Tag Archives: seeking

Short-Selling: What Are You Optimizing?

Summary What separates investing from gambling? Positive expected value. Short-selling has a negative expected value – more negative than some casino games. What are you optimizing? In theory investing is about optimizing return, but many investors’ behavior suggests they are optimizing/minimizing something else. For some heavy short-sellers, it’s intellectual stimulation. I don’t think short selling is right for me or most investors, but this is just my still-evolving opinion. Full disclosure: I’ve never shorted a stock in my life. As such, I’m probably terribly biased and not credible. Short selling is betting that a stock or security will go down. Instead of buying low and selling high, you first sell high and then buy low. You do so by borrowing someone else’s shares when you initially sell and then replacing those shares later on by buying them. For reasons I will explain in this article, I don’t think most investors, including myself, should engage in short selling. Some should, but even for those for whom short selling (“shorting”) is appropriate, it probably should not be used as a primary strategy. This argument has been hashed out many times. I could repeat what’s been discussed many times. For example, when you engage in shorting your upside is limited and downside unlimited – the unfavorable reverse of going long. Instead, I will focus on what I see as the most important points for me and perhaps where I’ve added some original thought. When you short-sell a stock, the odds are against you What separates investing from gambling? Sure, investing isn’t done in a casino, it’s much more calculated, there’s far more money in it, etc. The biggest difference though, is that when you gamble, there is a negative expected value – the odds are against you. The casino takes a cut. When you invest, there is no golden rule saying it has to be a favorable bet, but equities in the US have been increasing rather consistently for over 150 years (see Jeremy Siegel’s excellent book Stocks for the Long Run ). Studies of “rules-based” systematic investing styles like buying the lowest 10% of the market by EV/EBIT and rebalancing annually will often include the returns of the opposite decile (the highest 10% of the market by EV/EBIT in our example). The idea is that the larger the gap in returns between the two poles, the more predictive value the metric has. So what’s the point? Well when you look at these studies, it’s surprisingly hard to find one where the worst decile is actually delivering negative returns. This is significant because it means that stocks don’t only appreciate substantially on average, it’s also hard to find some that will go down at all. For myself and presumably many other investors, this odds-against-you fact is a total deal breaker. I remember in high school, I would print out the Las Vegas odds of each weeks NFL games and offer to do straight bets with anyone on any game so long as I had the favorite. I was okay with this activity because by picking the favorite without paying for it, I had a positive expected value – even though I didn’t know that term at the time. Several months ago, I was viewing the Ultimate Fighting Championship with family and someone suggested we bet on the fights. We would pool money and bet on who would win the fight and what round (or decision) they would win in The gamble was, on the surface zero-sum. No one was taking a cut of the bets. And I did research. I immediately pulled out my smartphone and looked up the favorite in each fight. I then looked up what percentage of UFC fights end by knockout versus decision. (click to enlarge) 41% of fights go to decision. Assuming a three round fight (most fights are 3 rounds, championship fights are 5), that 41% is significantly higher than the 25% it would be if each outcome were equally likely. So in each fight, I picked the favorite by decision with some confidence that I had a positive expected value. I won three out of the four fights we bet on. My approach to these situations where the game is explicitly zero or positive sum is in stark contrast to negative expected value situations. Casinos take a cut of all bets by structuring games such that odds are slightly in their favor. The lottery usually has a very negative expected value because: the winnings are taxed at the highest federal income rate and by your state as well municipalities take a huge cut (it’s a significant source of revenue for them) the advertised prize is not a present value, it’s usually a long-term annuity – taking the cash up front means getting far less there could be multiple winners that split the winnings, and the probability of this increases when the pot is large and many tickets are sold, offsetting the EV benefit of the higher pot. I’ve never engaged in these sorts of activities and would have a lot of trouble forcing myself to. It is counter to the investor mindset. But short sellers do just this. On average, they will lose money. The expected value is negative. The idea, though, is that by doing deep enough research and being opportunistic enough, they can make the expected value positive. This is tough for me to accept. First, the odds are dramatically against them on the surface. If stocks appreciate 9.5-10% a year in nominal terms, those odds are far worse for the short seller than some casino games. For example, in blackjack, the odds of you winning versus the dealer are 48%. Roulette is something like 47.4%. If stocks are appreciating 9.5-10% that’s the equivalent of ~45%. And that’s just the direct costs. Then there’s taxes, dividends you must pay on the shares you short, borrowing costs on hard to borrow stocks (unfortunately, many of the stocks with the best short cases have the highest borrowing costs because everyone wants to short them). This is somewhat offset by the fact that you can (I believe) use some of the cash you receive from the sale upfront for other things in the interim. I believe this depends on your creditworthiness as perceived by your broker, the size of the short sale relative to your assets, etc. Some brokers may require you to keep the margin in cash, which eliminates this benefit. The bottom-line: short selling is a negative expected value activity, so why do it? What are you optimizing? Value Investors Club is a great site. The quality of research is very high and there are some smart people on it – some of the smartest people in the investment industry, in fact. That’s why it confounds me that some of these investors are so short-focused. Some of these investors have written 25 articles and like 23 of them are shorts. Some of the smartest investors with the highest profiles are also heavy shorters. David Einhorn and Bill Ackman come to mind. Ackman now describes his firm as primarily long but opportunistically short, which may be the case, but historically he’s done a lot of shorting. I have a theory that these investors are attracted to shorting precisely because the expected value is worse than going long. It’s harder. It requires deeper research. It’s intellectually stimulating. It’s exhilarating. These things probably really appeal to smart people with a chip on their shoulders for some reason. But what is investing about? Is the goal of investing to optimize return or optimize intellectual stimulation? Most investors agree verbally that it’s all about return, but most don’t behave that way – and there are other examples. Obsessions over volatility, dividends, minimizing taxes, etc. are all examples of other things I’ve found many investors trying to optimize through their behavior. Buffett has said a few insightful things on this topic: “You don’t get points for difficulty” The mono-linked chain metaphor The one-foot hurdle metaphor It is certainly understandable that for investors capable of analyzing and understanding very difficult situations, it is challenging to focus on easy ones. Conclusions I have some other thoughts like the idea of specialization – maybe an investor, for some reason like a deep skeptical streak, is much better at shorting than going long – but they will have to wait for another post. This article is just me putting my thoughts to paper. At this point, I’m comfortable recommending that most investors (including myself) focus on positive expected value situations to optimize return and that means avoiding short selling.

Public Utility Commission Decisions Will Determine The Future Of Investor Owned Utilities

Investors in utilities should be considering the impact of alternate energy sources on utilities. One of the best way to measure the impact is by looking at the decisions of the Public Utility Commissions and how they respond to alternate energy sources. We look at California market as one example where the Public Utility Commission decisions should discourage utility investments. When electricity rates go up in a region, consumers in that region are quick to blame the local utilities and cast them as villains. This phenomenon is particularly acute when it comes to Investor Owned Utilities. While the IOUs profit motive gets most of the blame, in many regions of the US, utilities operate under some very specific mandates from local Public Utility Commissions. This dynamic did not matter much to utility investors in the past since utilities were in a monopolistic situation and customers did not have much of a choice when it comes to energy sources. However, times are changing and in this era of distributed energy, utility investors should factor in the mindset of the relevant PUCs in determining which utility investments are vulnerable. The concern about utility future is especially acute in states where solar penetration is increasing rapidly. In these states, a local PUC’s response to solar and wind technologies is one very good way to assess whether a utility can do well in its regulatory landscape. In this context, we look at the regulatory landscape in California – a state with the highest solar penetration in the US outside of Hawaii. California Public Utilities Commission, or CPUC, after much contentious dialogue, announced a much awaited new rate design a few weeks back. While not completely unexpected, the rate decision is reflective of ongoing poor rate setting history in California and has severe long term implications for California’s three major Investor Owned Utilities Pacific Gas & Electric (NYSE: PCG ), Southern California Edison [owned by Edison International] (NYSE: EIX ) , San Diego Gas & Electric [owned by Sempra Energy] (NYSE: SRE ) While the decision itself is a long complex document with many nuances, the highlights of the ruling are as follows: – A minimum bill of $10 as opposed to a fixed bill requested by the utilities – Two tiered rate structure with a 25% cost difference between the tiers – A new super user rate for heavy electric users – A relatively accelerated path to TOU rate structures – 4 year glide path to new tiered rate structures Almost all of these decisions, except for the TOU rate structures, while directionally positive compared to the prior rate structures, fall woefully