Tag Archives : short selling


Dirty Water 5

Disclosure: Short Cadiz (CDZI). This post expresses personal opinion about the company’s political strategy. It is not an investment thesis. Cable Car has no relationship with any of the individuals mentioned herein.

When a public company attacks a short seller, buyer beware.

After years of litigation and bureaucratic wrangling, management’s mounting frustration with the drawn-out approval process for the Cadiz water project is understandable. Proponents of the company’s increasingly long-shot project must have been upset by the October 2015 Bureau of Land Management (BLM) decision preventing it from using an obscure loophole to sidestep a federal environmental review.

Under the circumstances, Cadiz’ aggressive and expensive political response could be forgivable. However, the company’s August 2016 decision to engage in a coordinated smear campaign against an investor and a junior BLM staffer was unfair. The company’s disappointment at political setbacks does not justify public character assassination, nor does Cadiz advance its cause by making unfounded accusations.

Through a FOIA request, Cadiz obtained a series of emails between a BLM employee and Thomas McGannon, a partner at an investment adviser researching the water project. Cadiz issued a press release claiming the emails revealed the BLM decision “lacked objectivity” and provided the documents to the Wall Street Journal, peddling a thoroughly biased interpretation that accused the BLM and Mr. McGannon of impropriety. Perhaps swayed by its own political preferences (Senator Diane Feinstein, D-CA, is the lead opponent of the Cadiz project), the Journal published an unconscionable editorial, “The Pipeline and the Short Seller,” that unjustifiably accused Mr. McGannon of insider trading. The editorial noted that Cadiz provided the emails to the author, and Cadiz quickly amplified the editorial with another press release.

Call for retraction

Investors more accustomed to the investigative journalism the Journal is known for should be offended by the use of its mouthpiece for a company with a history of stock promotion at the expense of the reputation of a member of the investment community. I believe the Wall Street Journal owes Mr. McGannon an apology and retraction for its arguably defamatory editorial. The editorial falsely stated that “one Cadiz investor had inside information that could have allowed him to make a killing” and that the BLM “shared non-public information” with him.

In my opinion, the information exchanged in the emails was neither material nor non-public. Parts of the exchange sought informal views on whether proposed project modifications would be subject to BLM jurisdiction, not any indication of how the BLM might rule on an alternative. The rest concerned primarily procedural updates on the timing of BLM deliberations, not any indication of the likely outcome.

Administrative process timelines are a matter of public record. While agencies have FOIA procedures for releasing more extensive material including internal documents, which are also public information, it is entirely proper for government employees to share quotidian process updates with any member of the public who calls or writes to ask. Investors routinely interact with government agencies in this manner. Furthermore, there is nothing wrong with requesting information that an agency can choose not to release. Erik Pignata, the BLM employee with whom Mr. McGannon corresponded, made clear in one email that he could share only scheduling details, not the outcome of internal BLM discussions.

The Journal also makes hay of the time elapsed between emails and the fact that Mr. McGannon and Mr. Pignata also spoke on the phone. This amounts to an entirely unsubstantiated suggestion that the BLM FOIA office broke the law by failing to release relevant records. There is nothing in the FOIA response that suggests any emails are missing. And while it is theoretically possible that a phone conversation could have revealed non-public information, there is no evidence whatsoever for such an inflammatory suggestion.

According to Cadiz, the company’s requests for status updates from the BLM went unanswered. If their correspondence was also directed to Mr. Pignata and if he did not provide timeline details to Cadiz, he erred in not being equally responsive. Yet despite Mr. McGannon’s expression of opinions, there is nothing in the messages that indicates any substantive bias against the project from Mr. Pignata or his superiors at the BLM. Only a single comment from Mr. Pignata, after the decision was announced, implied that one controversial aspect of the local environmental review might have been “shady.”

The editorial was published in August, but I’m just now writing about it because it took time to receive a reply to my own FOIA request. I obtained the same series of emails by requesting the response provided to Cadiz. I am publishing that response in full here, as the Journal might have done instead of selectively quoting out of context. In my view, Mr. McGannon is at most guilty of being a bit overeager and irritating in his persistence, but you can be the judge of that for yourself:

PDF icon Read the emails

Why wade in?

Character is everything in the investment management industry. Even the whiff of impropriety, no matter how unfounded an accusation of wrongdoing, has been known to damage careers, prompting job losses and even investor redemptions. Publicly accusing an investor of misappropriating private information is particularly invidious, as it plays to popular misconceptions about what actually constitutes criminal insider trading. The reputational damage is done by the mere suggestion of cheating. The Journal editorial would implicitly criminalize a great deal of routine due diligence.

While I am wary of criticizing a company as litigious as Cadiz, I feel strongly that the public shaming of a fellow investor is unjust. I regularly seek public information from government agencies, as do my peers in investment research and investigative journalism. That is not wrong, and it should not be portrayed as being somehow insidious. Irrespective of the ultimate approval status of the Cadiz water project and Cable Car’s investment outcome, Cadiz sets a dangerous precedent.

