Life and Death
Its often difficult to tell which companies have the right stuff to thrive. Look at solar - there are a host of solar companies each with somewhat different technologies. Which are competitive right now? And it seems there's a new solar idea being bandied about every week. Can your solar stock survive what coming out of solar research labs, not to mention developments in the wider energy arena? Good question and as I'm not an energy technology expert I don't know.
I have a pretty good idea, however, that whatever wins, its gonna put another nail in the coffin of king coal. Yes I know coal use is doing very well worldwide, and this may continue, but in the US at least, between cheap natural gas, environmental regulation, and alternative energy at the margins, the trend is down. And while I anticipate the industry surviving in diminished form, its weakest members are getting pulled under. We've already seen two casualties, Patriot Coal and James River, and more look set to follow.
Similarly, online commerce has upended retail. Does that mean Walmart disappears in the near future? I doubt it. But what about Sears, JC Penney and Barnes and Noble? These companies have serious competitive issues and continued losses have already sapped much of their financial strength.
Which in a nutshell describes what I call dead shorts: companies in disrupted industries with serious competitive issues and weak financial resources. Its an investment strategy I've been refining since I shorting newspaper stocks in 2007 and have applied to coal and retail more recently.
Dying vs. Overvalued
Many like to short on valuation. And as the Amazons, Netflixs and Green Mountains of the world go vertical and depart from all connection with fundamentals their mouths begin to water.There's a certain appeal to thinking you're the smart one in the room, the contrarian who quietly smiles while the fools rush in and says told ya so when the inevitable comes. Except sometimes the fool rush has exhausted your margin and/or your psychological strength and you're forced to cover at the top.
I've shorted momentum stocks, sometimes done well - and sometimes very badly. I shorted Amazon in late 1998 around 200 and a couple months later was forced to closed at 192, or rather 576 when adjusted for a 3:1 split! I made the most of the money back shorting the likes of Juniper and Brocade when the bubble burst, but it was a very bumpy ride. The crash and recovery of 2002 was similar in reverse, with big ups followed by big downs. Mo-mo shorts are great when your timing is right, but timing is hard.
Picking dead shorts is certainly not without its challenges, but there is less likelihood of a free hall pass, or mo-mo explosion fueled by a rising market. 2013 saw the S&P rise almost 30%: this didn't help JCP, BKS, or coal companies like ANR and WLT.
Looking for the Knockout
Even clearly one-sided boxing matches can go to the loser when the decision relies on the fickleness of judges' scorecards. Knockouts leave no doubt.
Stocks are similar. Look at JC Penney's many billionaire fans of the last few years: Ackman, Soros, Bass, Cuban - the list screams savvy. Add rosy-eyed analysts and posters to the mix, and even the most challenged of companies can run against you -- unless they run out of money. Bankruptcy leaves no doubt and is the ultimate goal of a dead short. Patriot Coal, my best dead short, got there about within 7 months of me taking a position. I think JC Penney will get there, but the process may last a while.
Down is Good
The psychology of dead shorts can be very different from momentum shorts. With momo stocks often the idea is to try to catch things right before the fall, and you savor price appreciation as you wait to get in (though i think it might be smarter to wait for a misstep first). With dead shorts, down can be good even if you don't have a position yet. If a stock drops from 20 to 10 should you kick yourself for missing the move? Well if you think the thing is headed for 0 does it matter? A stock which has just dropped by 50% probably has worse prospects than before and you didn't have to commit capital during that period. 50 shares short at 20 vs. 100 at 10 has the same payout if the stock goes to 0.
Dead Short Criteria
I will now look a little more in depth at the main four criteria I use when evaluating dead shorts: 1) killer competition 2) limited ability to transform 3) weak financial condition 4) hidden value
1) Murder weapon
Professor Plum in the power plant with ...natural gas. The first thing a look for in a dead short is what's gonna kill this company. Coal's nemesis in the US is huge new supplies of natural gas from fracking, with perhaps an assist from regulation (though its hard to imagine stringent regulations if no alternative to coal such as natural gas were available). Likewise, e-commerce is changing retail enough that companies like Sears, JC Penney and Barnes and Noble are having serious trouble.
2) Limited ability to transform
Most companies in competitive straits realize this and attempt a transformation. Many newspaper companies, which were great shorts around 2007, have shed or downgraded paper operations and transformed into media companies centered on television and the Internet. Media General and Gannett are good examples. Media General sold its newspapers in May 2012 to concentrate on television. It has more than tripled since then. Similarly, AOL has offset declines in its subscriber business with emphasis on advertising and other digital ventures. The stock has recovered well since its 2011 lows and is financially healthy. You should be vigilant about transformations when playing dead shorts. And if you find your dead short's turnaround seems viable, consider reversing your bet. I closed my MEG short at a good profit, but regret not going long (I was seriously considering it, but just couldn't get by ugliness on the balance sheet).
One reason i really like coal shorts is that its hard to imagine them having an out. Their mining expertise, coal properties and business relationships don't seem to have offer anything relevant to the future of energy. And many made acquisitions at the top, leaving them in a condition which forms the third consideration for dead shorts
3) An already weakened state
Predators prefer easy kills to long chases. A company with resource can prolong its survival to the point your profits are minimal or, in the worst case, engineer a transformation (which might not be the worst case if you reverse directions as mentioned before).
Balance sheets really get mentioned in long investing, and if cash flow and profit growth are healthy maybe thats rational. But when evaluating dead shorts, they can give an indication whether to expect a quick knockout or prolonged battle, and whether the resources to effect a strategic transformation are present.
As with many coal companies, weak balances sheets look likely to hamstring efforts to resuscitate JC Penney and Sears. Cash reserves are being shored up just to reassure suppliers and meet operational needs, leaving little left for transformation.
4) Hidden Assets
Even if the company is a failure as a going concern, it may have some assets which are worth more than its current market cap. There is speculation that Sears' real estate portfolio is such an asset. Blackberry's patent trove has also been mentioned as potentially worth billions. While I have my doubts in these cases, its important to make sure there aren't any hidden corporate jewels which might upset your calculations.
Pensions obligations are another item to be considered, though these can go either way. Some companies have large unfunded pension obligations. When market do well and pension assets rise, however, others may be sitting on surpluses..
I have read on the internet that when the stock of a bankrupt company gets delisted, you don't have tax liability because there is no closing transaction. This seems to be false, and you will have a liability at some point when your shares get extinguished. Reaching this point, however, can take years. I shorted Patriot call in early 2012. It went bankrupt that same year, but the shares were only extinguished this year. Leaving me with two extra years to put my full profits to work. Another potential advantage of a successful dead short.
Those are the basics of dead short investing. In future installments, I'll discuss some more nuance, case studies, and my experiences with related strategies such as declining shorts. We live in an era with ever increasing technological change, where the pace of capitalism's creative destruction seems ever swifter in weeding out companies not using resources efficiently. I think this will provide lots of opportunity for those attuned to dead short investing.
Analyst's Disclosure: I am/we are short JCP, SHLD, BKS.
I am short many of the companies listed here. These are generally long-term positions I hope to hold till bankruptcy, but should a business turnaround occur, I will close them.
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