short of what is required to align California electric rates with the market forces. In evaluating the decision, it is instructive to understand the parameters that the PUC set for itself for this rate design. The so-called rate design principles, RDP, adopted by the Commission are as follows: 1. Low-income and medical baseline customers should have access to enough electricity to ensure basic needs (such as health and comfort) are met at an affordable cost; 2. Rates should be based on marginal cost; 3. Rates should be based on cost-causation principles; 4. Rates should encourage conservation and energy efficiency; 5. Rates should encourage reduction of both coincident and non-coincident peak demand; 6. Rates should be stable and understandable and provide customer choice; 7. Rates should generally avoid cross-subsidies, unless the cross-subsidies appropriately support explicit state policy goals; 8. Incentives should be explicit and transparent; 9. Rates should encourage economically efficient decision-making; 10. Transitions to new rate structures should emphasize customer education and outreach that enhances customer understanding and acceptance of new rates, and minimizes and appropriately considers the bill impacts associated with such transitions. What is most ironic about these rate design principles is that many of these goals are in conflict with each other and there is not a single criteria that mentions the goal as delivering low cost long term electricity to consumers. Understandably, a look at the pricing difference between California IOUs and municipal utilities (image below from energy.ca.gov) indicates that CPUC has largely been a failure in delivering low prices to California consumers. (click to enlarge) The root of the problem related to CPUC’s incoherent principles and an over reliance on cost based metrics, instead of market based metrics, in setting utility directives. This poor process has led to historical over investment in assets to justify a higher return to the IOU shareholders. This worked reasonably well for all involved (except customers) as long as there was no competition to the utilities. However, solar energy, and to a lesser degree, wind energy, are dramatically changing the market place dynamics. With many alternate sources of distributed generation accessible to customers, utilities are no longer the energy generating monopolies they used to be. The CPUC, unfortunately, continues to see consumers as subjects that pay the rates they set without considering that the electric generation landscape has changed and the consumer today has choices. CPUC rate structures hide many different subsidies in the form of volumetric rate structures. These subsidies will be problematic to utilities because they are not applied evenly across all the energy sources and will be increasingly coming at the expense of utilities. By being oblivious or nearly completely ignoring market forces, the CPUC is on the course to making utilities a lot less relevant for a big part of its customer base. Given the exponential growth in solar, this subsidy structure will start exacting an increasingly heavier toll on these utilities. The problem, especially in California, is likely to get worse if the PUC continues with its net metering policies and layers in subsidies for battery technologies on top of the already expensive other subsidies. Unless Pacific Gas & Electric, Southern California Edison, and San Diego Gas & Electric can meaningfully alter this regulatory landscape, their future in California will be threatened. Investors will do well to stay away from these and other utilities that operate in an archaic framework that does not properly recognize the threat of solar to the utility business models. We see Pacific Gas & Electric as one of the highest risk utilities. Our view on PCG: Avoid

How To Avoid Potential Value Traps With Net-Nets And Other Deep Value Stocks

Summary Rejecting ideas fast is a key aspect of making one’s stock research and investment process more efficient and effective. I provide several categories of companies and specific stocks that I rejected as potential value traps, as I ran through my raw stock screens. My exclusive research service, Asia/U.S. Deep-Value Wide-Moat Stocks, flags potential value traps with corporate governance issues, financial statement manipulation risks and other red flags. Background On The Idea Of Rejecting Potential Value Traps I have been a keen follower of Nate Tobik’s (Oddball Stocks) writings and work on deep value investing. In October 2014, Nate participated in a value investing seminar, where the video of his presentation was posted online here. In Nate’s presentation, he spoke about the process of finding and investing in oddball stocks. What caught my attention was this first bullet point on his slide titled ‘Evaluating Ideas’ where Nate wrote “Fail fast: Want to reject ideas as quickly as possible.” In the sections below, I outline certain (non-exhaustive) categories of companies and specific stocks that I rejected as potential value traps, as I ran through my raw stock screens. Past Dealings With Minority Shareholders Wong’s Kong King International (532 HK) operates under two segments: Trading and Manufacturing. The Trading segment is engaged in the trading and distribution of chemicals, materials and equipment used in the manufacturing of printed circuit boards and electronic products; while its Manufacturing business is involved in the manufacturing of electrical and electronic products. Wong’s Kong King is a net-net trading at 0.60 