My recent pieces on the U.S. Treasury bubble and our "House of Cards Economy," China's decline, and the alarmingly negative long-term fundamentals in Europe have, admittedly, been bearish. I say this with no regret. I'm not an eternal pessimist. In fact, I think our next crisis will give birth to an American population with the will to elect politicians on the basis of sound economic policy. This new America will consistently vote for less government spending, lower taxes, and less government intervention within the free market. Certainly, Americans understand that a purely free market leads to obvious problems, but our new leaders will largely avoid aggressive interventionist policies.
One can certainly hope.
My general thesis on the issues our economy faces in 2012 and beyond can be seen in the linked articles. That being said, while 2012 offers plenty of opportunity on the long side, the short side has, in my opinion, the most exciting profit potential. In addition to issues specific to my short ideas, a sick global macro picture will weigh on stocks all year. These issues include:
- A deteriorating eurozone situation, with a lack of political support (thankfully!) to fire up the printing presses and debase the euro. This will lead to actual structural changes (and several years of a painful decline in what was an artificial standard of living financed by outrageous spending), or outright defaults across the eurozone.
- A deadlocked U.S. economy with legitimate high-inflation prospects driven by a rapidly expanding money supply and artificially low interest rates (more on this can be seen in the treasury bubble piece).
- The end of astonishing growth in China and India. While a correction in China may actually have positive lasting effects back here in the states, both nations are major sources of international demand. Additionally, U.S. firms, particularly those within the technology sector, derive large amounts of their revenues from China.
The 2 Best Short Ideas for 2012
Idea #1: Short Investment Banks: To understand why to short some of Wall Street's most recognizable names, it's necessary to understand the economics of investment banking.
Investment banks generate a large portion of their revenues from what is often termed as "activity." The largest Investment banks fight hard to be part of the underwriting groups for the sale of stock, both on initial public offerings and larger secondary offerings. Additionally, IBs will from time to time be approached by firms looking to merge with or buy another company. IBs will also even approach firms with merger or purchase ideas, using key, exciting words like "synergies" (if you didn't already know, investment banking is mostly salesmanship). The banks also underwrite sales of debt, including junk bonds; these bond deals are typically ultra-favorable, as most junk bonds just keep getting sold to the public until demand runs dry and investors have been wiped out.
Investment banks also engage in general market activities, including "market-making." Some IBs are paid commissions for clearing large transactions. In this ZIRP (zero interest rate policy) environment, IBs have begun to speculate (ok, trade) in the market more than usual. While IBs have long traded for their own accounts, Fed policy has induced a speculative fervor; Investment banks engage in various long term lending, though this has been limited since trading can offer better returns than lending can.
Finally, IBs also rely on wealthy clients to invest their money in their accounts. For this, the banks draw huge commissions.
Investment banks are quite levered to the stock market and its trends, investor optimism, and corporate optimism.
With every bull market comes an onslaught of expensive, fluffed, overhyped, and oftentimes worthless IPOs. 2011 was no slack in this area. LinkedIn, Zynga, Groupon, Angie's List, the list goes on and on. Recently, these new issues have gotten hit hard by the unwinding of a historic bull market; an undying occurrence.
With the exception of something, like perhaps, Facebook, investor appetite for multi-billion dollar issues from companies with no meaningful earnings and shaky business models is drying up pretty quickly. A worsening macro condition in 2012 will only extend and deepen investor pessimism. Most companies won't bother going public unless they're getting more than they give up (one reason why IPOs rarely make sense as investments), and 2012's market probably won't provide that. Hence, a decline in underwriting fees, and a subsequent hit to revenues.
As for M&A activity, it will likely be hard to get the financing for the biggest of deals. While the stock market has hung on throughout the euro crisis, credit markets have undeniably tightened and activity has slowed.
Finally, the Volcker Rule, which limits IBs ability to trade for their own accounts, is also expected to dig into profits over time.
We've already seen the effect of a weak market on Goldman Sachs (GS). Goldman lost money for only the second time since 1999 in 3Q 2011, and it doesn't look much better going forward. Revenues declined 60% from last year.
Most important is the exposure to potentially toxic European debt. Deutsche Bank has about 4.5 billion euros worth of exposure to the PIIGS countries alone; about 13% of their entire market cap. Goldman has nearly $40 billion in EU exposure. Morgan Stanley's $8.5 billion in meaningful exposure has worried investors for months.
Societe Generale is often speculated as the first big euro bank to fail, while Credit Suisse, BNP Paribas, and other European-based banks are fighting to cut exposure.
Finally, there is the important concept that these behemoth money centers are sitting on billions of cash that they cannot meaningfully deploy, and the fiat currencies themselves shed a good deal of their value while they remain stationary.
Specific Short Recommendations
Goldman Sachs (GS): Goldman and its P/E of 14 may appear to be fairly attractive, but there is a legitimate chance for Goldman to lose money in 2012. A continuation of weak corporate activity and a lack of investor interest is going to sap profits alone, but a European country's default could set the stage for a partial of complete run on deposits. As is the case with its counterparts, the counter-party derivative risk is also endless.
Societe Generale (OTC:SCGLY): Still worth nearly $17 billion, a short on SCGLY is basically a bet on the bank being shaken by a major European event, and an eventual bankruptcy. Europe is unlikely to have the resources or political will should SCGLY bankruptcy occur, so short-side investors stand to make a good deal of money here. Upside risk is particularly limited; actual business operations for IBs are worse in Europe than they are here, and the asset risk is endless.