As if the risks of short selling were not high enough, Cadiz has introduced the added possibility of the news media and even Congress (see below) being enlisted in a campaign of reputational damage against critics. Based solely on the project economics and its history, a large number of short sellers have independently reached the same conclusions as the Pump Stopper article cited by Mr. McGannon in one of his emails. The Pump Stopper article mentions unsuccessful attempts by the author to contact Cadiz as well as FOIA requests, which are publicly available. These imply that Cadiz was able to determine the identity of the article’s author, strongly suggesting that the campaign against Mr. McGannon was retaliatory in nature. The Journal should have known better than to get involved.

I have never knowingly interacted with Mr. McGannon, and I do not know if he was the source of the anonymous report. I know nothing of his character. However, I think it manifestly unfair for an individual’s reputation to be tarnished in this manner.

Cadiz protests too much

What passes for acceptable mudslinging in the corridors of Washington can be more damaging to non-politicians. Perhaps the reason for the company’s willingness to attack the BLM and a third-party investor is that Cadiz and its legal counsel/part-time CEO, Scott Slater, are no strangers to lobbying and backroom politics.

Mr. Slater is a shareholder of the law firm of Brownstein Hyatt Farber Schreck LLP (BHFS), which has been the company’s primary legal services provider since he joined as General Counsel in 2008. BHFS has a large corporate and government relations practice that includes significant lobbying work. The firm also operates a political action committee funded by shareholders of the firm, BHFS-E, PC PAC. The PAC makes about $400,000 of bipartisan contributions per election cycle.

Although Mr. Slater became CEO in 2013, he remains employed by BHFS and free to provide other services for them while collecting a $300,000 annual salary from Cadiz. On top of Mr. Slater’s salary, Cadiz pays an additional $300,000 annual retainer to BHFS for legal services relating to the project.

The retainer is a minimum commitment; the actual fees paid to BHFS by Cadiz have not been disclosed in aggregate but are considerably higher. For example, federal filings show Cadiz makes a $110,000 quarterly payment to BHFS for lobbying representation alone, while BHFS has simultaneously represented the company in various legal challenges to the project. Cadiz lobbying payments to BHFS began in Q4 2010 and have ranged from $400,000-440,000 every year since. In total, CDZI shareholders have compensated BHFS at least $2.4 million through June 2016 just for representation in Washington, although in five quarters the disclosures indicated that BHFS was compensated despite performing no lobbying activity.

What’s more, BHFS is eligible to receive incentive compensation based on project approval milestones. The firm has already earned three incentive awards since 2009, a total of 259,312 shares worth over $1.8 million at current market prices. They are eligible to receive a further 200,000 shares worth over $1.4 million upon achievement of additional milestones.

Mr. Slater’s unique employment situation makes BHFS a related party to Cadiz, a status that has been omitted from the related party disclosures in the company’s annual reports and proxy filings. Curiously, it was not until the second quarter 10-Q filed on August 8, 2016 that the company explicitly acknowledged BHFS as a related party in an SEC filing. I will leave it to securities lawyers to debate whether item 404(a) of regulation S-K provided a sufficient exemption from disclosing the total payments to BHFS.

CDZI, a company with only 10 full-time equivalent employees, spent $12.6 million on general and administrative expenses excluding stock-based compensation in 2015 and $9.0 million in 2014. Shareholders ought to know just how much of that went to Mr. Slater’s law firm.

Statement on apparent bias

Readers familiar with CDZI will have noticed that I have not yet mentioned the letters sent by Jason Chaffetz (R-UT) of the House of Representatives Oversight and Government Reform Committee to the BLM and Whetstone Capital. Partly that is because the committee’s activities appear to be rather more focused at the moment on another manufactured government email controversy and are unlikely to go anywhere. Yet the letters present the same concerns as the Cadiz press releases and Journal editorial. They also raise the separate question of why a Congressional committee would so readily adopt a financially interested company’s misleading insinuations of wrongdoing when describing innocuous correspondence.

It is probably only a coincidence that Representative Chaffetz has received 3 donations totaling $5,000 from BHFS-E, PC PAC. Cynthia Lummis (R-WY), his co-signer, received $1,000 from the PAC in 2013.

According to Federal Election Commission records, Mr. Slater has been an unusually prolific donor to politicians. He has given at least $78,977 of his personal funds to political committees and candidates for federal elective office, including $26,817 through the BHFS-E, PC PAC. I do not wish to insinuate that there has been any explicit quid pro quo from politicians in response to Mr. Slater’s or the PAC’s donations. Nevertheless, political contributions are a potential source of bias. The significant flow funds from CDZI investors to BHFS makes their political action activities important to consider as well.