times P/NCAV. Based on its share price of HK$0.65 as of September 25, 2015, Wong’s Kong King’s share price is approaching its 5-year low, while its P/B ratio of 0.34 is close to the 10-year low of 0.32. In August 2006, Wong’s Kong King announced that Chairman Mr Senta Wong proposed to privatize the Company via a Scheme of Arrangement at HK$1.38 per share. The proposed privatization did not go through because it was not approved by the majority of independent shareholders (excluding controlling shareholders/interested parties) in October 2006. In April 2007, the Company announced that it will dispose of substantially all the operating businesses and assets of the Company to Mr Senta Wong and distribute the sales proceeds of approximately HK$1.17 billion or HK$1.65 per share to shareholders (“Proposal”); the Company will become an empty shell and subsequently be delisted. At the Special General Meeting in June 2007, the resolution relating to the Proposal was not passed by independent shareholders. Only 47.22% of the votes were cast in favor of the Proposal, falling short of the 75% required. Mr David Webb, a well-known activist investor, owned more than 3.16% of Wong’s Kong King’s shares at that point the Proposal was announced, and highlighted that he “would veto it at the shareholders’ meeting on June 28.” According to a South China Morning Post article dated June 7, 2007, Mr David Webb said that “We estimate that fair value of this stock to be around eight times trailing earnings, or over HK$3 per share. We would reject an offer below HK$2.50.” According to the circular issued by the independent financial advisors, comparable companies trade at mean and median P/Es of 9.64 and 8.84 respectively, compared with a 4.68 times implied P/E based on the HK$1.65 per share disposal value. While Wong’s Kong King is enticing as a deep value net-net stock at current valuations, the Company’s past actions indicate that it is less likely that an attractive or reasonable privatization offer will be on the cards anytime soon. Sub-Optimal Capital Allocation Miko International Holdings (1247 HK) is “a mid-to-high end children’s apparel brand in China. Its “redkids” brand is ranked second among mid-to-high end children’s apparel brands in China,” according to its company profile . Miko is a net-net valued by the market at 0.54 times P/NCAV. Net cash also accounted for approximately 124% of Miko’s market capitalization, implying the investors are getting the Company’s core business operations for free at current valuations. In June 2015, the Company announced it was issuing 85 million new placement shares (10.3% of the issued share capital) at HK$1.03 per share, or 10% discount to its closing share price of HK$1.15 on June 24, 2015. In the end, the placement was terminated in July 2015, due to “continued high volatility in Hong Kong and PRC securities market and unstable political and economic conditions in Europe.” Nevertheless, the proposed placement did not make sense considering the significant amount of net cash (HK$528 million of net cash on its books as at end-June 2015 versus HK$87.6 million to be raised) it has on its balance sheet and the stock’s low valuations (even at that point in time). Good companies engage in value-accretive capital allocation practices by placing out new shares when their stock is overvalued, and repurchasing shares when their stock is undervalued; companies which are potential value traps do the reverse. Target Of Short-Sellers China Zhongwang (OTC: CHZHY ) (1333 HK) is the world’s second largest and Asia’s largest producer and developer of industrial aluminum extrusion products.” China Zhongwang is a deep value stock trading at half of its book value, which is close to its historical P/B low of 0.46. Dupre Analytics (DA), a short-seller research firm, issued a report on China Zhongwang and disclosed its short position in the Company in end-July 2015. DA claimed that the Company’s “real revenues are much lower than reported,” and “overstated CAPEX expenses” among other allegations. China Zhongwang has since made clarifications in announcements here and here , rebutting DA’s claims. In the announcements, the Company’s Board “reiterates that the allegations in the DA Report are groundless, and that the DA Report contains various misrepresentations, malicious and false allegations and obvious factual errors.” I follow a couple of short-seller research firms and their work; I tend to avoid stocks highlighted by them as I prefer not to bet against the “smart money.” I also use the Beneish M-Score as a tool to filter for potential value traps. Takeaways I always liked the quote “Losing an illusion makes you wiser than finding a truth,” and I found that this applies equally to value investing. The earlier that one loses the illusion that all deep value stocks are unjustifiably cheap, and rejects certain potential investment candidates and adds them to his or her list of value traps to be avoided, the closer he or she will get closer to finding and picking the truly undervalued stocks. (Note: I am not a English major; I might have misinterpretated the quote and applied it incorrectly.) Note: I flag potential value traps with corporate governance issues, financial statement manipulation risks and other red flags as part of my Asia/U.S. Deep-Value Wide-Moat Stocks exclusive research service. My subscribers get access to the list of value traps for both deep value & wide moat stocks, in addition to monthly top ideas, potential investment candidate profiles and potential investment candidate watchlists.