2/7/2011

Short Selling

“Short Selling, Strategies, Risks, and

Rewards,” edited by Frank Fabozzi,
Wiley Finance 2004

Overview

• Market Sentiments on Short Selling: Fact or Fiction?

• Two examples:
– Short selling Enron
– Short selling subprime mortgages
• The Mechanics of Short Selling
• Short Sale Constraints and Overpricing
• Short Selling Strategies

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Market Sentiments on Short Selling

• Criticisms on Short Selling:

– Short selling is un-American and against God.
• Proverbs 24:17: “Do not rejoice when your enemy falls, and do not let your heart be
glad when he stumbles.”
– It is done by rogues, thieves, and especially pessimists, who are, of
course, the worst of the lot.
– We should halt it, restrict it, or at the very least revile those who make
it their vocation.
• These criticisms increase in volume during market crisis
– Short sellers are blamed to be the cause of the market‟s decline.
• Life is already tough for short sellers.
– Rules making short selling harder: “uptick rule”
– Outright ban on short selling in many markets

Wrong Views!

• Economic Argument:
– The ability to express a pessimistic view by selling short improves
market efficiency.
– Without short selling, prices are in a sense uncapped.
• The only way to express a negative view on overvaluation is to go on a buying strike.
– Overpriced stocks (including destructive bubbles) are best fought by
allowing all opinions to affect prices.
• Political Argument:
– Banning short selling is just not democracy!
– If beating up political dissenters is un-American, how can we justify
restricting “financial” dissenters in the stock market?

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What Do Short Sellers Do? – A Regression Analysis

• Regressing short selling index returns on Fama-French factors:

– CSFB Short Return = a + b1*[S&P500 Return] + b2*[Value-Growth] +
b3*[Small-Large]
– Data: CSFB/Tremont 1994-2003
– T-statistics:
• S&P500: -16.4
• HML: +3.1
• SMB: -7.4
• R-squared: 76.7%

• Next add an interaction term:

– (S&P500 return) * (S&P500 return over the prior year)
– T-statistic: -2.65

Interpretation

• Negative b1 on [S&P500 Return]:

– Short sellers as a group are indeed net short stocks.
• Negative interaction term:
– Short sellers get shorter after market rallies.
– More short when market goes up and less when it falls.
• Positive b2 on [Value-Growth]:
– Shorting more expensive growth stocks.
– NOT shorting distressed firms to drive them to doom!
• Negative b3 on [Small-Large]:
– Shorting smaller than average stocks.

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Homework (Individual)

• Download “HFRShortIndex.xls” from compass site.

– HFR Short Bias Index: 01/1990 to 06/2009
• Download Fama-French three factors (monthly) from Ken
French‟s website:
– http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.ht
ml
• Replicate the previous regression analysis
• A plus if you can also include the interaction term in the
regression.

Hurdles Faced by Short Sellers

• Swimming against the tide:

– Long-run equity premium is positive.
– Specific stocks short sold tend to be the ones heavily favored by
prevailing wisdom.
• Greater risks involved:
– “Don‟t short because you can lose an infinite amount of money.”
• More difficult to convince investors to stick with you:
– Stocks may move more overvalued after shorting them.
• Lose even more in an irrational bubble.
– If investors “rationalize” the overvaluation by a “new world” argument:
• “You stink, let us out of our lockup please.”

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Why Do They Still Do It?

• Greed – of course!
• Like many who excel in any field, short sellers do it partly
because they have no choice but to fight based on their belief,
especially when they see:
– The public fooled into buying over-valued nonsense;
– Fraud perpetrated without retribution; and
– Huckster lauded by a stock market dying to anoint the next emperor
without clothes.
• Ultimately, the shorts are in it to make money.
– If they can help right a wrong while acting on their own interest, why
not? – Kind of how capitalism is supposed to work no?