Cadiz has focused its lobbying efforts during the current session on trying to insert an appropriations rider that would nullify the BLM decision. These efforts were primarily oriented toward Department of Interior appropriations legislation, which eventually passed the House but has been deferred to the lame-duck session by the most recent continuing resolution. I believe the language is highly unlikely to become law due to Senator Feinstein’s continuing opposition.

Interestingly, Cadiz’ second quarter lobbying disclosure form for BHFS added a new category of lobbying activities relating to the “Senate FAA authorization bill and amendments.” Obviously, the FAA reauthorization bill had nothing to do with water in the California desert, but BHFS evidently tried unsuccessfully to add a rider to that legislation sometime during the second quarter.

The Senate version of the bill was sponsored by John Thune (R-SD), Chair of the Commerce, Science, and Transportation committee. Mr. Slater donated $1,000 to Senator Thune on June 1, 2016, his first and only donation to the Senator. BHFS had not supported him since 2010. Senator Gary Peters (D-MI), a junior member of the committee who had not received any money from BHFS since 2011, made headlines in March for inserting other unrelated amendments into the legislation. On May 15, 2016, Mr. Slater donated $1,000 to Senator Peters. Neither senator faces a competitive reelection contest at the moment, giving Mr. Slater’s donations the appearance of an overt attempt to gain influence during concomitant lobbying efforts sponsored by his company.

Cadiz has also tried to win support from California’s federal Congressional delegation. Tim Sheehan, Cadiz CFO, supported Wendy’s Greuel’s unsuccessful House bid in 2014. Richard Stoddard, former CEO, donated to John Tavaglione’s ill-fated 2012 bid. Tavaglione is a Riverside county supervisor who has supported the project publicly. Both candidates for Barbara Boxer’s Senate seat this year have received contributions from either Mr. Slater or Keith Brackpool, Cadiz’ board chairman. To be fair, receipt of donations does not guarantee preferential treatment; even Senator Feinstein received $4,500 from the BHFS-E, PC PAC in 2012 (though nothing since).

In all, 19 current and former representatives are listed by the company on its most recent project support list. No doubt Cadiz has also supported local officials on the list as well, but since FEC data is more readily available, consider just the listed federal supporters of the Cadiz water project. At least 10 of these representatives have accepted money from Cadiz insiders through the second quarter of 2016:

Cumulative contributions from Cadiz insiders to stated supporters of Cadiz water project

Representative District Status BHFS-E, PC PAC Slater Other CDZI Executives Total
Jim Costa D-Fresno in office - 7,400 32,200 $39,600
Duncan Hunter R-El Cajon in office 5,500 - - 5,500
Darrell Issa R-Vista in office 4,000 - - 4,000
Ed Royce R-Hacienda Heights in office 4,000 - - 4,000
Ken Calvert R-Corona in office 2,500 500 500 3,500
Paul Cook R-Yucca Valley in office - 2,000 1,000 3,000
Linda Sanchez D-Cerritos in office 1,000 - - 1,000
Loretta Sanchez D-Santa Ana in office - 1,000 - 1,000
Gary Miller R-Redlands retired - 1,000 - 1,000
Doug LaMalfa R-Auburn in office 500 - - 500
Tony Cardenas D-Panorama City in office - - - -
Tom McClintock R-Roseville in office - - - -
Scott Peters D-San Diego in office - - - -
Collin Peterson D-Minnesota in office - - - -
Dana Rohrbacher R-Huntington Beach in office - - - -
Norma Torres D-Ontario in office - - - -
Mimi Walters R-Laguna Niguel in office - - - -
John Campbell R-Irvine retired - - - -
Gloria Negrete-McLeod D-Ontario retired - - - -
Totals $17,500 $11,900 $33,700 $63,100

In the company’s words, apparently now a “palpable dark cloud” hovers over the Congressional decision-making process.


Preview of coming attractions

Update May 22: Cable Car is Short Plus500.

Disclosure: Short.

Recent developments at a company that I have been researching over the past few months have prompted me to want to document my thoughts sooner rather than later. It’s not usually my approach to write a long, “strong sell” hit piece, but I’ve been planning a Hempton-style, multi-part series of blog posts to explain my positioning that may finally be timely. Investor Relations stopped returning my calls, and I think I understand why now. It’s a busy week from a personal and professional standpoint, but time permitting I hope to share why I’m now pressing the position.

A small teaser:


Below is the 2013 income statement of the company’s principal operating subsidiary, which represented approximately 87% of reported revenue for the Group:

2013 annual accounts

Now compare the 2014 accounts of the same subsidiary under a new auditor:

2014 accounts

More to come.


Hanergy and the Shanghai-Hong Kong Stock Connect 2

Disclosure: No position in 566 HK.

Northbound short selling has been allowed for six trading sessions on the Shanghai-Hong Kong Stock Connect (沪港通) and so far not a single A share has been sold short. It’s not yet possible at Interactive Brokers, so apparently other brokers are also still figuring out the settlement logistics.

