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Practical Red Flags

In early October of this year, I gave a Red Flags speech at the Traders4ACause charity event at Wynn Resorts in Las Vegas. I was honored to have spoken alongside Sahm Andrangi (@KerrisdaleCapital), Jon Najarian (@jonnajarian), Ryan Sellers (@openoutcrier), Andrew Left (@CitronResearch) and GeoInvesting writer Christopher Irons (@QTRResearch) – truly great highlights of my trip. Similar to the event I attended last year at the Mandalay Bay Resort, I had very productive meetings with other investors, learning about their investment strategies and goals.

One investor, Brice Foose, gave me a tip I regrettably did not act on. He was right-on with his call that biotech firm Neothetics (NASDAQ:NEOT) was about to pop based on some Information Arbitrage (InfoArb) he came across after listening to one of the company’s conference calls. A few days after the conference, NEOT climbed nearly 300% when that information was catalyzed.  Being a Peter Lynch fan (“buy what you know”), I should have paid more attention. Brice works in the pharmaceutical industry.  As a new member to Geo, Brice has two more ideas he is getting ready to contribute to our pro portal. Thank you, Brice.

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Bull at Heart, But Keeping It Real

I am a bullish investor at heart. Sure, I could just invest in Facebook Inc. (NMS:FB), Amazon (NMS:AMZN), Netflix Inc. (NMS:NFLX), Alphabet Inc. (NMS:GOOG), otherwise known as “FANG”, but I really enjoy looking for smaller firms that are the building blocks of the U.S. and global economy. I just find it more fun and rewarding.  Did you know that small firms make up 99.7% of U.S. employer firms? Sometimes these microcap stocks turn into big caps, like Monster Beverage (NMS:MNST) and Wal-Mart Stores Inc. (NYSE:WMT).

Crossing over to the short-side for a while, which I did starting in 2010, was not an easy leap for me. However, it has been a great learning experience.

Even though I am not a short seller, as a full-time investor I always look for red flags with my investments, as a kind of portfolio protection.  Even though Peter Lynch and his “partner in crime” Joel Tillinghast are bulls, they understand and continually stress the importance of reading SEC filing risk factors and footnotes to understand the potential perils associated with some investments.

It wasn’t really until the reverse merger scams associated with U.S. Listed China-based companies started injecting their poison into the U.S. financial system that I started getting interested in turning red flag research into a short selling strategy. I had already aptly assigned the moniker “ChinaHybrids” to these companies when they were actually favored as long plays.  Ironically, since we’d be referring to them a lot in the coming years on the short side, it became a convenient second nature.

I am thankful for this experience and glad to have something in my back pocket to supplement my predominantly long strategy. Heck, even the godfather of value of investing, Benjamin Graham, shorted stocks.

Short Selling Goes Mainstream

Short-sellers who educated investors on the fraud that China was exporting to the U.S through reverse mergers put short selling on the map, often using the red flags approach as fodder for their research. Between 2010 to 2014, Carson Block of Muddy Waters Research, Jon Carnes (AKA Alfred Little), Andrew Left of Citron, Sahm Andrangi of Kerrisdale Capital and GeoInvesting exposed billions of dollars’ worth of ChinaHybrid fraud. The attention invited investors from all walks of life into the short selling community.  For a while, it was easy to find fraud in these companies, as they were not really hiding it given the lack of authoritative oversight on this side of the world.  Pulling a few China filings, talking to a local shopkeeper and visiting an abandoned factory were all the steps you needed to uncover the frauds.

For short-sellers, the ideal scenario is one where your thesis will be catalyzed quickly to limit your time exposure and short squeeze risk. Many investors lost their shirts betting against subprime housing, even though they were right. Timing was not on their side.

Practical Red Flags Analyzed

Times have changed, bringing new challenges to short strategies.  New short sellers are finding out that the China days were not the new normal, but rather an aberration.  While fraud is still perpetrated by management teams, it’s not a slam dunk to prove anymore. You might even say there is a bit of apathy towards the theme, where it’s tough to get investors to even care about what’s been uncovered.

A good deal of short selling has gone back to the grind, such as shorting on valuation or operational risks; in these cases, you may have to wait for your short thesis to play out, exposing you to unwanted risks.

That is where red flag research comes in.  The stronger your red flags are, the more confidence you can build for a short, and not necessarily fraud, case.  I am going to briefly discuss four red flags topics that don’t indicate outright fraud, but do pose risks.  It’s also helpful to look at some of them from both a long and short perspective.  In other words, if you are a short-seller, it is so important to understand how a bull could counter your argument, a classic tactic used by some of the best debaters in the world.

I often focus on the following red flags:

  1. Margins
  2. Inconsistencies
  3. Subsequent events foot notes in SEC filings
  4. GAAP vs. Non-GAAP

1. Margin Red Flags

Short sellers will often argue that a stock is fraudulent or overvalued if margins are materially higher than companies in the same sector. While this may be the case, or while margins may revert to the mean, some companies just do things better and the long thesis on margins may be the right one. Looking at comps is good, but studying companies for unique advantages or disadvantages is a key part of the research process. If you note that a company that is basically operating in the same way as its peers, yet its margins are astronomically higher, there may be some cause for concern.