A Short-Seller‟s Tale:
James Chanos and Enron

• The following trading case illustrates how James Chanos, a

shot seller at Kynikos Associates, developed his negative
investment view of the Enron Corporation based on
accounting information.

• James Chanos has an impressive short selling record:

– Enron
– Tyco International
– Boston Market restaurant chain
– Homebuilders
– Some of the world‟s biggest banks

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Short Selling Enron

 In October 2000, a friend of James asked him if he had seen an

interesting article in The Texas Wall Street Journal, about the
accounting practices at large energy trading firms.
 “Gain-on-sale” accounting allows a company to estimate the future
profitability of a trade made today and book a profit today based on the
present value of the estimated future profits.

 Such accounting practice makes it easier for management to inflate

earnings by making favorable assumptions.

 If these rosy assumptions fail to realize in the future, then management

would simply do new and bigger deals to offset those downward
revisions.

Short Selling Enron (cont.)

 James then analyzed Enron‟s 1999 Form 10-K filing.

 Despite using the gain-on-sale model, Enron‟s return on capital was a
mere 7% before taxes.
 James believed that Enron‟s cost of capital was likely in excess of 7%
and probably close to 9%.
 This meant that, from an economic point of view, Enron was not really
earning any money despite reporting “profits” to its shareholders.

 The mismatch between cost of capital and return on

investment became the cornerstone for Jame‟s bearish view on
Enron.
 James began shorting Enron stock in November 2000.

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Short Selling Enron (cont.)

• James was also troubled by Enron‟s cryptic disclosure

regarding various related-party transactions.
– Enron organized the related-party entities for the apparent purpose of
trading with their parent company.
– They were run by an Enron executive.
– Despite reading the footnotes in Enron‟s financial statements about
these transactions over and over again, James could not decipher
exactly what impact they had on Enron‟s overall financial condition.

• Another disturbing factor was the large amount of insider

selling of Enron stock by senior executives.

Short Selling Enron (cont.)

 James was also puzzled by Enron‟s boasts in late 2000

regarding the company‟s initiative in the telecommunications
field.
 Enron bragged that the PV of Enron‟s opportunity in that market could
be $20 - $30 per share.
 Jame‟s own analysis suggested that the industry had exhibited a
warning sign of excess capacity by late 2000.

 Beginning in January 2001, James spoke with a number of

analysts to discuss Enron and its valuation.
 Conclusion: There is no way to analyze Enron.

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Short Selling Enron (cont.)

 In the spring of 2001, James heard reports that a number of

senior executives were departing from the company. Further,
insider selling of Enron stock continued unabated.

 James‟ analysis of Enron‟s 2000 Form 10-K continued to show

low returns on capital as well as a number of one-time gains
that boosted Enron‟s earnings.

 In the summer of 2001, energy and power prices began to

drop. Rumors surfaced that Enron has been caught „long‟ in
the power market.

Short Selling Enron (cont.)

 Also in the summer of 2001, stories began circulating about

Enron‟s affiliated partnerships and how Enron‟s stock price
itself was important to Enron‟s financial well-being.

 In August 2001, Jeff Skilling abruptly resigned as Enron‟s

CEO for „personal reasons‟. To James, there is no louder alarm
bell in a controversial company than the unexplained, sudden
departure of a CEO.

 James increased the short positions in Enron shares following

Jeff Skilling‟s resignation.

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Short Selling Enron (cont.)

Chano‟s Next Target

Biggest conglomerate of all: China Inc.

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China: Miracle or Bubble?

• Chano‟s bearish view:

– Excess credit from the stimulus program is leading to artificial growth.
• Bank lending doubled in 2009 from 2008
• Raising the risk of a wave of nonperforming loans
– Significant amount of stimulus money, along with huge foreign inflows
of “speculative capital”, has been funneled into the stock and real estate
markets.
• China‟s surging real estate sector == “Dubai time 1,000 – or worse”

• Some other contrarians share similar views.