Hong Kong-listed shares, on the other hand, remain fertile hunting ground for short sale candidates. But seller beware! The influence of Shanghai’s frothy, retail-driven stock market may be beginning to be felt. One line in a WSJ article about the recent unexplained and unjustifiable rise of Hanergy Thin Film (566 HK) caught my eye: “The company’s share price has nearly quadrupled, to HK$6.80 on Friday, since the trading link opened on November 17, making it the best-performing and most widely held stock in the program known as Shanghai-Hong Kong Stock Connect.” To what extent might retail interest have driven such a massive change in the valuation of a loss-making solar panel manufacturer whose accounting and relationship with its parent has long drawn scrutiny from shortsellers?

First, an anecdote

I am reminded of a conversation I had with my uncle in Shanghai earlier this year, a few days after the Shanghai Composite fell nearly 8% in one day. Not to pick on him, but my uncle is the quintessential retail daytrader. He and my aunt have long enjoyed telling family about their occasional speculative stock trades, but as the Chinese A-share market has heated up, they have become more serious about actively trading their savings. My 16-year-old cousin proudly told me about her first real-money three-bagger last fall, which she had picked at random. A sign of the times, perhaps?

Since I invest for a living, we were naturally very interested to hear one another’s perspectives on the stock market. It was fascinating to learn about the range of financial products and securities lending-related innovations available to retail accounts in the mainland, many of which are quite complex. But I must confess; the conversation suffered from more than the usual language barriers. It wasn’t just that I don’t recognize the Chinese name for, say, Bollinger bands (“布林线”) off the top of my head—we were speaking entirely different languages. I told him about the meeting we had had with NetDragon the day before and how I think the business trades well below asset value despite exciting growth prospects over the next 3-5 years. He responded by explaining how he only buys a stock when it has had at least 3 “red” days in a row, and that after a couple of “green” days it was time to sell. (In China, the color red is considered good luck, so the red/green negative/positive association the rest of the world uses is inverted—a small part of my motivation for choosing neutral blues for Cable Car’s logo! See the tickers in the photo below from January.)

View of stock tickers in the Shanghai financial district January 2015

View of stock tickers in the Shanghai financial district January 2015

To his credit, my uncle understands the dangers of trading on margin, unlike much of his competition, and he is quite thoughtful and careful about his position sizing. But like most of his fellow retail traders in China, he is not evaluating stocks on any sort of fundamental basis. He is a momentum trader and a speculator with a long bias, and he knows that eventually what goes up must come down.

Back to Hanergy

In my opinion, this sort of non-fundamental trading creates opportunities for fundamental investors with a longer time horizon. Conversely, it can also be a reason why mispricing persists in markets that remain dominated by retail investors. Estimates vary, but Shanghai trading is thought to still be at least 50% retail-driven, with Hong Kong around 30% according to INSEAD. In US markets, it is often clear when an illiquid, low-capitalization security has been pumped by uninformed retail speculators. There is typically a paper trail of newletters or cheerleading posts on message boards. When it comes to Hanergy, I may not be looking in the right places, but I haven’t seen the usual signs of a pump-and-dump in Chinese media.

It’s possible that interest may be arising through boiler room-style marketing by brokerage firms, but it seems at least plausible that the simple fact of the recent rise in the share price has created a momentum bubble that feeds on itself. My experience with Chinese retail investors is that they like to buy stocks that have gone up recently. On the surface, it seems improbable for a company with a US$36 billion market capitalization and meaningful float to be influenced by retail volume. However, retail interest—especially through the Stock Connect Program—has contributed a significant amount of the trading volume during the rise. Southbound trade in Hanergy has exceeded 25% of trading volume on some days, and it has represented net purchases (buy volume minus sell volume) every day except one since the beginning of February.

The chart below shows the percentage of total trading volume represented by estimated gross Stock Connect volumes as the price has increased.

Southbound Stock Connect volumes have represented 7-26% of daily Hanergy trading volume since February

Southbound Stock Connect volumes have represented 7-26% of daily Hanergy trading volume since February

For better or worse, I have been unable to secure a borrow on Hanergy, so this is more of an academic exercise for me. But it is fascinating to witness the formation of a valuation anomaly and speculate as to its cause.  Perhaps the bubble will continue as long as mainland retail money continues its net inflow into the stock.

 


The raw daily data below is from FactSet and the HKEX Daily Top 10 Southbound securities, available for trading sessions beginning February 2, 2015. *Estimated from February monthly figure.

