In the spirit of this week's shaky market, we're going to discuss short selling. It's a skill every reader should have, and it's one few use. To read our "plea" to sell stocks short, click here. Today, we'll start with our latest short-selling coup…
We wrote it, did you short it?
| Copper is considered a leading indicator for stock prices. Copper prices peaked in mid-April last year, just two weeks before the stock market entered its correction phase. And [according to one of my favorite indicators] copper could be close to a top now, as well...
[The pattern I see forming in copper] usually breaks to the downside. In this case, a breakdown below the support line projects… a drop of about 20%. If copper drops 20%, shares of the biggest copper mining company, Freeport-McMoRan (FCX) will get crushed. FCX is a good proxy for the price of copper. – Jeff Clark, February 15, 2011, S&A Short Report |
Yesterday, shares of Freeport McMoRan plunged with the broad market. And the puts Jeff recommended soared. Short Report subscribers closed half their position for a 117% gain in eight days.
Today, Jeff issued another short sale recommendation… a company he successfully shorted three weeks ago. When Jeff first shorted this company, it was trading near its 52-week high. Investors were paying 57 times earnings (while the growth rate of those earnings was declining). While the market was blind to the insane valuation, Jeff bought puts on the e-commerce company. Then, the company announced bad earnings and lowered its earnings forecast for the next quarter and the next year… The stock plunged. Short Report readers sold those puts for a 60%-to-80% gain.
Since the poor earnings announcement, the company's shares have rallied back to their previous highs. Based on the new numbers, shares are now trading at 88 times earnings (even more outrageous than the previous 57x multiple). As Jeff noted in his update, "That's an insane valuation for even the mightiest of growth companies." We've seen how this plays out… And Jeff re-recommended puts on this company. He expects readers to make at least 129%. To access the trade, click here.
Also, if you're interested in learning more about the S&A Short Report and Jeff's trading strategies, make sure to read our interview series here and here.
Jeff is a trader. He sells stocks short based on short-term technical indicators (outrageous valuations, as in the example above, serve to fortify his opinion). Porter takes a different approach to short selling. He focuses on macroeconomic factors and fundamental analysis. He looks for what he calls "buggy-whip makers" – companies heading toward obsolescence. He also looks for frauds (like Enron or WorldCom) or heavily indebted firms (like MGM or General Motors). He does not short valuation. It's a tough lesson to learn.
In the late 1990s, Porter shorted Netscape. As you know, Netscape is an Internet browser. It gave away its product for free. Despite a nonexistent revenue model, the stock was valued around $1 billion. After Porter put on the short, the stock fell from around $20 to $14. Then AOL decided to buy the company for around $90 a share. He got crushed.
Later, after Time Warner bought AOL, we discovered AOL was a giant accounting fraud, and it took one of the largest writedowns in corporate history. Was Porter right? Yes. But he still lost money.
On the other hand, look at Porter's short of hard-drive makers Seagate Technologies and Western Digital. Their valuations weren't crazy when he initiated the short. But their industry was dead. Porter argued the market for hard drives will die as "flash" storage dominates. In his February 2010 issue, he wrote:
| So why would I recommend shorting a digital-storage maker in the face of escalating rates of bandwidth growth? Two reasons. First, most of the digital storage fueling the Internet growth today is being installed at the corporate level. For example, Microsoft's new cloud computing service, SkyDrive, allows users to keep up to 25 gigabytes (GB) of data on their severs for free. That's roughly 2.5 million e-mails. Or a pickup truck filled with books. Or about 12,000 digital photos. For most users, this is enough storage – for free.
Similarly, dozens of small businesses, like Carbonite, allow users to back up all of their files for around $50 per year. These services are easier to use than an extra hard drive because they don't require any expertise – you just sign up and everything is backed up automatically. Even worse for Western Digital is the increasing efficiency of solid-state storage devices – what's commonly known as "flash" media storage. Remember when the iPod first came out in 2003? It was about as big as a cigarette box and could hold maybe 2,000 songs. Its storage system was a tiny hard drive. A few years later, Apple introduced much smaller iPods. They held fewer songs, but they were much lighter and much more energy efficient. They didn't have a hard drive at all, just a flash memory card – a semiconductor designed for memory. |
Stansberry's Investment Advisory subscribers made more than 50% and 30% shorting Seagate and Western Digital, respectively.
So how do you spot the next obsolete business? It's harder than you'd think. Hedge-fund manager Carlo Cannell says he likes to find businesses "laying wounded on the side of the road, so he just has to put a final bullet in their head."
While speaking at the 2010 Value Investing Congress (VIC), Cannell expanded on his short-selling methods. He likes shorting restaurant stocks, because "eventually, they all fail." While his statement is an exaggeration, most restaurants are terrible businesses. Cannell also looks for businesses too stupid to exist. He showed a slide at the VIC of a company that made wearable computers… It was a man wearing a massive piece of headgear and probably 10 pounds of hardware. The company, naturally, went to zero.
But even these small, stupid companies can shake you out of your short position with volatility. That's why (when shorting for fundamental reasons) you need to be certain of a company's demise before going short – the upside for a short sale is 100%, but the downside is unlimited.
We can't recommend a lot of the companies Cannell talks about because they're too small… Our subscribers wouldn't find shares to short. We need to recommend larger stocks. Luckily, we're finding plenty of stocks with obsolete business models to short. Take our Barnes & Noble short…
| Selling books has always been a low-margin business. Barnes & Noble lives on a razor-thin 3% operating margin. It simply cannot afford a decrease in top-line revenue. And there's no doubt that will happen this year. Despite the launch of Barnes and Noble's e-book reader (the Nook), the company's sales would have declined in the first quarter except for a huge acquisition (B&N College).