– Mark Hart launched Corriente China Opportunity fund in Dec 2009.
• Betting on the fall of Renminbi by purchasing put options on the currency
– Corriente is known largely for the more than 500% gain it earned by
shorting subprime mortgages.

Another Shorting Seller‟s Tale:

Steve Eisman and Subprime Mortgages

• How many smart guys directly bet against the multi-trillion-

dollar subprime mortgage market?
– Very few: between 10 to 20

• Some of these guys‟ stories, like Steve Eisman (FrontPoint

LLC), were chronicled in a best-selling book:
– “The Big Short: Inside the Doomsday Machine”, by Michael Lewis

• Here is a condensed version …

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Who is Steve Eisman?

• Education:
– B.A. from University of Pennsylvania
– J.D. from Harvard Law School: with honors
• How did Steve get his first finance job?
– “I hated being a lawyer. My parents worked as brokers at Oppenheimer
securities. They managed to finagle me a job. It’s not pretty but that’s
what happened.”
– Beloved and respected by colleagues and clients, Steve‟s parents could
hire whoever they want.
• Before Steve, they also hired his old nanny on the Oppenheimer trading floor.
– In 1991, Steve started his career as an equity analyst.

Steve‟s Personality

• Friends: smart, honest, fearless to break with consensus

• Others: rude, obnoxious, and aggressive
• Steve‟s wife:
– “He’s not tactically rude. He’s sincerely rude. … Steve lives inside his
head.”
• Steve‟s mother-in-law: after their first meeting
– “Well, we can’t use him but we can definitely auction him off at UJA
(United Jewish Appeal).”
• Steve‟s mother:
– “Steven actually has two personalities …”

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Early and Mid 1990s: Proponent of Subprime Bonds

• Originated by Salomon Brothers, subprime mortgage bonds

were designed to lower the borrowing costs for less
creditworthy homeowners.
– Allowing existing homeowners to cash out the accumulated home
equity and replace higher rate credit card debt with lower rate mortgage
debt.
• Steve was one of the leading proponents.
– Oppenheimer was one of the leading bankers to the new industry.
– By mid 1990s, dozens of subprime lending companies were IPOed
each year.
– Still, subprime lending is just a trivial fraction of the US credit markets.

September 1997: Damned the Entire Industry

• After sifting every pool of subprime loans for 6 months:

– High delinquency rate:
• A fraction of subprime loans kept on balance sheet
– Reported ever-growing earnings driven by illusionary accounting:
• Profits booked at the time of loan origination (assuming no prepayment and no
default)
– Ponzi Scheme:
• Raise more capital → Create more subprime loans → Book more profits

• Steve‟s report trashed all of the subprime originnators

– “He created a shitstorm.”
• Less than one year later:
– Russia defaulted → LTCM failed → Flight to safety → Capital supply
choked for subprime lenders → All Died 

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2002-2005: Set Up Own Shop

• 2002: Joined a big HF called Chilton Investment.

– Discovered the fraud of Household Finance Corporation
– Pushed for legal action → Failed → Appalled and concluded that
• “the system was really, ‘Fuck the poor.‟”

• 2004: Quit Chilton and opened his own HF FrontPoint

• 2005: The subprime machine was up and running full speed.
– $507B out of $625B subprime loans were packaged into mortgage bonds.
– Loan terms were deteriorating: 75% were floating-rate loans
– Did the market learn anything from 1990s?
• “You can keep on making these loans, just don’t keep them on your books.”
– Steve saw the fortune of shorting – question is
• When and How?

2006: Shorting Game Started

• Greg Lippmann – a bond trader at Deutsche Bank – provided

Steve Eisman the quantitative support and the financial
instrument to carry out the short.
• Lippmann‟s one-man quant support team: Eugene Xu
– “A real Chinese guy – not even Chinese American – who apparently
spoke no English, just numbers.”
– “China had this national math competition, .., in which Eugene had
finished second. In all of China.”
– Responsible for all the quant analysis in Lippmann‟s presentation
• No one bothered to question Lippmann‟s math or data.
– “How can a guy who can’t speak English lie?”