Date Buy
(HKD m)
Sell
(HKD m)
Net
(HKD m)
VWAP
(HKD)
Est. Stock Connect Volume
(m shrs)
Total Volume
(m shrs)
Stock Connect %
2-Feb 13 6 7 $3.61 5 95 5.6%
3-Feb 18 12 6 3.64 8 80 10.1%
4-Feb 19 13 7 3.77 9 116 7.4%
5-Feb 67 21 47 4.09 22 187 11.5%
6-Feb 39 18 21 4.20 14 127 10.6%
9-Feb 34 23 11 4.22 13 79 16.9%
10-Feb 46 21 24 4.31 16 91 17.3%
11-Feb 102 25 77 4.51 28 167 16.9%
12-Feb 75 7 67 4.47 18 116 15.8%
13-Feb 55 8 47 4.53 14 104 13.3%
*17/18-Feb *10 *18 (8) 4.35 7 73 9.0%
25-Feb 58 7 51 4.48 15 60 24.4%
26-Feb 25 9 16 4.52 8 63 12.1%
27-Feb 48 7 42 4.51 12 64 19.0%
2-Mar 123 7 117 4.69 28 107 25.9%
3-Mar 138 37 101 5.10 34 178 19.2%
4-Mar 239 64 175 5.92 51 414 12.3%
5-Mar 491 337 154 7.58 109 583 18.7%
6-Mar 250 182 68 6.84 63 322 19.6%
9-Mar 154  66 87 6.65 33 152 21.7%
Total 2,005 887 1,118 $5.50  506 3,180 15.9%

 

 


Short WRLD 6

Disclosure: Short World Acceptance Corp (WRLD)

For round two of the FactSet/SumZero Top Idea contest, I wrote about WRLD. Since this is the first full-length short thesis I’m publishing on the blog, a bit of background from the FAQ:

Why does Cable Car short stocks?

Although short-selling is logistically difficult and increasingly competitive, it is an essential tool to reduce the impact of market downturns on a portfolio. During falling markets, many stocks will decline in price, even those of companies with strong business models. During these times, having capital available to reinvest in high-quality companies can provide an important source of return over the long term. Short positions that increase in value when other positions are declining provide incremental capital when it is needed most.

In normal times, short sales can also generate incremental return by capitalizing on mispricing that results from misunderstandings in the marketplace. Security selection involves recognizing asset prices that can decrease as well as those that can increase. Cable Car does not view short selling as a moral judgement. Although Cable Car sometimes shorts companies it suspects of fraud or malfeasance, short positions often reflect Cable Car’s view that the market’s expectations for an otherwise good business have gotten too high. The activity of short sellers is an important part of fully functioning capital markets.

In general, I am reluctant to publicize most of my short positions. Although I’m a firm believer that short sellers play an important role in financial markets, they tend to attract unwanted attention. I’m not trying to demonize anyone in my report, and hopefully no one wants to demonize me. WRLD is a crowded position (there was even another write-up in the contest about it), so I don’t think I’ll be poster child for it. Not that I’d mind if it works out the way I anticipate!

This piece is written for other professional investors and discusses the technical factors and timing considerations that make me think WRLD is compelling today. As always, feedback and dissenting views are welcomed.


Click here to download the write-up.

By accessing the report, you acknowledge that the information contained therein is for information purposes only and should not be considered a recommendation to take any action with respect to any security.


CYNK: Sometimes your prime broker is looking out for you 1

Disclosure: No position in CYNK. Thankfully. This post is intended to discuss my reaction to a topical market situation. It has been edited to remove the details of trading activity in CYNK in order to avoid reference to the performance of a past specific recommendation. 

Last spring, before the Bitcoin mania had peaked and prior to starting Cable Car, I discovered a way to short BTC using a very sketchy online exchange. I briefly shorted a single Bitcoin in a personal account, covered after a small gain that almost made up for the transaction costs, and happily withdrew my balance with the learning experience as my reward. A part of me wanted to do it just to be able to say I had one day. Reasonable people may disagree over whether crypto-currencies ultimately have any value (I am not a believer), but I found the notion of shorting something truly worthless to be irresistible. Financial assets that appear to have no intrinsic value at all — pump-and-dump schemes, penny stocks, frauds, some bankruptcies — draw a certain type of value-oriented short-seller like moths to a flame. And it can be playing with fire.

The latest such sign of the apocalypse making the rounds is Cynk Technology Corp (CYNK), which I’ve seen mentioned by no less than half a dozen investors I respect. CYNK is a Belize-based pink sheets pump-and-dump, presumably, with negative shareholders’ equity, no revenue, and a vague intent to develop a social media business. Despite all that, it is a startlingly successful stock promotion scheme, with what appears to be a $4.3 billion market cap on paper after today’s 150% gain, up from $23 million a month ago. The usual pattern of such things is that after the price reaches stratospheric levels, promoters sell their shares, the share price craters, and the hordes of day traders who had helped run up the share price move on. The underlying promotion activity can be illegal, but it is very difficult for the SEC to police. I have no insight into whether any laws were broken to get CYNK to where it is today, but the outcome is the height of absurdity. The intrinsic value of CYNK, to any reasonable observer, is zero. And yet here we are, watching a bubble in action.