When I intend to go long, I want to know what inning of the margin cycle its products are in. This is especially important when analyzing companies with commodity-type characteristics, such as in the tech industry (semiconductors). Often, you will see tech companies IPO near the peak of a margin cycle.

I like to track historical margins over time to see if I can find trends on how long a margin cycles for new products typically last. Then, I like to find out where the current products are in their life cycles.  I make sure to also track changes in R&D spend to see if the company is building its “innovation pipeline”.  If not, something could be wrong inside the company.

If you can time this cycle right, you can set yourself up with a juicy short when the company misses analysts’ financial estimates.

2. Red Flags Seen With Inconsistencies

I like to make sure that managements’ comments across research resources are consistent. This is a great way for beginners to get in the short game and for short-sellers to avoid disastrous outcomes by shorting “headlines”.  As a bull or bear, you need to read press releases, related conference call transcripts and SEC filings to see if they are conveying a consistent message and/or if they could be creating an InfoArb opportunity.

For example, a stock that reports a bad quarter may look like an obvious short, but management may offer more detail in its conference call implying that the bad quarter was out of the norm. The opposite can also be true when a company reports a great quarter.

Dilution risk and liquidity needs are the first risk factors I look at. Dilution is kryptonite to bulls and a gift from heaven for bears.  The “Liquidity and Capital Resources” section of 10-Qs and 10-Ks and the “Risk Factors” section of 10-Ks can let you know if a company needs to raise money soon. I have even found instances where liquidity needs in each of these sections of the same 10-K differed in their assessment of liquidity needs.

History has a way of repeating itself.  At times, I will come across companies where management has a history claiming its company is well capitalized.  It then turns around and raises equity capital anyway. We saw this playout with many fraudulent ChinaHybrids.

It’s important not to jump the gun when a company files to raise money if the proceeds will be used to pay down debt or consummate an accretive acquisition.  In these cases, the fresh new capital could actually be reason to go long.  Also, not all secondary stock offerings are dilutive. Small and microcap stocks sometimes have big legacy stockholders that sell their stakes through an underwriter in a non-dilutive secondary where no new shares are issued. These stocks often recover quickly after the overhang is out of the way and the uncertainty about the big seller is removed, or selling pressure abates.

3. Red Flags in Subsequent Events

While we are on the subject of SEC filings, they are a great source for long and short biased research because they are voluminous and boring. This means that many investors don’t have the time or patience to read them. One of my favorite (yet overlooked) sections in SEC filings is the “Subsequent Events” section of 10-Qs and 10-Ks. This is the area that will highlight new developments or expand on news that has taken place between the preparation of the current public disclosure and the next filing period.  A great example of this is Appliance Recycling Centers Of (NASDAQ:ARCI).

ARCI recently shot up 200% to ~$1.75 after announcing a restructuring where it sold underperforming assets and raised cash. Not too long after that, it issued a press release that it acquired a company in the hot telematics industry, but its press release offered little details about the acquired company or the terms of the transaction.  Shortly after this announcement, ARCI filed its 2017 second quarter results. The subsequent events footnote revealed that:

  • ARCI Purchased a development stage company. This was very odd since management had portrayed a message that they were turning the company around by selling garbage assets.
  • ARCI will issue preferred stock that will convert into 30 million shares, a shocking 4X dilution for shareholders
  • The acquired company is owned by the CEO of Live Ventures Inc Common (NASDAQ:LIVE), which was the subject of a critical report by noted short seller Rick Pearson (@MoxReports).
  • Related party issues existed between ARCI and the acquired company. Ironically, I initially approached this story from bullish frame of reference, intrigued by a potential turnaround.

4. Red Flags Inside the Numbers – GAAP vs. Non-GAAP

Companies have a great deal of latitude on how they can present their earnings per share (EPS), without breaking the law. Citron Research’s “body slam” of Valeant Pharmaceuticals Interna (NYSE:VRX) is a prime example of how companies can play around with non-GAAP numbers to make their EPS “shine”.

Don’t get too comfortable with GAAP numbers either:  as a bull, you can easily walk into a trap when companies follow the “law” set by regulators, but still feel “comfortable” inflating earnings per share. I am constantly looking at GAAP numbers to see if they need to be adjusted up or down for non-operational items, such as one-time gains from tax benefits, restructuring expenses and hedging gains/losses.

Your best bet is to learn how to calculate your own “clean” EPS or EBITDA number to compare them to the company-reported GAAP and non-GAAP numbers.  This article, ”To GAAP or Non-GAAP, That Is The Question,” delves a little more into this topic.

These are just a few examples of how thorough research can lead you down the right path and give you more confidence when looking for short opportunities. On the flip side, they can protect your portfolio if you are a bull. Please email me personally at maj@geoinvesting.com if you would like me to send you some case studies regarding the red flag topics discussed.

A little about me

I lead the GeoInvesting Team (GeoTeam) on a daily basis to actively build a healthy investment opportunity pipeline and heighten GeoInvesting’s awareness in the financial market. I stress the concept of “information arbitrage” in an era where information overload has actually made it more difficult for investors to locate profitable information.  An arbitrage exists when a disconnect between stock prices and available public information on a company is noticeable, and monetarily worth pursuing.