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Analysis by the 2nd Smartest Man in China

• Housing prices and subprime default risk:

– “They (housing markets) didn’t need to collapse; they merely needed to
stop rising so fast.”
– In 2005 when the house prices were still rising, default rates were close
to 4%.
– If default rate >= 7%, then BBB- tranche will be wiped out.
– If default rate >= 8%, then BBB tranche will be wiped out.
– …
• Trigger events: Summer 2006
– S&P‟s announcement of rating model change
– Housing prices began to fall across the country

How to Short?

• Before 2006, Steve was already betting against the shares of

subprime loan originators and home builders financed by
subprime loans.
– New Century, IndyMac Bank, Toll Brothers, etc.
• Not perfect and expensive:
– High dividends: 20% dividend yield for New Century
– Borrowing cost: 12% per year
– Total cost for shorting $100m shares: $32m
• A “perfect” instrument:
– “Credit Default Swap”

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Credit Default Swap: Advantages

• CDS is actually not a swap but an insurance policy:

– 6-year CDS on $100m subprime bonds
• Cost: $200K annual fixed premium payment
• Payoff: $100m if loss on the loans rose from 4% to 8% in the next 6 years

• The “beauty” of CDS:

– Solved the timing problem:
• Steve no longer needed to guess exactly when the subprime market would crash.
– No need to lay down cash up front:
• Limited and fixed downside: 2% per year for at most 6 years
• Upside: multiples of premium paid
– Easy to buy:
• Goldman and later Deutsche Bank were selling CDS in $100m chunk cheap!

Goldman or Middleman:
Who was on the Other Side of the Bet?

• Goldman? – of course NOT!

– “Goldman would never be so stupid as to make huge naked bets that
millions of insolvent Americans would repay their home loans.”
– Goldman simply created the multi-billion $ deals and passed the risk to
a third party.
• Who was assuming the subprime risk? – AIG
– Since 1987, AIG has provided insurance against corporate credit risk.
• CDS on corporate bond
– In early 2000s, expanded into insurance again consumer credit risk.
• CDS on credit card debt, student loans, auto loans, prime mortgages, …
– After 2004, nothing but subprime mortgage loans.
• $50 billion BBB subprime mortgage bonds in a matter of months.
• Goldman‟s profit margin: 2% - 0.12%

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Magic Goldman:
Convert Lead into Gold

• A mortgage bond:
– Pooling together thousands of mortgage loans and cutting into tranches.
• A collateralized debt obligation (CDO):
– Pooling together hundreds of mortgage bonds (usually the riskiest
tranches) and slicing them again.
– 80% of them were pronounced AAA by Moody‟s.
• A synthetic CDO:
– Pooling together hundreds of CDSs on BBB-rated mortgage bonds
– The cash flows of CDS replicated those of BBB-rated mortgage bonds.
– 80% of synthetic CDOs were pronounced AAA by Moody‟s.
• The CDO synthetics created a snowball of subprime risk
whose size was far larger than the actual subprime lending.

What to Short? (Act I)

• Steve‟s team went out to hunt for the juiciest shorts – “bonds
ultimately backed by the mortgages most likely to default.”
– Sifting through piles of loans
• Common characteristics:
– Loans originated in places where housing prices rose the fastest:
• Sand states: California, Florida, Nevada, and Arizona
– Loans originated by the more dubious mortgage lenders:
• Long Beach Savings: the 1st to embrace the “originate and sell” model
– Mortgage pools with higher than average low-doc or no-doc loans
• “In Bakersfield, California, a Mexican strawberry picker with an income of $14,000
and no English was lent every penny he needed to buy a house for $724,000.”
• Steve‟s babysitter – a lovely woman from Jamaica – owned 5 townhouses in
Queens.