This post is in fact a bit of a confessional. Last Tuesday, I shorted a very small position in CYNK that I closed not long afterwards. I am embarrassed to have participated at all. At the time, CYNK was already down over 40% intraday, and it appeared to be following the classic pattern of a “dump”. The fact that a significant amount of borrowable shares had become available from my prime brokerage suggested that the float might have increased due to promoters dumping their shares. Yet when I started to think about shorting it again on the way back up this week, no shares were available. I don’t actually think it’s a deliberate policy on the part of the brokerage to withhold shares in a situation like this (that confuses cause and effect — the lack of available borrow may have actually been the cause of a squeeze), but I was willing to short CYNK at $6/share this morning, had there been shares available. Since there weren’t, I have no position, and I avoided a more than 100% intraday loss. Usually I’m not pleased when I can’t borrow a stock I want to short, but this time I am!

CYNK closed today at $14.71. Were I still short, I could have tolerated the loss, but I’d be on some level just as much of a victim as whatever gullible shareholders are buying at these prices and will ultimately be left holding the bag.

I may still short CYNK, in very small size, if shares are available when it inevitably starts to decline. That’s what I feel the need to confess! It is ineluctable, this desire to have some (very carefully sized and curated) short exposure to what David Einhorn recently called “silly prices,” while hoping they don’t get any sillier.

But there is one caveat! One thing that may just hold me back is a notion I haven’t seen any of the myriad commentators discuss: does CYNK really have the number of shares outstanding it claims? Dishonest people have falsified many many things in unaudited financial statements. Why not share count? Couldn’t that line in its filings be just as fraudulent as the business itself? According to the limited filings it makes with the OTC bulletin board, CYNK had 291.45 million shares outstanding as of March 31, 2014. Even the OTC website itself is very lackadaisical about the figure. It has a typo that misstates shares outstanding as 191.45 million, throwing the market cap off by a whopping $1.47 billion! Even if the 291.45 million figure is correct, 210 million of these are held by the founder and sole employee of CYNK, and they supposedly bear a restrictive legend (how restrictive, I wonder?) preventing them from being sold. To some extent, only the float of 81.45 million shares represents real capitalization, but even that would be pretty absurd by now at well over a billion dollars.

Instead, I question whether there really are 81 million shares floating around. Cumulative volume traded in the past 30 days, since all this nonsense began, is only 1.5 million shares. Today, despite the massive price increase, only 124,000 shares changed hands. It is not uncommon for the targets of pump-and-dump schemes to trade several times their float in a single day. Why should CYNK be different? Either there is an impressively patient group of promoters waiting to sell their shares, or an extraordinarily bullish group of long-term penny stock investors (do such people exist?) withholding millions of shares from the current frenzy, or CYNK does not actually have anywhere near 81 million shares outstanding.

I hate to rain on the parade of everyone else as excited as I was about the insanely high notional market cap, but I don’t think CYNK really has the capitalization it appears to. Based on the low trading volume, I’d guess fewer than 1 million shares are held by people not connected to the company or promoters, if they even exist at all. At, say, a $14 million market cap, CYNK no longer looks quite so appetizing as a short candidate, even with an intrinsic value of zero.


Closing the loop on GLRI 3

Disclosure: Long GLRIW, Short GLRI. This post has been edited to remove details of trading activity. This post is designed to follow up on prior analysis regarding a current investment and should under no circumstances be considered an advertisement for the performance of past specific recommendations.

Although there’s a business to run, I do aspire to follow up on blog topics when I say I will. Only a few months in and it seems I’ve already forgotten about one. (I will cover the rest of the seed topics mentioned in my first post eventually). About 9 weeks ago, I said I would discuss how to value the post-transaction Glori Energy (GLRI) business. To my handful of non-blood relative readers, sorry!

Valuing GLRI

As it turns out, I couldn’t quite get comfortable with the valuation exercise myself. I have been exiting my position in the warrants and am presently fully hedged on the remaining position. As mentioned before, Glori has an interesting model. They acquire producing oil fields, apply their proprietary technology, and if successful increase recoveries and reduce the decline rate of the field. In principle the business should be able to generate attractive internal rates of return by purchasing oil fields at an implied yield (from the seller’s perspective), increasing that yield through their recovery technology, and then selling at a premium to redeploy the capital into other fields. By repeating this process using leverage, the business could produce attractive returns over the long term.

While yields might be attractive on a project basis, the ultimate returns to shareholders are considerably more difficult to assess. It is uncertain what projects will be acquired, on what financial terms, and of course with what degree of success in improving the ultimate recoveries. GLRI’s disclosures indicated that the AERO recovery system has had mixed success, including at least one field where recoveries did not improve at all, with a great deal of sensitivity to the geologic conditions of the fields where it is deployed. From my perspective, that makes the success of the technology simply too difficult to handicap, and I will happily let others underwrite the long-term success or failure of the business.

