A Peculiar Investment Strategy

The other day while strolling through my portfolio, I noticed a strange thing. A high proportion of my stock picks -- my own purchases and those about which I've written positively in the last year -- are on the Reg SHO threshold security list. What's more, these stocks have some nice returns. Consider the following companies, all card-carrying members of the Reg SHO threshold list:

First, a few explanations. An asterisk indicates that I currently own the stock. The "price then" is either my average purchase price or the price on the date that I wrote about that stock. The return is a simple return. Normally, I'd annualize the return, but since most of these returns were achieved over a time period of months, the annualized return becomes stupidly large.

I also didn't include Tempur-Pedic (NYSE:TPX), which is up about 27% since I discussed it in early March. It has occasionally been on the threshold list for five or six days since that time, but it isn't a constant like the other stocks, so I skipped it.

Overall, these are some impressive results over a short time period. It was enough to make me wonder whether the threshold security list could actually be a source of investment ideas.

Now, I realize that this is a rather unscientific table I've put together, but bear with me for a few moments while we see whether this hypothesis holds water.

I've got a little list
The Regulation SHO threshold security list contains stocks that have significant, ongoing "failure to deliver" problems. Suppose you buy 100 shares of Beetam Collection Agency (Ticker: MOB) from me. I take your money, then turn around and say, "Sorry, dude, I don't have your shares." Then you've got a failure to deliver.

Such failures can happen by accident, but when they're ongoing, it's more likely they're caused by naked shorting. Normally when you short a stock, you borrow the shares from someone else to sell, hoping to buy them back at a lower price some time later. With a naked short, you skip the borrowing step. (That's the abridged version. For the unabridged, check out these great articles by Karl Thiel, here and here.)

Naked shorting is illegal, with the exception of temporary naked shorting by market makers while maintaining an orderly market. However, if you listen to the convincing arguments by Overstock.com's CEO, Patrick Byrne, it seems pretty clear that some parties are waging strategic naked shorting campaigns. There's a lot of obfuscation on the issue, but I believe it's difficult to avoid the conclusion that illegal naked shorting results in certain securities being constant members of the threshold securities list.

The hypothesis
So, aside from my anecdotal experience, why could the threshold securities list be a possible source of ideas? Well, as a value investor, I specialize in finding stocks that people either hate or ignore. Such businesses often fall far below their fair value, which means that there are profits to be made by buying the stock and waiting for it to bounce back. And the threshold securities list definitely contains hated stocks.

Second, I believe that the additional supply of counterfeit naked shorted shares and the fear, uncertainty, and doubt that short campaigns create could adversely affect the price of a security. If these factors push the company below fair value without causing irreparable harm to the operations of the company, then I'll be happy to own the shares.

Third, I believe that shorts are excellent at sharing their arguments and identifying weaknesses in companies. This is a valuable service to investors. If I'm able to read the best negative arguments of the shorts and refute them, then it can actually increase my confidence in my analysis of the investment. Plus, if the scenario described by shorts does start to play out, then I'll notice relatively early and hopefully escape with enough money to buy lunch.

My findings
So, armed with this theory, I went trawling the threshold list looking for securities that looked really cheap. The results? Disappointing.

The vast majority of the companies on the list were businesses I'd stay away from. I'm a traditionalist. I actually like my companies to generate cash rather than chew up investors' money and then go back for more. This criterion may seem basic, but it proved a high hurdle for most of the companies on the list. Many of the remaining companies were things like Martha Stewart Living Omnimedia (NYSE:MSO) -- potentially decent businesses trading at prices way above what I would be willing to pay.

Of course, this result is predictable. Aside from a few bombastic exceptions, short sellers aren't in the game for entertainment -- they're in it to make money. Consequently, it's not terribly surprising that when they make a big bet that shares will fall in price, they target weak and overpriced companies. So, one would expect the threshold list to be populated by such companies.

The upshot
Therefore, while there were a couple of businesses that looked intriguing, overall, this method of stock selection seems likely to be far less efficient than just looking directly for great businesses trading at low prices. Thus, rather than mining the threshold list, it instead makes sense continuing the methods that helped me identify these top-performing companies in the first place: screening for values, reading discussion boards that focus on value investing, and cherry-picking Motley Fool Inside Value selections. If you're interested in the latter two methods, you can find out more here.

Fool contributor Richard Gibbons has many dumb hypotheses, most of which turn out like this one. He owns share in Fairfax Financial, First Marblehead, and Overstock.com, but none of the other securities mentioned in this article. First Marblehead is a Motley Fool Hidden Gems recommendation.