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What to Short? (Act II)

• In 2007, Steve started to short CDOs and synthetic CDOs.

– “the engine of doom”
• Who supplied demand for CDOs collateralized by BBB-rated
tranches or CDSs?
– Investment firms like Harding Advisory managed by Wing Chau.
• How did Wing Chau “manage: CDOs?
– Bought the CDOs or synthetic CDOs created by big Wall Street firms.
• A new kind of “front man” hired by Wall Street firms: NO questions asked!
– Sold the CDOs to large institutional investors
• German banks, Taiwanese insurance companies, Japanese farmers‟ unions, etc.
– Compensation: 0.01% up front fee ($26m in one year)
• Steve purchased specific CDSs on Wing Chau‟s CDOs.

Steve‟s Next Target?

• Higher-education stocks!!
– http://www.businessweek.com/news/2010-05-27/eisman-of-big-short-
says-sell-education-stocks-update2-.html

• “Until recently, I thought that there would never again be an

opportunity to be involved with an industry as socially
destructive and morally bankrupt as the subprime mortgage
industry. I was wrong. The for-profit education industry has
proven equal to the task.” – Steve Eisman

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Mechanics of the Equity Lending Market

The Lending Process

Owner

Shares Fees
150% Collateral

Securities Lender Shares Borrower

(Short Seller)
Rebate

Cash Return

Cash Investment

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The Lending Process

• A short seller must first locate a lender and then sell the shares
short.
– Short sale proceeds are deposited with the lender as collateral.
• For U.S. stocks, 100% of the loan value.
• Marked to market on a daily basis.
– Margin requirement:
• Regulation T: 50% initial margin requirement
• Maintenance Margin: 30% on NYSE and NASDAQ

• While a stock is on loan, the lender invests the collateral and

receives interest on this investment.
– Return part of the interest to short seller – Rebate (negotiable)
– Cost of borrow: market interest rate – rebate rate

Marking to Market: An Example

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Lenders

• Custodian Banks: largest equity lenders

– Clearing and holding positions for large institutional investors.
– Acting as lending agents with the beneficial owners‟ permission.
– Prearranged fee sharing agreement:
• 75% of lending revenue going to beneficial owners
• 25% going to custodian banks
– Sometimes lending revenue to beneficial owners may completely offset
custodial and clearance fees for institutional investors.
• Specialty third-party agent lenders:
– Agent firms representing the beneficial owner
– Offering more specialized reporting, flexibility, and more lending
revenue.

Lenders (cont.)

• Direct lending by beneficial owners

– Via an exclusive lending arrangement
• the owner commits his assets to one particular borrower for a specific period of
time.
• CalPERS: an auction system with the winning bidder gaining access to it portfolio
for a predetermined period of time
– Managing own internal lending department
• Benefit: total control of the lending process
• Cost: large fixed costs in setting up the infrastructure

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Lender‟s Rights

• Receiving any dividends or distributions by the issuing firm.

– Substitute payment: paid by the borrower.

• Participating in any corporate actions.

– The lender wishes to participate in a tender offer.
– But the borrower is unable to return the shares in time.
– Then the borrower is required to pay the lender the tender price.

• Giving up the right to vote.

– However, the lender can recall the security from the borrower for any
reason, including exercising voting rights.

Lender‟s Risks

• Investment risk: Risk of investing the collateral

– Low risk investment: overnight repo
– High risk investment: long-term; lower credit quality
• Citibank, acting as an agent lender, recently lost about $80 million
in collateral on an investment in asset-backed security.
• Counterparty risk: failure of borrower to provide additional collateral or
failure to return the security
– Lending only to the most creditworthy borrowers
– Imposing credit limits
– Daily marking to market
• Operational risk: failure to collect dividends, notify corporate actions, etc.
– Maintaining a good lending system which tracks dividends, corporate
actions, and the collateralization of loans.