As for valuation, using multiples of forecast EBITDA or earnings is a bit silly given the uncertain acquisition profile, though that hasn’t stopped a few sell-side firms from trying. At the arms length valuation established by the transaction and the new fully diluted market cap, the best one could do in my opinion would be to attempt to extrapolate from the yield profile of the most recent acquisition to the company as a whole. Treating the stock like a fund, assuming the technology works as promised and the company can redeploy all of its available capital in acquisitions on similar terms, what would be the notional levered cash flow yield? At least that is how I would try to approach it. The stock is a little like investing in a listed oil and gas private equity vehicle, and with confidence in the underlying technology, one could conceivably compare the prospective risk-adjusted long-term returns to similar investment opportunities elsewhere. At the current price, there is implied value to the technology. If it doesn’t succeed increasing recoveries, then GLRI should be worth little more than its net asset value. The right assessment of asset value is of course an entirely separate discussion, which depends on reserve valuation estimates, the oil price, and interest rates, but it is significantly below the current enterprise value, and there are plenty of other options for E&P speculation.

Arbitrage

As the initial write-up indicates, this was a special situation relating to a one-time transaction. I am ultimately not willing to underwrite speculation on the value of the business itself.

Meanwhile, the conversion right on the warrants has made for an interesting arbitrage situation. The 10:1 conversion window runs May 16-June 15, and creates a sort of convertible arbitrage opportunity during this period. At times during the window, it has been (and may again become) possible to purchase 10 warrants for less than the value of 1 share of GLRI. GLRI was difficult to locate early in the window, but for accounts large enough to participate in a pre-borrow program, I chose to hedge the entire warrant position by shorting GLRI. As the price of the underlying has risen closer to the $10 strike price, the warrants have become more efficiently priced. The slight premium to GLRI in the current price reflects option value over and above the conversion right. This is of course a basic idea behind convertible bond arbitrage — by owning a convertible security with an embedded option and hedging the price risk by shorting the underlying, one can capture some option premium while limiting downside. Cable Car does not generally engage in convertible arbitrage, but at the moment it offers a potentially more attractive risk/return tradeoff than selling the unhedged warrant position outright.


What happens when you short a stock to zero? 12

Disclosure: This post contains details of historical trades made in a personal account prior to the establishment of Cable Car and does not represent recommendations by Cable Car.

The short answer is that it may not be worthwhile.

One motivation I have for blogging is to discuss elements of investing I wish I’d been able to learn about more easily when I first encountered them. There is a surprising paucity of information online regarding the mechanics of trade settlement and clearing, although the details can be relevant to the outcome of an investment, particularly a short sale. Much of what you might read on the topic is incomplete and potentially misleading. The handful of times I have been short a stock all the way until the bitter end, I was surprised at the unforeseen costs. Note that this post is specific to my experience with Interactive Brokers, but it is likely similar to the process at other brokerages.

It turns out that when a stock is delisted, short positions are not necessarily closed immediately. Short sellers are exposed to the risk of an indefinite, high-interest stock loan until shares are cancelled. For this post, I’m focusing on shares that are cancelled after a bankruptcy proceeding and expire worthless. However, other delisting events can lead to similar issues. For example, if a stock is the subject of a takeover offer, the shares may have appraisal rights. If the short position is assigned against shares that exercise these rights, the short seller would ultimately be responsible for the court-ordered compensation months or years later. More on that another time, perhaps.

Bankruptcy

When a company exits bankruptcy protection in the US, the plan of reorganization or liquidation specifies what will happen to the stock. Usually, but not always, common equity is cancelled and becomes worthless on the effective date of the plan. Prior to this, shares of bankrupt companies are traded on the pink sheets with the ticker suffix -Q. Although primarily the province of speculators and day traders, these securities sometimes still have significant market cap and liquidity, presenting a tempting short sale candidate. Sometimes this residual equity value is the result of optionality, reflecting the chance the equity ends up with a recovery. Indeed, there are many examples of how shorting a bankrupt company that is not certain to go to zero can be a very dangerous proposition:

American Airlines (AAMRQ) stock price during bankruptcy

American Airlines (AAMRQ) stock rose more than 40x from its close of $0.26 when it filed on November 29, 2011 to emergence on December 9, 2013.

However, in other situations, this option value is illusory. In the case of a pre-pack bankruptcy, for example, stakeholders have already agreed upon a plan of reorganization in conjunction with the initial bankruptcy filing. Court documents may clearly indicate that shares will be cancelled, and no near-term improvement in operating results could possibly salvage any value for shares. Up until a plan of reorganization is confirmed by the bankruptcy court, there is theoretically a risk that a proposal could emerge that would result in an equity recovery. Yet even after a plan has been confirmed, soon-to-be-worthless shares may still exhibit a great deal of volatility. These are situations where it may be desirable to short the stock (or maintain an existing short position) until the shares are ultimately delisted and cancelled.

