). Its long-term outlook isn’t great either because its most profitable product is fast becoming obsolete. Meanwhile, sales rates for new, less profitable products are modest and the business is hobbled by more than $2 billion in debt, all of which is coming due in less than two years. On the plus side, the company still generates a fair amount of cash, almost $400 million last year. Too bad interest payments to service its monstrous debt load were almost as large.
Declining sales, a sunsetting business model and crushing debt. If that isn’t a recipe for bankruptcy, I don’t know what is. Oh yeah, did I mention that this same company has already filed for Chapter 11 protection twice in the last decade?
I’d love to tell you the name of this business. Hell, I just wrote a book called Dead Companies Walking and this is probably the best example of a company heading for oblivion in the market today. But naming it would almost certainly wind up costing me and my investors a ton of money.
People have a lot of misconceptions about short sellers. Take Bill Ackman’s epic grudge match with Herbalife. Investors either think he’s a hero for taking on a fraudulent enterprise or a villain trying to smear a legitimate business so that he can drag down its stock price (the Wall Street Journal just reported that prosecutors and the FBI have been investigating Ackman associates for potential stock manipulation). But, Herbalife and Ackman aside, the vast majority of companies that fail every year aren’t frauds and the vast majority of short sellers aren’t crusading heroes exposing pyramid schemes or heartless predators looking to tank the markets. The truth is, any short seller who targets healthy, profitable companies will not be in business for long. And, as I’ve learned all too painfully, going public with your positions can hurt your returns—and not just because it might bring the FBI to your door.
A year and a half ago, I wrote an article for Seeking Alpha on the biotech company Dendreon. Like the mystery company that reported earnings last week, Dendreon’s stock was around six bucks at the time. It was also clearly exhibiting the two most common symptoms of a dead company walking: declining revenues and large, looming debt. A massive bond issue was coming due and sales of its sole product, a novel treatment for prostate cancer, had cratered after two competitors began marketing cheaper alternatives.
Studying its numbers, I couldn’t see any chance for Dendreon to avoid the corporate grim reaper. And yet, as so often happens, many investors refused to face reality. They looked at the same reports I did and invented all sorts of reasons that Dendreon would eventually recover. This is very common. I’ve seen it time and time again. False optimism will keep a clearly doomed company’s stock price shockingly high right up until its management issues a liquidity warning. It’s happening again with my mystery company. Even after it released that toxic waste dump of an earnings report, its stock only dropped 7 percent on the day.
Hope can be very expensive.
So why won’t I name this company? Shortly before writing that article on Dendreon, I had initiated a 300,000 share short position with the full intention of riding its stock all the way to zero, as I’ve done with more than 200 other companies in my career. But after the article came out, Dendreon’s “negative rebate,” the amount my prime broker charges me to borrow the stock, went through the roof as a boatload of investors piled into the short. I’m not saying my article was the only reason this happened, but it sure didn’t help. I was forced to cover my position with the share price still north of $3. Six months later, Dendreon filed for bankruptcy and its stock was delisted. All told, opening my big mouth and writing that article cost my fund a million bucks. Ouch.
When it comes to short positions, candor can be very expensive, too.