The Toilet Bowl Effect

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 |  Includes: ABKI, QQQ, WNDW
by: Edward Schneider, CFA

A lot of low-quality PIPEs and private placements are coming out lately. I just received two today.

Maybe we are witnessing the Toilet Bowl Effect. As the market keeps going higher, a lot of crap starts floating to the top. Any market correction would serve as a plunger, flushing these crappy stocks down the drain.

Further supporting this theory is the performance of the low-quality shorts in our fund. These tend to be the worst fundamental tech stocks on the planet with median EV/revenue multiples > 500x, hemorrhaging cash, weak balance sheets, and broken business models. After getting decimated in 2011, they started performing better in Q1 2011 on an equal-weighted basis, following the lead of the Nasdaq (QQQ).

Shorted Stocks Total Return*
Q1 2012 CY 2011
Shorts Total Return +1.8% +56.3%
Advancers/Short Losses 26 18
Decliners/ Short Gains 14 35
Nasdaq +18.7% -1.8%
* Shorted stocks' positive returns equates to a falling stock price.
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The sample size could be a bit larger and more diverse, but the anecdotal evidence intuitively makes sense. These are high-beta companies that thrive when risk is perceived to be very low. From my experience, these speculative OTC Bulletin Board stocks are the last to bloom (i.e requiring a longer duration bull market), and the first to wilt (i.e. fall quickly on the first sign of a market correction). But when they bloom, they can go up dramatically, and that is the best time to short them if you can locate the shares.

The top five year-to-date stock price increases among our shorts are Eyes On The Go, New Energy Technologies (NENE.OB), TherapeuticsMD (NYSEMKT:TXMD), Location Based Technologies, and Abakan (OTCPK:ABKI). These stocks are due for a fall on a fundamental as well as technical basis, in our opinion.

Susceptible Shorts
Shorted Stock Ticker Price 4/4/12 YTD % chg Ent Val EV/Revs Net Loss
Eyes On The Go AXCG.PK $0.14 +600% $164M 40429x -$0.4M
New Energy Tech NENE.OB $2.74 +134% $55M No Revs -$3.0M
TherapeuticsMD TXMD.OB $2.50 +67% $214M 172X -$12.9M
Location Based Tech LBAS.OB $0.47 +56% $91M 1540x -$9.3M
Abakan ABKI.PK $1.55 +50% $98M 109x -$2.1M
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At the onset of 2012, we provided a positive stock market outlook for 2012 (see here). The market may have more upside. Still, it is more challenging today to find the >2x home-run long stocks, after the extended market rally since December. On the other hand, these bubbly shorts are looking increasingly attractive.

Disclosure: I am short NENE.OB, OTCPK:ABKI.

Additional disclosure: I am also short TXMD.OB, AXCG.PK, LBAS.OB