Process

Although this post is about the trade mechanics, I’m no expert on what happens behind the scenes at the brokerage. But as I understand it, after shares are delisted, short positions are matched against long positions held at the same brokerage through a process called assignment. Opening the short position may have required the prime broker to borrow shares from another broker-dealer. If the broker can locate shares in its own inventory (from another client) to offset the short position, or if the loan was internal to begin with, then the short position can be closed immediately. The broker returns the borrowed shares to the long holder, the short position is closed, and the shares are marked to zero. The short seller keeps the short sale proceeds and the long holder the cancelled security.

On the other hand, if the stock loan was from a third party and the broker cannot assign the short position internally, the short position remains open even after shares stop trading. This is where things get problematic. If shares are available for borrow before a delisting at all, the interest rate is typically very high due to high demand. A short seller may be paying well over 100% APY on the loan and posting significant margin on the position. In the US, stock positions are settled by a central clearing house, the Depository Trust & Clearing Corporation (DTCC). While exchanges will typically suspend shares from trading after the company emerges from bankruptcy and shares are extinguished by court order, the shares do not actually cease to exist until DTCC marks them to zero. DTCC is a large organization, and the process can take a while.

I have had two very different experiences in these situations that illustrate the process.

Source Interlink (SORCQ)

Source Interlink (SORCQ) shares during bankruptcy

Source Interlink (SORCQ) filed for a pre-pack bankruptcy in April 2009 and emerged 60 days later.

Source Interlink is a periodicals distributor that restructured in 2009, after an ill-timed acquisition of a CD and DVD distribution business. The company filed a pre-pack, consensual bankruptcy that called for equity to be cancelled. Although an equity committee was formed, it was pretty clear (and had been for some time) that the enterprise value was less than the value of the outstanding debt. I shorted shares at an average cost of $0.12 and added to my position after the plan was confirmed on June 19. Shares were delisted on June 24, 2009.

Unfortunately, SORCQ was a low priority for DTCC, and Interactive Brokers was not able to assign the position internally. On June 25, the position was marked to zero but remained open. DTCC did not process the cancellation until September 3, 2009, 9 weeks later! Additionally, the SEC has a margin requirement for securities priced under $5, requiring a minimum of $2.50 in margin per share short. Due to these requirements, I had to post margin per share for the entire 9-week period, making it impossible to initiate new investments with the capital during this time. There was no way to close the position because SORCQ no longer traded, and nothing to do but wait. Given the large number of other interesting ideas in the marketplace at that time, it was probably not a worthwhile endeavor in the end.

K-V Pharmaceutical (KVPHQ)

KVPHQ shares during bankruptcy

Shortly before its plan of reorganization was confirmed, K-V Pharmaceutical (KVPHQ) shares spiked on false hope of an equity recovery.

More recently, I was intrigued by a pitch on K-V Pharmaceutical. The company is a pharmaceutical manufacturer whose sole product, Makena, has a much cheaper generic alternative made by compounding pharmacies. Despite FDA approval of Makena, sales disappointed due to lower-priced competition and the company filed for bankruptcy in 2012. K-V had nearly completed its bankruptcy proceedings when a bill in Congress last summer offered a sliver of hope to equity holders. The bill, a response to a widely publicized meningitis outbreak at a compounding pharmacy, could have limited competition from compounding pharmacies, which in turn would improve Makena’s prospects.

That may yet be the case if legislation passes in the future, but at the time of the bill’s introduction, Congress was about to go on a recess, and stakeholders had already agreed to a plan of reorganization. I shorted KVPHQ, covering after the brief entrance of Glenview Capital with a large stake, indicating possible formation of an equity committee. Surprisingly, Glenview appeared to change its mind after only a few days. Later on, KVPHQ was still available to short at $0.10 share even after the plan was confirmed on August 28.

Borrow was widely available on KVPHQ throughout the final weeks of trading; however, it was very expensive. Interactive Brokers charged an indicative rate of 120% APY; however, like many brokerages they have a policy of rounding up the collateral to the nearest $1.00. For a 10-cent stock, this meant the effective cost to borrow was a stratospherical 1200% effective rate. In other words, shorting at $0.10 would have cost more in interest charges than the short sale proceeds earned if DTCC took more than 30 days to cancel the position. Ultimately, I decided not to carry a position past the delisting, given the high borrow cost. I later learned that DTCC acted within a day of the delisting, perhaps given the higher profile of K-V relative to Source Interlink.

So is it worthwhile?

DTCC may have gotten more efficient, but there remain some short positions which stay open for months or years on end, pending action by the depositary. This presents an unacceptable risk of indefinitely tying up capital for most short sellers. The main reason to maintain such a position would be for tax purposes. If a short seller had a much higher basis from before the company became distressed in the first place, then waiting for the position to be closed would defer the short term capital gain until the position were ultimately extinguished.

Otherwise, seller beware.