Whenever the topic involves shorting stocks, the email response tends to be enormous. That happened to me last week after writing about 10 Heavily Shorted Stocks and questioning why the leading two on the list -- American Capital Strategies (NASDAQ:ACAS) and Identix (NASDAQ:IDNX) -- are, well, on the list.
Several responses suggesting why these companies are shorted in market-leading numbers are still waiting in my mailbox, because I've only read those I've had time for. Many readers anticipate an update today, so I'll summarize what I've received so far. (Thanks to everyone who wrote.)
All the intrigue surrounds American Capital Strategies, a Business Development Company (BDC) that essentially pays most its earnings to shareholders, maintaining a tax-favored status. It lends $5 million to $40 million to companies in need, charging interest rates averaging 13%, indicating high risk. The stock yields 11%, yet it's the most heavily shorted issue on the Nasdaq of those with daily volume topping 500,000 shares.
Why?
Herb Greenberg and others writing at TheStreet.com (NASDAQ:TSCM) have roundly criticized American Capital, and many readers have cried "foul" on the critiques. The battle between longs and shorts runs back to the summer of 2002, and is a lot to digest. As someone new to the topic, here's how I see the two arguments, summarized:
- Bears argue that American Capital faces increased loan losses due to its high-risk lending practices; it doesn't disclose enough of its loan information; it's overvalued and financially stretched when you consider net income rather than the commonly cited net operating income; the weak economy hurts the business; it's not earning enough to keep paying its dividend; and it's a Ponzi scheme, regularly selling shares at above book value to finance payouts. Finally, given all the noise, the SEC opened an informal inquiry, but nothing has been heard.
- Bulls argue that American Capital has been growing book value and its dividend for years; it discloses as much loan information as it should, and can't disclose more because it primarily loans to private companies; the improving economy will help it; insiders have been buying stock aggressively, not selling; recent disclosures on investments have shown success; and finally, shorts attacking the stock are the same shorts who have attacked similar businesses (largely unsuccessfully), including Allied Capital (NYSE:ALD), a firm with a 40-year history.
That's how heads are butting over the stock. Then there are the conspiracy and conflict-of-interest complaints that came from enough readers that I'll share some. Here's how one reader put the American Capital situation:
The reason [American Capital] has such a short position is David Rocker of Rocker Partners Hedge Fund. Rocker initiated a short position on Allied Capital originally... His stated reason was that Allied did not "mark-to-market" their portfolio since the portfolio was comprised of smaller non-publicly traded companies. Allied is a quality company with a long history of growth.... Allied fought back, even coining the term, "You can't re-state a dividend."
Rocker also tapped TheStreet.[epithet] to help his cause and Herb Greenberg obliged with several damning articles, all way off target. Rocker owns about 10% of TheStreet -- interesting.
Rocker and Greenberg moved their smear campaign to American Capital about 15 months ago. Same reasons: A slow economy, loan portfolio in question, American Capital management came from Allied. To be fair, American has had a few portfolio company problems, as one might expect, but the bottom line is they have grown book value and increased the dividend.
Rockers' current [short] project is NovaStar Financial (NYSE:NFI)...
I think the Rocker plan is to take short positions, start a public smear campaign, quietly exit the position to retail shorters (even going long on NFI to the tune of 240,000 shares), and move on to next stock. This is a very brief summary of the American Capital question, but the facts are: Rocker, Greenberg smear campaigns; Rocker, 10% ownership of TheStreet; no substantial analysis by the shorts explaining their reasons for shorting. All said, I've benefited immensely going long on Rocker attacks.
Although I find TheStreet.com to have useful journalism, this reader's complaints echoed those of many other readers, as well as those on a site devoted to American Capital's industry, www.bdcinvestor.com. Most shareholders argue that the bear arguments are baseless opinion -- mere "campaigns." And when you read about the connections between Greenberg, Rocker, TheStreet.com, and others involved, it's easy to see how shareholders feel conspired against.
Rocker did, after all, reportedly own more than 200,000 naked put option contracts on American Capital when TheStreet.com -- of which Rocker was the third-largest shareholder -- began to repeatedly attack the company. Next, TheStreet.com's Greenberg took the story to Fortune. At the same time, another Street.com contributor, Sonic Capital's hedge fund manager Mark Haefele, was also short the stock and was being quoted as a source by Greenberg (with less than full disclosure), while Haefele himself also wrote bearish columns on the stock for TheStreet.
The funny thing is, of all the published stories I've read on this company -- including stories on TheStreet, in Fortune, and in Barron's (which had a more balanced article) -- it's pretty obvious that nobody truly knows what the hell they're writing about. Including me. But I'm not taking a position on the stock, and everybody else is.
Bears are calling the stock a Ponzi scheme and trying to explain why with financial arguments that are so unclear it's almost certain they don't understand the financials. They are hypothesizing, guessing, speculating, and merely drawing the conclusions they want to draw. Then they cloak it all under the pretense of certainty. Additionally, TheStreet.com writers clearly did not understand how this company finances its dividend, even though they made that a main point of their argument.
American Capital was attacked so often with repeated arguments and, it claims, misstatements, that it wrote numerous rebuttals and responses to the articles (scroll both up and down). Generally, I frown on companies that respond to noisemakers, but when shareholder value is attacked again and again, it probably merits a public response.
I'm still learning about this situation, but it already has the feel of something I want to steer clear of. At the Fool, our focus is investing in compelling, strong, and understandable opportunities for long-term gain.
I can't tell from the numbers given whether American Capital is a good operation or not, and the arguments both for and against it are speculative. I need a clear understanding of a company's business and financials before sinking money into it -- or shorting. The way this business is by default run, I don't believe that's possible (for me and for most others), and I won't pretend it is.
Others readers, however, voice confidence:
The company has a credible management and a good track record, if you review their loan exits this year the majority have resulted in gains above stated valuations. I am betting heavily against the shorts and, at an 11% dividend, time is on my side. With the stock slowly recovering and with the dividend, I expect shorts to lose patience with their position....
Right or wrong, as this saga unfolds I'll be rooting for the longs rather than the big-money shorts. I've been a Cubs fan since '78 -- I'm drawn to underdogs. Plus, company insiders have been buying shares, and insiders generally know more than outsiders. Generally.
More on this topic when merited.
Identix
Few people cared to write in about Identix, even though it's second on the list of shorts. Those who did write said the company's face-recognition technology is only in early adopter stage, its fingerprint ID technology is a commodity with low margins, and shorts didn't expect it to receive a recent government contract it won.
Have a great weekend...
Jeff Fischer does not own shares in companies mentioned. Opinions quoted and paraphrased here are not necessarily the opinions of the writer or the Fool. The Motley Fool is investors writing for investors.
