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Whenever I look at a momentum stock (with off-the-wall valuation metrics, mind you), one of the very first things I take a look at is the short seller interest in the stock. Short sellers, generally speaking, aren't stupid, but they're not always right. When I see a stock that was previously highly shorted start to see significant and "permanent" covering, then I have to have a really strong case for why I would want to go in after so many others were proven wrong.

However, when I see shares of a highly shorted (but rising) name continue to see a steady and marked increase in the number of shares shorted, I get the distinct impression that these short sellers view the share price increase as a "gift" and continue to further increase their positions. These shorts aren't usually individuals, but are in fact institutions/hedge funds who generally have done extensive research on the positions. They won't be so easily "scared" out of their positions when the stock marches up and, as unlikely as it seems during the stock's run, they usually win.

Why Do Short Sellers Short?

You probably think the following whenever a stock that you hold gets whacked on a particular day:

Damn those evil short sellers!

I notice, in particular, whenever somebody makes a short call here on Seeking Alpha, the longs usually get freaked out, make ad hominem attacks on the contributor, and even send very rude messages to anybody who may think the contributor has a point (my inbox is filled with some nasty hate mail). However, you should no more "hate" a short seller than you should someone who is long. This is a market, and in order for it to exist, there need to be contrasting views.

In fact, by hating short sellers, you may as well hate anybody who has ever hit the "sell" button on any particular stock. They're doing the same exact thing a short seller is doing: betting that the odds are good that the stock goes down from the sell point.

With that out of the way, short sellers commonly short for the following reason:

  • Belief that a company's fundamentals do not match up with reality (i.e. a stock bubble) and that a correction is inevitable (this is the most painful one for short sellers, since the market can remain irrational for a long time)
  • Strong suspicion that there is fraud going on and expect the stock to eventually go to zero as truth unfolds
  • They believe that the company's main source of profits/revenues is in secular decline and that bankruptcy is not unlikely
  • An expectation that recent outsized growth is due to factors that are unlikely to be sustainable in the longer term

So, what's the short interest for 3D Systems (DDD) look like?

The Shorts Aren't Giving Up

Take a look at the trend in the short interest in

Notice that the short interest has more than doubled since 2/15, meaning that even as the stock has tripled, the shorts have increased their bets all the way up, with only a relatively few of them giving up and covering (notice the "spurts" of covering immediately followed by more shorting). This is a red flag for those going long the stock, and I believe that we have seen this sort of thing before.

Improving Fundamentals, But Not Organically?

3D Systems is a momentum stock fueled by a string of earnings/revenue beats that appear to be fueled by acquisition after acquisition, as Mr. Georgi Dimitrov very deeply analyzed so keenly in his article, "3D Systems: A Sobering Reality". It is quite easy to grow all relevant metrics when you acquire businesses that generate revenue and free cash flow.

It seems to me that despite the stock's rise, the short sellers know that it is only a matter of time before the revenue growth starts to slow considerably. However, the very real risk is that these acquisition sprees, coupled with further hype, could keep the shorts waiting (and/or feeling the squeeze) for months, if not years.

The Stock Is Easily Moved

One thing that comes off as particularly interesting is that the stock is quite easily moved by groups such as Citron Research. The most recent downward move was caused by a report from the aforementioned firm that basically pointed out what many had been pointing out for months: 3D printing is a neat idea, but it probably won't bring the fundamental financial riches that people buying the stock at these levels expect. Now, it's not so much the content of the report that's striking, but rather the intense reaction that the share price saw as a result of the report:

DDD Chart

DDD data by YCharts

The volatility and sensitivity to even the slightly bit of negativity is indicative of just how tenuous of a position the company's lofty share-price happens to be in. This should give any serious investor some pause.

This brings me to my last point: 3D Systems is exhibiting the classic signs of a bubble.

Bubbles Everywhere...A Reminder

3D Systems is a Wall-Street darling stock, which in the absence of fundamentals that support the stock price movement, translates into "bubble that is about to burst". Just look at this chart and tell me where you've seen it before:

DDD Chart

DDD data by YCharts

In case you've been living under a proverbial stock rock, here are some other examples of charts that looked exactly like that:

RIMM Chart

RIMM data by YCharts

BVSN Chart

BVSN data by YCharts

GMCR Chart

GMCR data by YCharts

MCP Chart

MCP data by YCharts

It's very much like the typical penny-stock pump and dump, but with a bit more legitimacy since the companies (including DDD) don't trade on the pink sheets. The story, however, is always the same: the stock gets pumped and pumped up as the company keeps "beating" estimates and expectations from the sell-side. This leads to upgrades, flimsy explanations for sell-side analysts' earnings multiple targets, and a general hysteria. The dips are bought, the rips...are also bought, and the stock essentially is a money making machine for anybody who buys, and somewhat disastrous for those who short/sell...until the end.

See, bubbles all end. Buyers get exhausted and move in to take profits, which obviously involves some selling. As the stock price sees selling pressure, others who are also sitting on paper gains start wanting to take profits. This, of course, leads to a whole bunch of stop losses from the day-traders and the swing traders being triggered, leading to even more selling. And, of course, on top of all of this, the guys shorting on technicals swarm in and lay waste to the stock.

Some people try to "buy" this final dip, and you often see them screaming on message boards and StockTwits at how they're "buying the dip" and thanking the community for the "cheap shares", not realizing that they've just paid 100x earnings for a stock that everyone is now trying to get out of. They eventually get stopped out, or they're left holding the bag, watching their investment shrivel in horror.

This is starting to look like the "final" dip, but it is not yet confirmed:

(click to enlarge)

If the stock manages to hold above the blue line (50 day moving average), then it's not yet time to pull the trigger on the short sale. However, if it breaks that line, then I believe that there will be a triple play of profit taking, technical shorts, and long traders' stop loss orders being triggered, leading to a quite steep decline. If it breaks the red line (200 day moving average), then this stock is toast and the stock will, more likely than not, drift back into the $20 range where it was before all of the excitement began.

Conclusion

I think the cat is out of the bag on the "revenue growth by acquisition" story and believe that the stock has been in a momentum-fueled bubble over the last year. While I do not suspect fraud, I do expect that this is very near the end of the run for the company's stock. You have a $3.4B company that trades at 8.6x book, 10.38x EV/Revenue, and 43x EV/EBITDA. All with a technical picture that is looking bleaker, and a bunch of shorts that have not been scared out of their positions despite the stock's run.

Just be careful. Momentum stocks are fun to ride up when the getting's good, but at this stage of the game, the music could stop at any moment, and you could be left holding a very big bag. That being said, shorting such a low-float/high hype stock is still very dangerous. I wouldn't short it, but I would have a very difficult time going long for any reason other than a day trade.

Source: 3D Systems: Do The Shorts Have It Right?