Deutsche Bank (DB): Once again, significant asset risk, along with deteriorating business fundamentals and a general concept of deadlock make up for continued losses in 2012.
Morgan Stanley (MS): The market picked up on MS' European exposure a few months ago, and the stock took a large hit as a result. Regardless, plenty of downside remains, while the upside is capped by unknowable asset risks, a competitive and declining industry, and poor market sentiment.
Idea #2: Short Overvalued Momentum Stocks with Poor Business Models: If there is one thing in particular nervous investors hate with a passion, it's shaky business models with poor underlying cash flows and obscene valuations.
In bull markets, everything looks good. It doesn't seem ridiculous to assume a decade of 30% annual EPS growth when your favorite momentum stock has been crushing broader market gains. Price to earnings multiples, price to book, profit margins, and everything else goes out the window, except for a buzz-stat, like subscriber growth, or projected revenue growth (without considering how much those revenues cost).
Specific Short Recommendations
Salesforce.com: I've written a bit about Salesforce (CRM), and how their cute press releases have highlighted Non-GAAP earnings growth, with tiny little blurbs at the bottom mentioning how they expect to lose money in 2012, and imply extended losses:
For the full fiscal year 2012, the company expects to report a GAAP net loss per share of approximately ($0.03) to ($0.01), while diluted non-GAAP EPS is expected to be approximately $1.30 to $1.32. All EPS estimates include a one-time tax benefit of $0.04, associated with the acquisition of Radian6. The non-GAAP estimate excludes the effects of stock-based compensation expense, expected to be approximately $238 million, amortization of purchased intangibles related to acquisitions, expected to be approximately $60 million, and non-cash interest expense related to the convertible senior notes, expected to be approximately $11 million. EPS estimates assume a GAAP tax rate of 113%, and a non-GAAP tax rate of 33%. For the purpose of the EPS calculation, assume an average basic share count of approximately 136 million shares, and an average diluted share count of approximately 145 million shares. Salesforce.com completed its previously announced acquisition of Radian6 on May 2, 2011, and these estimates include the forecasted operating results for Radian6 from that date forward. Radian6 estimates incorporate a preliminary purchase price allocation, and are therefore subject to change.
Trading at more than 7,000 times earnings, CRM has been pumped up by every major wealth institution in the country, and the inevitable unwinding is going to hit the retail investors. Almost every firm rates it as a buy or strong buy, which of course means they are selling it to retail investors.
This analysis is enough to short on, and the "surprise" loss in fiscal 2012 will be a major catalyst for selling, but a look at actual business specifics provide good insight for how bad things really are.
The company consistently produces profit margins of less than 1%, and the last quarter showed a .16% figure. Return on invested capital is a ridiculous .2%, while ROE was also .2%.
The business consistently produces returns of less than 5%, even in the best of times, while expansion requires large capital expenditures. It's literally the anti-investment. Throw in the fact that you've got a real catalyst in what will be construed as a surprise (it was in fact an earnings "miss" when they last reported, causing shares to fall to about $105 from $135), and you've got yourself an awesome short opportunity.
Dunkin' Donuts (DNKN): While DNKN is not necessarily a "high-flyer," it is significantly overvauled.
Most investors don't know the background behind exactly who floated the shares on the open market. If you think it was Dunkin's exciting new management team, you're mistaken.
Dunkin' was taken private by a group of three private equity firms (one of which is Bain Cpaital, Mitt Romney's old firm) a few years ago. unable to generate legitimate growth or natural profits for themselves, the firms paid themselves a nice $500 million "special" dividend to make up for their losses of both money and resources. The $500 million was dropped right on to Dunkin's balance sheet, and 25% of the shares were floated for the public. The firms retained 75% of the shares, with plans to sell at higher prices, obviously, in a short while. Not surprisingly, the owners are throwing another 22 million shares on the open market.
As I mentioned in a previous piece on DNKN:
Investors should really be asking themselves why, if DNKN is such a great investment, did the private equity investors sell out at an operating loss? And, as is true with all IPOs, selling shares in a company is quite literally selling pieces of the business, and if you were really getting a good value by investing in them, isn't management pretty stupid to give up the shares at a price lower than their intrinsic value? In this case, the investors probably realized that competing with Starbucks (SBUX), McDonald's (MCD), and regional stores is not an easy business, and that expanding nationally would require years of excessive investment that would take years to (maybe) see a rate of return.
The owners clearly have no motive to improve business, and they're selling out as fast as possible to greater fools. Time to short the Donuts and Coffee.
- Qlik Technologies (QLIK)
- Amazon (AMZN)
- LinkedIn (LNKD) (Still worth $6.5 billion)
- Baidu (BIDU) (Based on my Chinese "hard-landing" thesis, in conjunction with an overly optimistic valuation)
2012 is going to be a fascinating year. While it may not be particularly contrarian to want to be more exposed to the short side in 2012, the fundamentals lay out a pretty good case to do so.
For those familiar with options, puts are an obvious alternative to outright shorting, but options trading is complex in nature and can also be costly.
Additional disclosure: I will be initiating shorts in GS, DNKN, and likely DB in the coming weeks.