Just when you thought the story had played itself out, another chapter has been written in the MicroStrategy saga. The company is trying to shake itself of those selling its stock short, but the move is suspiciously nearsighted and is equivalent to trying to use the tail to wag the dog.
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Sometimes a story crosses my desk that, while not very newsworthy, nevertheless screams out for comment. Such is the case with e-business software company MicroStrategy (Nasdaq: MSTR) and the letter the company sent out to shareholders -- and transmitted to the world in press release form -- yesterday. In that letter the company urged its shareholders to help wage a war against traders who might be shorting the stock. MicroStrategy explained to its investors exactly what short selling is, how it may affect the company's share price, and how investors in MicroStrategy can go about limiting the number of shares that are available to be shorted. While the educational information is nice, Saylor's actions are nevertheless questionable. Shorting 101 It's riskier than hoping for a stock to go up, however, because the maximum profit is only 100% -- and that's if the stock goes all the way to zero. The maximum loss, on the other hand, is technically infinite, and an investor can easily lose several times more than they put up to short the stock. The risk/reward ratio is heavily weighted to the risk side, so most short sellers choose their positions extremely carefully. Short sellers are sometimes demonized since they are essentially rooting for a company to misstep and its shares to go down in value. They are also especially loathed by both "traditional" stockholders and company management. Heck, who likes someone who stands to profit from your misfortune? Nevertheless, I say short sellers are unnecessarily demonized because, when it all boils down to it, a company's performance as a business is the primary determinant of its long-term stock price. Sure, short selling in massive quantities may temporarily cause a stock price to dip, but this also gives a stock liquidity and allows those wishing to buy an opportunity to purchase at lower prices. What's more, every share held short represents a share that must be purchased down the road. As a result, having a large short interest (the percentage of outstanding shares held short) means a stock has a great number of future buyers built in. From margin to cash By encouraging investors to call their brokers and have their shares reclassified, MicroStrategy is essentially trying to limit the number of shares that are available for shorting. After all, its shares can't be shorted if there are no shares available to borrow. Furthermore, one of the dangers of short selling is that the number of available shares can fall below the number of shares shorted, forcing brokers to call in their IOUs. By greatly reducing supply, an enormous and involuntary amount of buying demand can be created. This may have been one of the reasons why MicroStrategy's stock did so well immediately after the letter was released. At one point yesterday, the stock had doubled inside a day and still managed to close up more than 75% in a single trading session. Many shorts probably felt uncomfortable about having crosshairs aimed at their foreheads and decided to close out their positions yesterday, creating a massive uptick on roughly 20 times more volume than the stock had seen in the previous 30 days. Crisis of credibility Not so fast. One of the reasons MicroStrategy may have been so focused on its share price was because the company, desperate for cash last summer when facing an SEC investigation and massive shareholder lawsuits, took out a highly "toxic" loan from an investment group. In exchange for $125 million, MicroStrategy issued debt that was convertible into common stock. The catch was that the conversion price on this debt was variable, and dependent on the closing price of the stock this coming June. The lower MicroStrategy's stock drifted, the more common shares would have to be issued to cover the loan, and the more existing shareholders would get diluted. (The Washington Post recently had an article on this issue, and it's a great read.) Interestingly, the company also announced yesterday that it had refinanced this convertible debt, paying a combination of cash and stock to rid itself of a potentially massive dilution liability. Therefore, the one thing that could possibly really motivate the company to pump up its stock was gone at the same time it waged war on the shorts. So why the focus on the "evil" shorts? Perhaps because the company's CEO, Michael Saylor, is in the process of systematically selling off 15,000 shares of stock a day for the next two years in order to raise the $100 million he committed to start a free online university. The lower the share price -- the stock had bottomed below $2 a share at the beginning of the month -- the shorter the funds go towards reaching the $100 million fundraising goal. One more likely reason is that MicroStrategy's management has been largely hung out to dry after aggressive accounting practices forced the company to restate earnings for 1997, 1998, and 1999 from a profit to a loss in each of those years. A thorough SEC investigation, numerous shareholder lawsuits (recently settled), and a stock that has fallen from over $300 a share to today's levels are just a few of the scarlet letters MicroStrategy's executives have had to deal with. Putting the focus on the short sellers instead of management sure is a convenient way to pass the buck. Still, the fact remains that a company's ability to generate future cash flow is the primary determinant of its stock's price. Why management is so intent on seeing its stock do well in the immediate-term is beyond me. It seems to me to be an act of almost desperation by trying to force the tail (the stock) to wag the dog (the business), and not the other way around. MicroStrategy's management should be focusing on their core business of selling software instead of going out on a witch hunt to find an easy scapegoat for its numerous problems. And so begins another chapter in the saga that is MicroStrategy. I'm sure this won't be the last we hear from this highly controversial company. Paul Larson occasionally shorts stocks, but he's never owned any position in MicroStrategy. You can see Paul's complete stock holdings online. The Motley Fool is investors writing for investors.
For those unfamiliar with short selling, an investor with a margin account may borrow shares of a company's stock -- one they expect will fall -- from their broker. The investor then sells the stock, pocketing the cash from the sale along with an "IOU" for the number of shares they borrowed and sold. The short seller aims to repurchase the shares at a lower price, thus paying off the IOU and taking home the difference.
What MicroStrategy did yesterday was encourage its shareholders to move their shares out of margin accounts and into cash accounts at their brokerages. When shares are held in a margin account, a broker can loan them out to other investors interested in shorting them because the broker is the one taking possession of the shares. Shares held in a cash account and put in an investor's name, however, cannot be loaned out for shorting activities. (Even so, this is a fairly uncommon step for most investors to take.)
And so MicroStrategy's management was able to cause the stock to go up, creating many happy shareholders and helping the company in the process, right?
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