Tom Jacobs wrote last week about Research Frontiers (Nasdaq: REFR), a company that has a patented suspended-particle technology for products to control the amount of light passing though glass. Or whatever.
I'm famously curmudgeonly about such things. Maybe Research Frontiers has a viable product in development, maybe it doesn't. Maybe its smoked glass will make Cheech & Chong's van look positively translucent, maybe not. Maybe its future returns will more than justify its market cap, maybe they won't. I don't know, and, frankly, I don't give a damn.
I've got better things to do than to try to assess the quality of a company's technology and patents. I have very little chance of doing that successfully, no matter how much time I spend on it. If that is all there is to a stock, if it's just a story of what might one day be, I want nothing to do with it. That goes for buying the stock or shorting it. I pass.
Don't buy story stocks
It is commonly thought that our strategy seeks to identify companies like Research Frontiers in their nascent stages. That is not the case. We are looking for emerging industries, not emerging technologies. We say in the Rule Breaker Strategy in Brief that "true sustainable advantages come from brand and visionary management, not necessarily from technological advantage."
It's true that patents have a place in the Rule Breaker criteria under number three, sustainable advantage, but they are a lousy thing to lean on, as Zeke Ashton recently explained. Philip Fisher said that reliance on patents is more a sign of weakness than of strength. In general, that is the case. The exception is the pharmaceutical industry, where patents are necessary to protect treatments from generic competition. In all other industries, patents offer little assurance of success.
That's why I wouldn't buy a company like Research Frontiers or, for that matter, Ballard Power Systems (Nasdaq: BLDP), which I've shied away from. They may promise cool, potentially world-changing technologies, but so do a lot of science fiction novels. They could deliver, sure, but I'm just not going to pay $320 million or $3.6 billion for companies that may never have a product to justify the price.
So why not short story stocks?
Tom quoted liberally from famous (or infamous, depending on your perspective) shorter Manuel Asensio, who recently appeared on the Motley Fool Radio Show. Asensio and other short-sellers, most notably Marc Cohodes of Rocker Partners, target companies that they feel are engaged in fraudulent activities from an accounting or operational perspective.
It's possible for individual investors who really know how to dig through SEC filings to identify warning signs of potentially fraudulent accounting. Howard Schilit, who runs a research service that exposes companies using accounting tricks to mask deep-seated problems, wrote an interesting book on the subject called Financial Shenanigans. Many of the warning signs Schilit identifies are familiar to people who have taken a few accounting classes. It's hard work to do, but it's doable.
It is much less doable, however, for individual investors to identify fraudulent technologies or those with limited potential. Asensio has claimed that Research Frontier's technology is "highly questionable." Since 17% of its tiny float sold short and potential shorters can't get shares, it's clear that many people agree. As the strong response we received on the Rule Breaker Strategies discussion board shows, however, it's clear that many knowledgeable and diligent investors also disagree.
Who's right? I don't know. There may be reasons to think that one or the other has a greater chance of being right, but, without understanding the technology and the industry it's addressing, I can't say for sure one way or another. In that case, why risk that a new technology may work? Why short Ballard, only to find that the world really will go to great lengths to have emission-free autos? For that matter, why short a company like Cree (Nasdaq: CREE), as Cohodes has, on the premise that its products will become a low-margin commodity, long before a competitor has materialized? Each of these companies could -- could -- dominate a large market.
What to short
I prefer to avoid "open" situations like these -- where there is the potential for rapid, high growth -- when shorting. I also don't short solely on valuation. Instead, I focus on the shorting criteria we have articulated in the past:
- Closed situation, i.e. a mature industry with limited growth potential.
- High debt-to-cash ratio.
- High average daily dollar volume and float, so that there is no trouble covering.
- Minimum share price of $7.
- Low relative strength.
- Lower current assets than current liabilities and long-term debt combined.
- Already jumped the shark.
Except for share price, Research Frontiers fits none of these criteria. It's debt-free, has $12 million in cash and $1 million in current liabilities. It's got a small float that's thinly traded, and it's near its 52-week high. It has taken a long time to develop its product, but whether it's jumped the shark or not is unclear.
Avoid long and short
When I see a company like this, I turn the other way. There are myriad stocks to choose from that are much better suited to a long position or a short position. Why place bets one way or the other on something like Research Frontiers? If I want to gamble on an unknown factor, I go to the blackjack table. There, at least, we all agree on the rules.
Brian Lund wishes sometimes that he didn't know the rules of blackjack. Needless to say, he owns none of the stocks mentioned. The Motley Fool is investors writing for investors.
