Bear Market Geniuses

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By ptnewell
January 22, 2001

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The historian Will Durant once remarked that many famous people become so mainly by being spectacularly wrong. There is no better illustration that Durant's rule still applies some fifty years later than Lehman Brother's bond analyst Ravi Suria. In May of 2000 he concluded that the Amazon's Q1 '00 cash flow situation was as good as Amazon could ever hope to do, and predicted collapse within a few months. He calculated that the absolute best scenario for Amazon would leave them ending 2000 without cash, and unable to make the $40 million in interest payments due in Q1 '01.

Of course these specific and quantitative predictions proved not just false but magnificently false. Two months after his warning, Amazon reported Q2 '00 results which -- directly contradicting Suria's claims -- showed vast improvement in almost every metric. Indeed, each subsequent quarter for Amazon has shown rapid improvement in gross margins, net margins, and cash flow. Each quarter has shown growth far outstripping his "best case" scenario, and Amazon has substantially more cash on hand now than when his prediction was made. Even the hardest core Amazon bears do not believe Amazon, with $1.1 billion in cash available, will be hard pressed to make the $40 million bond payment in 1Q '01. Thus Suria's "best case scenario" for Amazon has proven too pessimistic by an extraordinarily wide margin.

Mr. Suria has hardly suffered because of the wild inaccuracies of his prognostications. On the contrary, he has become a celebrity. Numerous publications from Business Week to Individual Investor, along with all financial television channels have hailed his ecclat. It is safe to say that had Suria merely been wrong about Amazon, he would have remained obscure. Only by being extravagantly wrong, by predicting that Amazon's cash available would deteriorate by 1/3 billion a quarter did Suria achieve fame.

An old Wall Street adage is to "never mistake a bull market for genius." Suria exemplifies the latest financial fad, "Bear Market Geniuses." The world is now filled with investors who shorted some company or the other they felt pessimistic about. So long as the stock traded on Nasdaq, they likely made money, probably lots of it. It seems probable that just as some bull market "geniuses" lost their shirts in 2000, more than a few Bear Market Geniuses are going to suffer reversal of fortunes in 2001. Of course the situation is not symmetric. It is much easier to go bankrupt shorting stocks than holding long.

The current distribution of Amazon shares is fascinating. Of the 356 million shares outstanding, 61% are held by insiders (notably Bezos, who has sold remarkably little of his enormous holdings). Of the remaining 139 million shares, which constitute the float, a whooping 83% are held by institutions. Yet 31% of the float is short. That may sound impossible. It's not. Some shares, which have been borrowed for shorting, have been borrowed again from the second owner. Indeed, considering at least SOME private investors must be sitting tight on their shares, far more shares are shorted than are actually in circulation. Clearly aggressive shorting of Amazon by individual investors is rampant.

The discrepancy between institutions, who have been buying and holding Amazon shares, and small time investors, who have been shorting Amazon willy-nilly, grows even more striking on closer examination. For example, from the SEC filings available on the Yahoo profile for Amazon, institutions were net buyers of Amazon in the third quarter of 2000, adding an incredible 19 million shares. This, at a time when institutions were dumping most tech stocks, and hapless small investors still buying. Clearly institutions, with their professional accountants, detailed cash flow projections, and investigative resources, have reached far different conclusions about Amazon's prospects then have small investors as a group.

With the end of the bear market, Amazon's peculiar distribution of share holders has become incendiary. In the typical short squeeze, small time investors become enthusiastic about a stock hated by those who do their calculating with green eyeshades on. Hedge funds get squeezed by small timers piling onto a fad. Typically the squeezes don't last long, perhaps a few days. In the case of Amazon, not only are institutions, supposedly the hard-eyed players, optimistic, they have locked up so many shares it is essentially impossible for all shorts to cover. Amazon is a stock known for its volatility in any event, and momentum players are likely to pile on during any prolonged run up. The bear market geniuses face perhaps the most explosive shorting disaster ever. If message boards are any guide, few are worried. A sanguine confidence in Amazon's imminent collapse, contrary to all plausible calculations, permeates the boards. Are they not geniuses, as proven by the profits made shorting Amazon in 2000?

Hardly. 2000 was a great year to decide to short an Internet stock. Amazon was just about the worst possible choice. Not dozens but scores of stocks such as ICGE, CMGI, ETYS, IVIL, etc have lost more than 95% of their value. Many others such as and have stopped trading altogether. Even the highly profitable blue chip Yahoo lost 90% of its value (256 to 25). Shorting any Internet stock last year was a great idea. Amazon proved to be the least intelligent pick possible. Perhaps this explains why Amazon shorts remain so resistant to the strong contrary evidence provided by heavy institutional buying. Quantitatively speaking, Amazon has the shorts with the poorest judgment.

As is usually the case, the relative strength of the stock is not without underlying reasons. The difficult roads in Amazon's journey to profitability are behind it. Amazon's book, CD and music video businesses are already highly profitable. Far from being progressively squeezed, margins in these businesses have steadily increased, with gross margins for the latest quarter apparently hitting 22%. To see how strong Amazon's current position is, one need only examine the source of its current losses. These are (1) Goodwill write downs; (2) Investment loss mark down of equities; (3) Employee stock options; (4) Depreciation of the cost of building distribution centers; (5) the startup costs of new lines of business (such as electronics); (6) the cost of expanding into new countries every few months.

Items (1) and (2) represent losses that occurred some time ago, and are gradually being recognized now. Bezos borrowed money and invested in or acquired companies which proved worthless, or nearly so. Stock options are cash flow positive for Amazon, and the distribution centers will not need rebuilding for many years. Thus if Amazon merely refrains from starting new businesses for a year or two, and Bezos refrains from further ill-advised investments, Amazon will be profitable in short order. While not a surety, such modest restraint hardly appears beyond grasp.

There is a difference between a bear market and the ability to pick a bad stock. The distinction is one that the Bear Market Geniuses currently shorting Amazon are likely to learn in emphatic style. Being spectacularly wrong as an analyst can make you famous. Being spectacularly wrong as an investor merely makes you poor.