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Borrowers

• Prime brokerage firms: largest stock borrowers

– Borrowing for their proprietary trading desk, for their hedge fund
clients, and for other leveraged investors.
• Borrower‟s Risks:
– Recall risk:
• Stocks being recalled by the lender before the short position is closed out.
– Happens in 2% of the loans
• Failure to return the shares will result in a buy-in:
– the lender can use borrower‟s collateral to buy shares to cover the loan.
– Rebate risk:
• The risk of a decrease in rebate rates

Determinants of Rebate Rates

• Determined by the supply and demand in the stock lending

market.
– Highly liquid stocks: 5 to 25 bps below the Fed funds rate each day
• General Collateral Rate
– Less liquid stocks: 35 bps below
• “Specials”: large borrowing demand
– Lower rebate rate negotiated on a case by case basis
– Roughly 7% of securities on special
– In rare cases, the rebate rate can be significantly negative.
• Shares of Stratos Lightwave Inc in Aug 2000: just after IPO
– 4,000 bps below general collateral rate
• Lenders keeping all the investment return on the collateral and earning a premium
for lending the shares.

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Short Sale Constraints and Overpricing

Short Sale Constraints

• Mechanical Impediments to Shorting

– There is not a centralized security lending market
• Searching for a lender and negotiating rebate rate could be costly and time-
consuming.
– The security lending market could be dysfunctional at times.
• Unable to short even for institutional investors no matter how much they
are willing to pay
• Bureaucratic market: favored customers stand a better chance of “getting
the borrow”
– Reports of short sellers exchanging drugs and sex in order to get the borrow –
not recommending this!
– Recall risk after getting the borrow

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Short Sale Constraints (cont.)

• Government Intervention
– The NYSE imposed special short selling regulations during WWI .
– Crackdown on short selling after 1929
• Uptick rule
• Investment Company Act of 1940: restricting mutual funds to short
– SEC investigated terrorist shorting following 9/11.
– Governments limit short selling following the burst of tech bubble.
– The SEC banned short selling of financial stocks from Sep 18 to Oct 8,
2008.

Short Sale Constraint (cont.)

• Hostility from the target firms:

– Managers don‟t like people who short sell their stock
• Especially when short sellers accuse the firms of frauds.
• They fight back!
– In extreme cases, violence and intimidation can occur.
• Shorting selling involving Tel-com Wireless Cable TV
– Official spokesperson: Ivana Trump
• “Several terrified investors told Barron‟s and the police that their families had been
threatened by convicted criminals who accused the investors of selling short.”
– Barron‟s, 12/14/1998
• On 11/01/1999, Barron‟s reported that one of the threatened individuals had been
found murdered, execution-style, in Colts Neck, New Jersey.

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Go Down Fighting: An Example

• Solv-Ex vs. Short Sellers

– Solv-Ex claimed to have a technology for economically extracting
crude oil from tar-laden sand.
– Short sellers said it was a fraud.
• Solv-Ex‟s anti-shorting strategies:
– Attempted to orchestrate a “short squeeze” by requesting shareholders
to withdraw shares from the lending market.
– Hired private investigators to find out who was spreading “rumors”
about the firm
– Filed a law suit against a well-known short seller
• Who was lying?
– Solv-EX filed for bankruptcy in 1997
– Court ruled that the firm indeed defrauded investors in 2000.

Overpricing

• Short sale constraints can prevent negative information from

being incorporated into the stock prices.
– A necessary but not sufficient condition for overpricing
• Substantial overpricing requires two things:
– Failure of rational investors to short overpriced stocks;
– Willingness of investors to buy overpriced stocks.
• The willingness to hold overpriced stocks can reflect:
– Irrational optimism by some investors: overconfidence
– Or rational speculative behavior reflecting differences of opinion.

