Petroalgae And Entertainment Arts Research: A Tale Of 2 Shorts

 |  Includes: EARI, PABL
by: Edward Schneider, CFA

As Charles Dickens once wrote "It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness...". Thus is the final tale of two shorts that I have written about previously - Entertainment Arts Research (OTCPK:EARI) - here and Petroalgae (PALG.PK) - here.

I recommended shorting EARI at $9.80 or a $714M market value in March 2010. We were finally able to short some shares at $5 a few months later. Last week our fund closed-out its short position on EARI at a price of $0.06, equating to a market cap of $4M. The fund was able to hold onto 95% of its short position when covering yesterday. Thus, we made a nice profit on EARI.

On June 1, 2011, I recommended shorting PALG at $16.50, a $1.8B market value plus $57M in debt. PALG's last price was $13.50 on September 27. Last week, the bid-ask was $5.25 - $11.50. Until recently, the spreads were $1 to $2, and it traded most days. Despite the fall in the PALG stock, it was only a break-even affair for our fund. We initiated our short in March 2011. We had to continually scrape-out more hard-to-find PALG shorts after being bought-in a few times at $18 - $20 in the second quarter. In July, we had the last forced buy-ins on our remaining PALG position at $15.75, and have not been able to find any more shares since then. Thus, PALG has not been the best of times for our fund.

Both EARI and PALG remain absolutely worthless on a fundamental basis. Neither company has generated a dime in revenues nor has any future revenue visibility. Both companies burn a lot of cash. EARI failed to attract (forget monetize) Christian zealots to its web site via faith-based video games and online avatar opportunities, and is now trying to make money through online grass-roots Christian music without success. PALG is little more than a glorified swamp in Florida that hopes to someday produce bio-fuels from algae. PALG is still a science project today. Even in the unlikely case of creating a cost-effective, proprietary commercial operation someday, PALG will have no substantial revenues for at least five more years.

Both companies made it extremely difficult to short shares. It took us six months to locate EARI stock, and over one year to locate PALG shares. In both stocks, we were enviably the only short position.

The contrast in EARI and PALG is really 1) buy-ins and 2) backers. PALG has a controlled free float of 2% to 5% ($35M to $90M). PALG has large backers, namely Valens Capital Management, to support the stock. Valens funding power combined with a small float of less than 5%, contributed to very small amounts of PALG stock available to short, and once shorted, facing rising prices on low volume, followed by forced buy-backs of the stock. We wanted to hang on until PALG stock would capitulate, but that has not been the case so far. With a current market cap of $1.4B, PALG remains an attractive fundamental short.

On the other hand, EARI does not have large backers to prop-up the stock price. We also managed to avoid major buy-ins on EARI. With most shorts, the buy-ins are more prevalent before the stock price falls. Once the stock breakdown begins, there is less risk of buy-ins.

PALG and EARI are microcosms of the under-supervised OTC Bulletin Board and Pink Sheet exchanges (also see here). I will share with you how reverse takeovers (RTOs) work that was derived from my own experiences over the years with stock promoters (note: this is not a direct accusation against PALG or EARI).

A small investor group will buy a quoted shell company for say $1M at $0.01 per share, and may issue new management more virtually free shares, albeit with a lock-up. They then complete the RTO by backing a new business led by these new managers into that shell company and rename it ("Hypeco"). The key is that insiders own most of Hypeco shares directly and control some more indirectly through an alliance of brokers, promoters, bloggers and other parties. This "unholy alliance" then goes and promotes Hypeco shares. First, through whisper channels of the second circle of insiders who may pay $0.20, and then through a wider circle of unsuspecting retail investors that are overtaken by greed as they see Hypeco breaking-out above $1. To fund Hypeco's cash burn, management will issue primary shares at steep discounts to the quoted price, with a lock-up to eliminate short-term arbitrage.

How do insiders profit? The Insiders set-up an offshore holding company that will hold the trading profits from net gains of selling cheap shares. Because it is offshore, they make it difficult for the SEC to enforce the 5% disclosure rule. The number of years and man-hours for the SEC to prosecute a case, makes it a good bet that Hypeco's insiders will get away with it. Then the fun begins. Funded by this offshore holding company, insiders make a large bid at say $0.10, and control a small offer at say $0.20. Then the promotion starts, with retail investors being aggressively marketed by the unholy alliance as Hypeco breaks-out on large, albeit manufactured, volume.

For every unsuspecting retail buyer of Hypeco, there is an insider making tremendous profits on their super-cheap shares. The insiders keep some profits, and then recirculate the rest of that cash to push the stock higher. An ensuing cycle of "pump-and-dump" schemes sucker retail investors to chase these overvalued stocks. This insider profit cycle continues until the float becomes too large to control, Hypeco's burn rate becomes too ominous to fund, and/or there is a market crash which normally hits these bulletin board and pink sheet stocks the hardest. But by that time, the insiders have accumulated enormous profits.

These insiders profiteering off of less sophisticated retail investors truly deserve the wrath of today's Wall Street protesters, Was it not a larger 1789 protest of the French masses against income inequality that prompted Charles Dickens to write "It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness...".?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.