Archive for March, 2010

Gravity

March 25, 2010

Gravity

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 business inflates the market cap, 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 (http://seekingalpha.com/article/27146-major-fuel-cell-stocks-in-review).
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 to 5. 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 (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/user/608449/instablog).

Sooner or later, gravity wins.

Disclosures: No position is currently held in any of the stocks mentioned in this article.

Advertisements

Extreme Tech Shorts

March 21, 2010

Entertainment Arts Research (EARI, 9.80, 19 Mar 2010)

Mkt Cap: $714M, Revs (LTM): $0, Loss (LTM): ($1.3M), Net Cash: ($0.3M), Short Interest: 0.3 days

EARI produces faith-based interactive video games and “edutainment”.

EARI chart 100319

This is the perfect fundamental short.

The stock is fairly new on the scene, so there is little short interest. It has an extremely high market cap of $714M.  It has been over-hyped recently, leading to a speculative spike in the stock price. Despite the hefty market cap, no revenues have ever been earned by this company. Promises of future revenue are based on still-to-be-developed products. The web site shows nothing more than a home page.

The skyrocketing stock price is primarily driven by the Universe of Faith (UOF) – a virtual world designed for the faith-based Christian community that was developed by EARI’s President Jonathan Eubanks. The Legacy Group Global (LGG) advertising agency will work with EARI to make the Christian community aware of faith-based video games, online avatar opportunities to express their faith, etc.  Adding to the speculation, was a second announcement of providing content for distribution through the Shaolin Temple of China.

In EARI’s press release about partnering with LGG in the UOF launch, Damon Davis, CEO of LGG, stated “History repeats itself. The Word of God, since the beginning has moved by being carried through the mouths of men and women who believed in the life changing, penetrating word of Truth. Whether it’s a bush pilot carrying Bibles in the back of a fixed wing airplane into the jungles of South America or an avatar of Joel Osteen in front of a virtual community of 2 billion people worldwide, it will be his mouth delivering this word to a community that will spread this message like wild fire to the four corners of the globe. UOF provides that and we are committed to its success.”

While I do not underestimate the power of the Church, my faith in this business venture supporting a market cap of anything close to $714M is being severely tested by past real-world experiences. Let’s look at the fate of Left Behind Games (LFBG), an EARI peer. At $0.0044 per share, LFBG has lost 95% of its market value from its June 2009 peak. They also produced interfaith video games, and claimed to have a large distribution agreement with Wal-Mart. The current market cap is $8M, losses were $6.8M on revenues of $0.1M. To support their loss-making operations, LFBG had to issue billions of shares at dilutive prices.

While some may try to argue that the quality differential between EARI and LFBG is greater than the market cap differential of 87x, the bubble created in EARI stock is even harder to dismiss. Even if EARI reaches millions of zealous Christians above the poverty line over the next five years, the ability to monetize those viewers to justify the current market cap is highly questionable. Just converting church-goers/television evangelists into online gamers and avatars, forget even monetizing them, will be a daunting challenge.

According to EARI’s only-two news releases, video content will start being released this month for UOF, and by Christmas for the Shaolin Temple venture. Time will tell.

Background on the Author:

I am a manager of a tech stock hedge fund. Today there is an opportunity to short extremely overvalued, fundamentally flawed tech stocks. My Fund aims for the very worst tech stocks with market caps over $50M, nominal revenues, heavy losses, low net cash or preferably net debt, little proprietary technology, and other qualitative and quantitative factors.

The biggest challenges are locating shares, avoiding buy-ins, dealing with excessive margin maintenance requirements on sub $2.50 per share stocks, and obtaining reasonable borrow rates for an extended time period.

In spite of these challenges, the strategy has worked quite well on an absolute basis since last year, despite the rising stock market.

From time to time, I will post company and market research notes. I will also disclose if my fund has a position in these companies when posted.

I would welcome any comments from peers who would like to share their experiences, or other investors who would like to learn more about shorting tech stocks.