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Short Selling Strategies

“Spotting Clues in Qs”

By
Ron Gutfleish and Lee Atzil
Elm Ridge Capital

Roadmap for Short Sellers

• What kinds of targets to pursue?

• How to screen for potential candidates?
• How to vet them?
• How to live with them?

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Short Targets: Who Plays Accounting Tricks?

• Earnings Manipulations: “Earnings before Bad Stuff”

– “Sell” product to customers who cannot afford it.
• Consider the profits as “recurring” and then
• Writing off the receivables later as a “nonrecurring” charge.
– Run factories at full capacity when there are orders for half that level.
• Book lower unit costs and inflate gross margins and then
• Write off the inventory later as a “nonrecurring” charge.
– Close down the ventures that do not perform well.
• Exclude those results from the EBBS headline.

• EBBS accounting has a very real cost.

– From 2000 to 2002, write-offs of “nonrecurring” charges totaled $50
per S&P share – more than the entire amount reported during the
previous 30 years.

Short Targets (cont.)

• Hiding Debt
– Third-party financing backed by the company‟s own guarantees.
• The related debt stays off the book.
• Revenues and profits booked as “recurring” income while any
credit losses classified as “nonrecurring”.

– Joint-venture (JV) financing arm

• Guarantee prices and commit capital until the financier makes
adequate profits.
• Debt and receivables stay off the balance sheet.

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Short Targets (cont.)

• Buying Profits
– Many accounting tricks to create “profits” through serial acquisition.
• Moving ongoing expenses into acquisition costs, and thus
• Minimizing their impact on the income statement.
– Slice the reported compensation of its target‟s management by boosting
the purchase price.
– Keep R&D off the book by waiting to buy a target until its product is
commercially feasible.
• Write off the entire purchase price as “in process R&D”, and then
• Include the acquired sales into EBBS without the associated R&D costs.
– Write down purchased inventory and equipment
– Reduce depreciation

Short Targets (cont.)

• Running Business to “Make the Number”

– Ship boatloads of product at the end of quarter to distributors.
• Providing price protection, lenient payment terms, and return provisions.
• Taking a “nonrecurring” charge if product does not sell.
– Use rebate vouchers.
• Booking the entire purchase price upfront, and later
• Recording the cost of vouchers as they come in.
– Accelerate short-term cash inflows while sacrificing future revenue.
• Getting customers to make large cash software license payment by giving them very
long-term deals that allow for lots of future users.

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Screening Quarterly Financials

• Rank companies according to the growing difference between

net income (earnings) and cash flow from operations (CFFO).
– Cash flows more difficult to manipulate
• Search for situations where accounts receivable is growing
faster than revenue.
– Also known as increases in days sales outstanding (DSO).
• Scan for inventories rising at a greater rate than sales.
– Growing in days sales of inventory (DSI).
• Look for increases in other current assets relative to revenue.
– Capitalize or defer booking costs even though continuing to pay out
cash.

Screening (cont.)

• Screen for declines in depreciation relative to gross property

plant and equipment (PP&E).
• Screen for declines in various allowances for
– Doubtful accounts relative to gross accounts receivable;
– Sales return relative to revenue;
– Inventory obsolescence reserve relative to inventory.
• Search for key words such as
– reversals, off-balance sheet, special purpose entity, related party, etc.
• Look for declining short interests over the past three months.
– Long holders and management can trigger “short squeeze”.

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Screening (cont.)

• Look for significant recurring charges.

• Look for unexplained changes in goodwill.
– Changes to the acquired company‟s assets and liabilities usually offset
by increased goodwill.
• Look for large un-expensed options.
• Watch out for significant insider sales.

Diagnosis

• Are the red flags raised by the screening real financial

symptoms of distress?
• Can we identify potential reasons to justify them?
• Will investors eventually care about the deterioration we
discovered?
• How our forecasts differ from those banking on a better
outcome?
• Can we determine reasonable upside/downside scenarios
(sensitivity analysis)?

