Klarman’s thoughts are detailed in the latest book that I have read , The Art of Short Selling by Kathryn F. Staley. I have never shorted in my life, and would never have considered reading this book had it not been for my friend who strongly suggested it. My friend graduated from Columbia’s value investing program, and is now an analyst at a value hedge fund with a spectacular long term record. He strongly convinced me to read the book even though I do not short sell. I am glad I listened to my friend!
Growing up through the tech bubble, I could not understand how anyone could short. There were stocks that were trading at absurd valuations that went up a further 500% in several years, if not several months. How can one short a stock based on valuation after the experience of the late 90s?
I approached the book with great skepticism, but an open mind. I read the book as a guide for a long only investor in finding “financial shenanigans”. The book proved quite valuable even if I never short a stock for the rest of my life. The author specifically warns about shorting based on valuation, which was one of my earlier fears.
The task of a short seller is not an easy one. Staley suggests reading the past six 10-qs, the past two 10-ks, and the past several proxies as a starting point. This is all before doing more extensive research on the company and industry! The author also suggests checking company stores, reading competitors’ financial statements and reading industry reports. The task of a short seller is definitely not for the lazy person.
The author does a great job of explaining various short situations which include; companies that require endless amounts of new capital to stay afloat, “theme stocks”, stocks that have no earnings that are set for failure, companies that make their financial statements confusing to try and make earnings look good, and even cases of outright fraud.
Most of the examples on the balance sheet include receivables and inventories rising much faster than sales. Securities not marketed to market, bad loans, and inventories with obsolete products is something else to look out for (technology companies can have much inventory become obsolete almost overnight due to rapid changes in technology). On the income statement earnings are dramatically inflated due to one time gains, which the management tries to hide deep inside the company fillings. The management might be hiding a clear disclosure of revenue booking practices. These are only a few of the many examples Staley gives. Let us go through a case study to see how the big picture looks.
Case study: Crazy Eddie
Sately states that Crazy Eddie makes the all-star list of short stocks; “sophisticated bubbles, Wall Street icons, and greed” all come together in the case of Crazy Eddie.
In June 1986 Crazy Eddie owner 24 retail consumer electronic stores in the New York metropolitan area. By this time the company was trading at 39x “earnings”. “Crazy” Eddie Antar (the CEO) hired several family members his brother, uncle, cousins etc. to be top managers in the company. Eddie, and another insider crony had sold $71.5 million of stock by June 1986.
The company engaged in several odd dealings with another corporation Benel Distribution, which was owned by Eddie’s sister and brother-in-law. The transactions included inventory sales, leases and joint advertising expenses. Crazy Eddie also conducted many transactions with family owned entities, which at the very least should have raised some red flags. The company also made interest free loans to Eddie and other family members! As ridiculous as this sounds, it gets worse as the company could not determine the amount lent out to Eddie and his family members!
Wall Street liked Crazy Eddie because their sale of VCRs was increasing rapidly in the mid 1980s. Conventional Wall Street wisdom was that every home in America would soon have a VCR. Wall Street also liked Crazy Eddie because the store had a reputation for low prices. Drexel was predicting $1 billion of total sales by 1990.
Wall Street seemed unconcerned that after-tax margins for the company were only 5%. The only way the company was able to compete was by achieving quick inventory turnover. Wall Street also got very excited by the fact that Crazy Eddie decided to enter the Home Shopping Network. Eddie assured the public that his company would be a massive seller om the Home Shopping Network, and that it would soon contribute $65 million a year to revenue.
In the middle of October 1986, Eddie announced third revenue earnings might be slightly lower than Wall Street estimates, the stock immediately dropped 15%. The 10q released in October 1987 showed sales up 42%, with inventories up a whopping a 142%. In November 1986, Eddie reduced his stake in the company by nearly 40%. However, in December of 1986 management announced the repurchase of three million shares stating “that the shares were undervalued”. Between December 1986 and October 1987, the stock had only decreased in price!
The 1987 10K revealed that sales were up by 42%, while inventories were up over triple that amount. Same store sales were down 19%, while Wall Street was expecting a 50% increase. Earnings for Q4 1987 were only $.02 a share, and gross margins were sliding downward.
In June of 1987 the SEC declared an investigation of the company, Chemical Bank cut off it’s $52 million line of credit, and a member of the board resigned. However, Eddie’s salaried doubled over the past year! Shareholders started taking note and so did Wall Street. Many shareholder suits were filled against management, and analysts who had previously recommended the stock only several months ago were now downgrading the company.
The final straw came in November 1987, Eddie was rumored to be seriously ill.The escalating of the previous year were finally explained. New management said they were missing $45 million of inventory. The company charged that Eddie falsified “inventory and profit reports, created phantom inventory, and destroyed the records in a cover-up”. Eddie was also accused of falsifying same store sales, by including wholesale sales in revenue figures. Eddie was accused of looting the company, and selling on insider information. In June 1989 Crazy Eddie filled for bankruptcy. Eddie surrendered to US marshals in February 1990.
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