There has been an unusually strong downward pressure on the stock price of A123 Systems (AONE) recently. Many investors don't like this stock. Its financials are terrible. Investors usually agree that it is a company that has been floated above bankruptcy just because it is in the green technology. As a result, many investors are tempted to short the stock based on this latest downdraft. Many investors are happy that the inevitable bankruptcy filing is finally upon A123 as the company is burning through cash at an enormous rate.
However, shouldn't we ask ourselves: What if it doesn't go bankrupt?
I usually try to analyze possible trades not on fundamentals or return expectations but on the risk/return trade off. Here are couple things to consider before shorting A123:
- Keep your honesty about why you are shorting the stock. At the levels as of this writing, if you are shorting the stock you are basically going for bankruptcy. Don't kid yourself that you are putting a trade based on valuation, fundamentals or price trends. If you are short and the company goes bankrupt you'll double your money. Otherwise, you are basically toast. Also remember when you are short your gains are limited. However, your losses can extend to 4X or 5X of your invested capital if suddenly the company comes out with some unexpected good news (a new deep pocketed customer or a less pricey Fisker).
- The recent price action is similar to a technical capitulation bottom. Are you ready to handle the losses if it capitulates? Capitulation is a very important formation in marking a bottom which I have discussed extensively relating to natural gas (Natural Gas: Possibly The Best Trade Of 2012 Fast Approaching and Natural Gas Capitulation: Your Critiques And My Answers). It is possible that an acceleration to the downside can actually mark the end of a trend.
- Back to the bankruptcy argument, consider how many other companies are in terrible shape in the green sector. Then try to explain why Solyndra is the only company that went under, although it has been argued that green technologies are not ready for commercialization yet. Bankruptcy is a very rare phenomenon in the financial age of restructurings and bailouts. What are the chances that they will let a dominant company like A123 go under?
- Consider the argument of the bulls before shorting. The market cap is a little above $200 million, as of this writing. You are buying one of the dominant players in a sector that is probably in the midst of one of the biggest revolutions in transportation. Ask yourself do you want to go against a company that is of such strategic importance?
- Lastly aside from all the facts about the A123 specifically, do you want to put on trades in a stock that is so volatile? Don't trade this stuck just because it seems like a sure thing that it will go bankrupt. A high beta stock is not good fit (too risky) for a lot of investors no matter what the opportunity is.
In short, does A123 deserve to go bankrupt? Absolutely. Will it go bankrupt? Well, that is still not as sure a thing as many investors incorrectly assume. Before you put on your short trades ask yourself:
Can you handle the losses if it doesn't go bankrupt?