Editor’s Note: This article covers stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.
Since 2010, I have written about a dozen articles on shorting extremely overvalued stocks with literally no fundamental value (for the last three - see here, here and here). Most of the stocks were technology/media stocks that traded on the US OTCBB market; the rest traded on Nasdaq, Vancouver and London.
At the time of the recommendations, nearly all of these stocks had enterprise values ranging from $150M to $2.4B, with nominal or no revenues, negative cash flows, and dysfunctional businesses. At best, they were worth a small fraction of their quoted market value.
Extreme Fundamental Shorting - Track Record
|Poly Shield Tech.||SHPR||2/6/14||$0.94||$0.79||+16%||yes|
|Save The World Air||OTCQX:ZERO||8/7/13||$1.75||$0.89||+49%||yes|
Eyes On The Go
|New Energy Tech.||OTCQB:NENE||4/5/12||$2.74||$2.70||+1%||no|
|Location Based Tech.||OTCPK:LBAS||4/5/12||$0.47||0.085||+82%||no|
|St. Elias Mines||SLI.V||10/31/11||C$2.49||C$0.04||+98%||no|
Only 2 of 26 shorts actually lost money, and the median return was +68%, despite a bull market since 2010. Returns increased over times as gravity brought these stocks down to their fundamental value of near-zero.
The Quan Technology Fund's short returns could be higher (via price declines) or lower (via price increases) than shown above, depending on when Quan initiated and covered the position. That said, Quan lost money on only 23 of the 134 stock shorts since inception over four years ago; a success rate of 83%, which is in line with the above Seeking Alpha recommendations. Below are Quan's short stock returns:
Quan Technology Fund (QTF) Short Stock Returns
|QTF Stock Shorts||+18%||+11%||+13%||+56%||+9%|
|DJ Dedicated Short Index||0%||-25%||-20%||+4%||-22%|
Unfortunately, shorting these speculative bubble-like companies is not that easy, otherwise, everyone would be doing it. Some of the challenges include:
- Locating shares to borrow - these are often hard-to-borrow (HTB) stocks. From my experience, for every five requests, you may receive one locate, and it will not be for a lot of shares. You will need to persistently put in orders to build up a position. Even then, this strategy will have difficulty to scale in size, depending on the stringency of the screening criteria and the broker network.
- Forced buy-ins - on occasion, the counterparty will force you to buy-back shares, often at elevated prices. This tends to happen between three days and two weeks after shorting the shares. Once the stock starts to fall, chances of a buy-in diminish. Most of the short losses incurred by QTF were forced buy-ins, that we could no longer borrow at higher prices.
- High borrow rates - some HTB stocks have high borrow rates that can fluctuate over time. Of the QTF's current 13 shorts, the median effective interest rate paid today is 10% per annum.
- Large cash needs - substantial cash reserves are required to: 1) set-up a margin account - you will need to have at least $100k in cash to set up a margin account for shorting, 2) meet margin maintenance requirements - in the QTF currently, the fund is forced to hold $1.48 for every $1 in its current short portfolio, 3) keep a cash buffer for margin calls - extra cash is needed to avoid forced margin calls on the portfolio.
- Wide spreads and wily market makers in OTCBB stocks.
- Promotional schemes - often targeting thousands of retail investors, an ecosystem of lower-tier brokers, promoters, and insiders, team up to pump-up certain OTCBB and Pink Sheet stocks. It becomes a self-fulfilling frenzy until the promotional budget runs out. A short-seller needs to anticipate and plan for these temporary run-ups.
- Asymmetric returns - a short can gain only up to 100%, but its loss is unlimited.
If these obstacles have not turned you off, and you still want to try extreme fundamental shorting, here is some friendly advice:
- Short what you know - the bulk of our shorts are in technology stocks. We have been managing technology funds for 20 years, and have built-up technology expertise. This provides a distinct advantage, especially in the less-researched OTCBB and Pink Sheet stocks. Relatedly, successful fundamental investing requires thorough due diligence. There are no short cuts.
- Diversify - limit your initial short to no more than 1% to 2% of the portfolio. This allows you to buy more in case of a run-up, and limits risk in the unlikely scenario that fundamentals change.
- Use several prime brokers to increase your chances of locating shares such as Interactive Brokers and TradeStation to name a few.
- Cover when the risk-reward is no longer attractive - usually when the market caps get near $25M, it is time to cover and move onto greener pastures.
- Capital/other factors - sometimes these questionable companies get huge amounts of funding, with large institutional support. It may not be worth the risk to remain short; consider locking-in gains even if the market cap is above your exit target (e.g. TherapeuticsMD). Also, keep an eye out for share cancellations that substantially decrease the market cap.
- Watch the float - make sure there are enough free-trading shares so that the share price is not completely manipulated.
- Be cold-blooded and unemotional - these stocks are often volatile with a lot of press releases. Ignore the noise, and focus on important issues.