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Edward Schneider, CFA
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Edward Schneider is a managing director of Quan Management LLC. Mr. Schneider has over 25 years of investment experience, including 18 years managing technology funds in both quoted equities and venture capital. Mr. Schneider holds a CFA designation, an MBA from Thunderbird and a BA from Emory... More
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    Mar 24, 2010 9:16 PM
    I have always been amazed at how certain stocks with no revenues, heavy losses, weak balance sheets, weak prospects, and questionable management can obtain exaggerated market caps sometimes in the hundreds of millions of dollars. These stocks can defy gravity for longer-than-expected periods, especially during bull market runs. Eventually, the stock prices deflate, although the market caps decline more gradually due to a rising share count.

    First, I would like to address how gravity can be defied for substantial time periods. In recent years, Reg SHO and other measures were introduced to curb naked shorts and generally protect smaller stocks. A by-product of Reg SHO, however, was to shelter promotional penny stocks that are pumped up by insiders. Previously, it was easier for the market mechanism to efficiently price these stocks.

    The biggest challenges today are locating shares, avoiding buy-ins, dealing with excessive margin maintenance requirements on sub-$2.50 per share stocks, obtaining reasonable borrow rates for an extended time period, dealing with OTCBB and Pink sheet market makers that manipulate stocks. Unlike Nasdaq, there is no requirement to respect the best bid and offer, nor is there any requirement to honor locates - creating a short squeeze on settlement date or thereafter. So currently, a tightly controlled float, high borrow rate, feisty market maker, low stock price, good promoter to pump the stock, and deep-pocketed backers that fund the cash burn, can lead to an inefficiently priced stock that is difficult to crack.

    (As a side point, is it fair to protect these pump-and-dump stocks, where insiders get rich at the expense of unsuspecting retail investors? Is it correct for OTCBB and Pink sheet exchanges to treat investors differently? Is it necessary to create arbitrary margin maintenance requirements on faulty math assumptions that protect penny stocks from being shorted?)

    So how does gravity bring these stocks back down to earth? Dilution to fund these negative cash flow businesses inflates their market caps, as does pumping up the shares on speculative news. A rising market cap with no fundamentals often creates more short interest (overcoming the above-mentioned barriers) and greater insider selling. Finally, a macro downturn that sucks liquidity out of the market is a death knell for most of these pump-and-dump stocks.

    I read a post by stockerblog from February 2007 on fuel cell stocks (seekingalpha.com/article/27146-major-fue...).
    An indicative sample of the extremely overvalued stocks mentioned in the article were decimated. ECOtality (ETLE, price/sales of 137x in Feb 2007) fell from about 100 in February 2007 to 5 today. Hydrogen Engine Center (HYEG, P/S of 411x in Feb 2007) went from 3.25 to 0.06. Medis Tech (MDTL, P/S of 900x in Feb 2007) slumped from 17 to 0.07. Normally, once these stocks begin their downward spiral to earth, they never fly again, although ECOtality is trying to resurrect itself. All three of these stocks experienced declines since February 2007 which then accelerated during the market crash at the onset of 2009.

    Sometimes, however, these pump-and-dump stocks can crash quickly irrespective of market conditions. This can be due to a confluence of factors such as how high was the market cap inflated, initial low short interest levels, solvency fears, insider lock-up expiration, just to name a few. For example, over the weekend, I posted a blog on Entertainment Arts Research (OTCPK:EARI) at $9.80. EARI fell 30% in three trading days to close at $6.90 on Wednesday, but still sports a market cap of $500M (http://seekingalpha.com/instablog/608449-techshort/60052-extreme-tech-shorts).

    Sooner or later, gravity wins.



    Disclosure: No positions in stocks mentioned
    Themes: tech short
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