Our Short Soared. Doh!

After reporting second-quarter results that met lowered expectations, biochip maker Affymetrix (Nasdaq: AFFX), our one and only short position, soared a spine-twisting 30% in one day. That made it the best performing stock on Nasdaq last Thursday. The best performer. Bar none. Numero uno on the whole dang exchange -- and we were short it, and still are.

Going into the earnings announcement, we sat pretty with a 23% gain. We shorted the stock on June 21, a mere five weeks ago, at $21.60 per share. It had since fallen to nearly $17. In the last two trading days, however, it soared to nearly $26, bringing many biotech stocks up with it. (At least we benefited by owning three other biotechs.) So, what happened? What's the great news?

Well, management at Affymetrix hypothesized that "the worst is behind" them. They believe that orders from large pharmaceutical companies will begin to increase again, after they had been flat to down the last few quarters. Our short sale was largely premised on the argument that orders would remain lackluster, partly because a company only needs so many gene chip arrays each year, and partly because a company like Affymetrix has such a limited client base. You don't sell gene chips on every Main Street in town like you do Starbucks coffee.

Additionally, our short was based on the fact that prices for gene chips are declining, which squeezes margins, partly because competition is growing.

Despite our long-term bearish arguments, we now face a new decision, but one that I don't regret. This short has already been an excellent lesson in finding, or rediscovering, one's investing comfort zone. Shorts are often nerve-racking. We shorted Trump Hotels & Casino Resorts (NYSE: DJT) in 1997. It promptly rose 40% on us. We waited months, and then years, until we eventually earned about a 45% profit on the short. The point was, though, that we were able to comfortably wait. That was a company with massive long-term debt, continuing losses, and little to zero sales growth. Also, the stock wasn't volatile. We were comfortable sitting on it. In fact, when we shorted it, we were ready to wait a long time to be rewarded, even years.

Affymetrix is different. It is very volatile. It isn't priced on fundamentals so much as it is priced on potential, and when the potential seems just a little brighter, the stock can soar 40% in two days (as it just did), adding $400 million in market value. It can soar like that because it is a biotech company, and thus people don't know how much long-term potential there really may be. A sniff of good news and it's off to the races. Trump's biz -- come on, everyone knew its potential was slight. There wasn't much danger of the casino stock running from $18 to $60 just because management said "the worst is behind us."

With Affymetrix, there is that chance. Add another bit of good news -- say a big new order placed for more chips -- and a few more positive comments from management, and ol' Affy could slam us for another 40% loss on top of last week's loss. That's the real danger. It's different from many shorts in that way.

Plus, the thing is, I actually don't disagree with last week's stock gain. It tells me something. It tells me that many people had feared what we feared -- or, I should say, what we hoped for (devilish as that sounds). We shorted the stock thinking that the business would remain slow after management surprised everyone with disappointing news in June. Many other people apparently believed that it would stagnate, too. So, when second-quarter sales met new expectations and management gave optimistic words rather than the warning that many investors expected, the stock logically leapt. Fair enough. Everyone reset expectations.

One painful possibility that we knew we would face, whatever happens next, is this: I believe that we might be proven correct on Affy in the long run. Its market is limited. Its valuation seems high. Two years from now, it might be down 50% from today's price, although it could first gain another 100% in the meantime. With our other shorts, like Trump, we'd be comfortable waiting out such gains. But we don't want to see Affy double on our dime, because it's too risky when it starts against us. First, it can move too much, too fast. Second, we don't want to risk being wrong and becoming incredibly plastered by this short. Instead, we like to close out losing, high-risk shorts at a less painful 20% to 30% loss.

So now what?
Now we're at a point of needing to make a new decision. Do we wait out management and hope that they're wrong? I mean, naturally they spoke as favorably as they possibly could at the conference call. They can always come back later and say, "We're sorry, things didn't pan out as we'd hoped." Companies do this all the time. It's called spin. It's called helping your stock price in a legal, reasonable way. Put your best face forward. If it doesn't work out, well, you did your best and you'll restate expectations.

Thus, now we're asking ourselves, do we hold out and hope that the business does remain slow, or do we take management's word as solid and wave the white flag? I knew that we might face this dilemma quickly with this short. Unlike with Trump, we went into this short knowing that it was, first and foremost, a short-term position based on second-quarter results. Indeed, I paced the East Coast last week wondering if we shouldn't just take our 20% gain and declare our victory even before the earnings announcement. But such a move was unlikely, and we didn't make it.

So, should we close out our Affymetrix short soon, or should we wait for real proof of an upturn in the business? After all, all that we've really had is words from management, and words come easy. We haven't seen real improvements yet. I'll tell you: After this 40% jump, we're thinking of waiting a while to see what happens next. We shouldn't be shaken out by words alone. After all, product sales for the second quarter were $41 million, only $1.8 million higher than last year, while royalty revenue actually declined by $1.5 million. Meanwhile, inventory-on-hand rose 76% to $30 million. That inventory is aging as Affy designs new products. So, yes, we have arguments for waiting on the short. But what do you think we should do? Share your opinion.

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