Unfortunately for Barnes & Noble shareholders, the company's website and its e-book business aren't nearly big enough to replace the continuing same-store sales (roughly 5% per quarter) figures at its bookstores, which make up the vast majority of its business. Quarterly revenues at the bookstores are more than $1 billion, while quarterly online sales are less than $250 million. Shorting Barnes & Noble is, in our view, a one-way bet. There's no way it can compete against instant, costless, digital distribution of books over a wireless network. Nor can it compete on a technological basis with either Amazon or Apple. Bookstores are finished. And so is Barnes and Noble. – Porter Stansberry and Braden Copeland, May 2010, Stansberry's Investment Advisory |
Yesterday, Barnes & Noble announced a profit of $60.6 million, down 25% from a year earlier. The company also cut its quarterly dividend to free up $60 million to pursue its digital strategies (namely its Nook e-reader) and other potential opportunities (it's considering purchasing some closed Borders locations).
The dividend cut is a desperate move – the sign of a company in its death throes. First off, $60 million is a paltry sum. How can Barnes & Noble expect to compete with Amazon, Google, and Apple (its competitors in the digital book market) with so little cash? Google has almost $35 billion in cash and short-term securities, Apple has $29 billion, and Amazon has more than $8 billion. In other words, $60 million (which Barnes & Noble had to cut its dividend to realize) is nothing to the company's larger competitors.
Second, why would Barnes & Noble consider buying more brick and mortar locations? Borders' bankruptcy proves the big-box book retailer business model is dead. Barnes & Noble plunged double-digits yesterday and another 9% today. SIA readers are up 28% on the position. There's more to go…
In case you missed Saturday's DailyWealth essay, we encourage you to print it off, read it several times, and keep it by your desk for years. It's one of the most important investment ideas you'll ever encounter.
In the essay, Digest contributor Dan Ferris answers one of the biggest questions brought about by our "End of America" video...
As you probably know by now, our End of America scenario is based on the idea that the United States government has taken on obligations it cannot ever hope to repay. This crushing debt load has brought the country into a currency crisis… one that will end the reign of the U.S. dollar as the world's reserve currency. If you're not familiar with our warnings and instructions on how to protect yourself, please watch our video.
Our prediction has led many readers to ask, "If you guys are right about the End of America prediction and a currency crisis, should I even own stocks? If yes, what ones could possibly produce wealth in this situation?" Dan's essay provides the answer to this question…
And he provides an overview of the single greatest stock strategy in the world. This strategy is simple. It is safe. It will produce a giant stream of income over the years. If you're interested in protecting yourself from our End of America scenario, you must know this strategy. This could be the most important essay you'll read all year. You can access it here.
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New 52-week highs (as of 2/22/11): Cenovus Energy (CVE), Mirasol Resources (MRZ.V), Sprott Resources (SCP.TO), Suncor Energy (SU), HMS Holdings (HMSY), Molina Healthcare (MOH), iShares Silver (SLV), ExxonMobil (XOM), Vanguard Natural Resources (VNR), North American Energy (NOA), Phillip Morris International (PM).
In the mailbag, some subscribers raise questions about shorting… and another writes in about our videos. Send your e-mail to feedback@stansberryresearch.com.
"There are many times where you recommend a stock that is NOT possible to get. BKS was one. Two major brokerages did not have and STILL do not have shares to short. You really need to address this in the newsletters as I am SURE many people could not purchase the stock. There are also other stocks that I try to buy the moment the newsletter comes but they have already risen past the max buy price. I am SURE that MOST of your subscribers do not get the stock. However in all these cases you take credit for nice gains when in fact most people could not get the stock. Not right but I guess it sells newsletters!" – Anonymous
Goldsmith comment: We get this e-mail all the time. And once again, we'll say… If a stock price rises before you get your newsletter, it could be a coincidence… Or it could be other readers were faster to buy than you. Whatever the reason, if you're patient, the stock normally returns to its buy range.
As for our short recommendations… As an editorial policy, we make sure brokerages have shares available to short before we issue a short recommendation. If you're just now trying to short BKS, we're not surprised you can't find shares. Between the Borders bankruptcy and BKS' recent bad numbers, the short bookseller trade has gained notoriety.
"Where can I find detailed help in learning how to short a stock by using options? I am afraid to do any options since I know little about it. Can you tell me where I can find detailed step by step fully explained instructions on how to do Options?" – Paid-up subscriber Kerry
Goldsmith comment: We actually just updated our Short Report Guide to Options Trading. S&A Short Report subscribers can read it here. We also occasionally discuss options trading in the Digest. In the February 26, 2010 Digest, we told readers why selling put options is such a good strategy.
"I agree with Porter. As the Creative Partner of a highly successful East Coast ad agency (I retired in 1985), I love the simplicity (no art direction necessary) of the message and I'm glad you're happy with the results. Anyone who has followed S&A knows that you also deliver the best research results in the business. Even though I always look for a cut-off switch to text halfway through the incredibly amateurish narration (to see which service is being hyped) I suffer in silence and stay the course.
"Of course, being a native Baltimorean (My dad, Lou Becker, was a popular society orchestra leader for over 50 years and I started my ad career at Fox Advertising (long gone) in the late 40s perhaps your location brings back wonderful memories of growing up in Forest Park. Stick with what works. That's why I'm still a faithful subscriber." – Paid-up subscriber Larry Becker
Goldsmith comment: Thanks, Larry. We appreciate your business.
Regards,
Sean Goldsmith
Baltimore, Maryland
February 23, 2011Clark nails the short copper trade… Don't short on valuation… The next industry to die… Which stocks to own for the End of America… Our new guide to trading options…