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Putting Up the Short Positions

• Size short positions with the recognition that the market will
continue to find reasons supporting the bulls.
– At least in the short run.
• Always stand ready to adapt to newly arrived information.
– Unwind positions if fundamental has changed;
– Increase position size if the stock is overreacting to news/rumors.
• Make sure that positions do not provoke extreme irrationality
and panic.
– Truth will reveal eventually, but
– We want to be around to watch it unfold.

Putting Up the Short Positions (cont.)

• A diversified short portfolio:

– Up to 120 positions sized according to the risk
– A more volatile technology short will be smaller than an established
player in consumer staples.
• Leave room to increase position sizes
– The short positions could be more overvalued next quarter.
– Take the punch now, increase the position sizes, and will be rewarded
more in the end.
• Keep in mind that we may make mistakes and/or be unlucky.
– Bite the bullet, learn the lesson, and move on.

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A Real Trading Example:

Information Technology (IT) Outsourcer

• Red Flags:
– Strong net income and EPS growth but declining cash flows.
– Accounting method: percentage-of-completion (POC)
• IT signed multiyear outsourcing contracts with customers and recognized
revenue under the POC method.
• Recognized revenue during the quarter
– Total revenue for the contract‟s duration multiplied by
– The ratio of costs incurred during the quarter to total estimated costs
for the entire contract life.
• IT can overestimate contract profitability by underestimating total costs.
– Report higher profit in early parts of the contract, and then
– Announce massive losses near completion.

A Real Trading Example (cont.)

• Red Flags:
– For the most recent quarter, EPS ↑ 14% while CFFO ↓ 6%
– Why did CFFO fall?
• DSOs had risen steadily in the precious 3 quarters.
• Depreciation and amortization (D&A) fell to 4.6% for the quarter:
– Compared to 6.2% for previous quarter and 6.7% a year earlier.
– Keeping D&A at 6.2% would knock of $0.09 off the reported EPS of
$0.69.
– Drop in SG&A expenses accompanied by large increase in intangible
assets – possible cost capitalization in recent acquisitions.
– New contract signings declined by 35% over the previous year.
– Four acquisitions not related to core business: $2 billion shopping spree
– Departure of key executives and increasing insider selling

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A Real Trading Example (cont.)

• Diagnosis: why the cheerleaders may be wrong?

– IT was operating in an highly competitive industry while lacking a
clear competitive advantage.
• Signing contracts with poor underlying economics.
• Enticing customers by agreeing to accept fixed payments lower than running IT in-
house.
– The IT industry was slowing down.
• The company seemed bent on aggressive pricing to lure customers and keeping EPS
growth by aggressive POC accounting.
– “stress testing” the red flags with a cheerleading sell-side analyst:
• The analyst could not explain why so many warning signs at the same time.
• The probability that all were unrelated seemed low.

A Real Trading Example (cont.)

• Putting Up the Short Position:

– Three quarters later, the shares came under pressure.
• Several press articles questioned IT Outsourcer‟s accounting practice.
• A series of announcements regarding problem contracts and delays.
• Negotiation terminated with several potential customers.

– Two more quarters later, IT Outsourcer announced that EPS was just
one fifth of original guidance.

– The stock lost over 50% after the EPS miss, and over 70% compared to
when the short position was put up.

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Group Assignment

• Read HBS Case #9-207-071: Selling Biovail Short

• Prepare a 10-15 minutes presentation:
– Background information about the firm
– What were the red flags identified by SAC, Gradient, and David Maris?
• Back up the red flags using appropriate accounting evidence
• You can use accounting statements provided in the case and/or expand the evidence
by searching the EDGAR.
– What is your diagnosis? Who is the guilty party?
• An interesting New York Times article covering the details of
the above case can be found at:
– http://www.nytimes.com/2006/03/26/business/yourmoney/26gradient.html

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