HOW TO FIND A STOCK THAT'S HEADED FOR TROUBLEGoing short could pay off handsomely in the year ahead-if you're careful
Looking for a stock to sell short? A year or so ago, that was a relatively uncomplicated exercise: There was a host of entire industry groups that seemed to be ripe for a decline. Internet service providers, for example, were especially tempting, and some have lived up to their promise by registering dramatic declines. But finding anything resembling a sure thing--a stock that veritably reeks--is a far from simple task nowadays.
Don't give up, though. More than ever, careful short-selling is likely to pay off handsomely in the year ahead. Hype is running rampant. As in recent years, valuations are spiraling for high-tech stocks, particularly those that are promoted over the Internet. But tread lightly. Such stocks vary widely in their fundamental virtues, and betting against them solely because they have had runups can be hazardous. Short-selling highly touted but illiquid stocks can result in the dreaded ''short squeeze,'' in which shareholders force traders to buy back the shares they have sold short--either by driving up the share prices or, sometimes, by simply demanding delivery of their stock.
POTENT TIP. Short-squeezes are a fact of life for anyone entering the game, even on a small scale. Still, stocks that have had extraordinary runups this year remain among the most potent tipoffs of a subsequent fall--for they sometimes can be a sign of overenthusiasm, or even out-and-out manipulation of the stock by unscrupulous brokers. Another red flag, among
NASDAQ-traded stocks, are issues with a limited number of market makers, particularly when the market-making volume each month is dominated by only two or three securities dealers. (Market-maker trading statistics can be obtained from your broker or from NASDAQ.) Such stocks, however, are often as hazardous to short as they are to own.
One possible class of short-sale candidates is stocks of companies that may face trouble in today's economic climate. Frederick B. Taylor, chief investment officer and vice-chairman of the board of U.S. Trust Corp., says that the current environment--with low inflation and powerful global competition--argues in favor of companies that can cut prices and against those that have difficulty doing so. He notes that telephone companies, for example, are being hard-pressed to cut prices.
Professional short-sellers have other ways of snaring targets. One method that has increasingly proven lucrative is to hunt for companies that frequently raise cash overseas via offerings under Regulation S of the securities laws. Such shares are offered at a discount, usually 20% or so, and then can be sold in the U.S. only 45 days later. A new, little-noted wrinkle among the Reg S offerings can be potentially damaging to current shareholders. Under a few Reg S deals being concluded, offshore investors buy preferred shares or debt that is convertible into common stock. Under the terms of the deal, the number of shares obtained at conversion actually increases as share prices decline. (If $10 million is raised, and the share price is $5 a share, 2 million shares are issued. If the share price is $2, 5 million shares are issued.) Sometimes there is no limit to the number of shares that can be issued, and ''these kinds of deals can be infinitely dilutive,'' observes one short-seller who keeps a sharp eye on Reg S deals.
THE BIG MO. Companies that have used this financing technique can be risky places to own shares, because share-price declines can be accelerated by all those shares being dumped on the market. Fortunately, new Securities & Exchange Commission rules now require that all Reg S deals be disclosed. Among the companies to have used this Reg S financing technique in the recent past are VideoLan Technologies, Pinnacle Micro, and Editek, all of which have experienced significant declines this year. Solv-Ex Corp., an Albuquerque-based oil-extraction company, recently disclosed in an SEC filing that it raised $13 million through a Reg S convertible deal.
''Momentum plays'' that have more motion than substance are another potential way of ferreting out stocks to short. Short-side traders are giving increased attention to one fast-moving stock--Centennial Technologies Inc., which makes cards for personal computers. The company is a favorite of cold-calling brokers, and its Big Board-traded stock has climbed almost 400% in the year to date. Its profit margin is alluring. But skeptics believe its accounts receivable are high, its cash flow poor, and the quality of its earnings low. Chesapeake Energy Corp. is another stock that has skyrocketed on a wave of investor enthusiasm, climbing some 135% this year despite the view of some detractors that its oil-producing capacity may not be as lofty as investors anticipate.
Another momentum play is MasTec Inc., which provides design and installation services to phone and cable-television companies. In just the past year or so, MasTec shares have nearly quadrupled, giving the company a market capitalization that now approaches $800 million--more than nine times book value. Although the company's sales have gained handsomely in recent months, shorts are wagering that MasTec cannot continue to sustain such gains. The company, like Centennial, is a favorite of small investors, and recently benefited from a ''buy'' rating by Jeffries & Co.
Increasingly, the Internet and the online services have become a good source of ideas for stocks that might be ready to fall out of bed. One high-tech favorite of the online world is Zitel Corp., which manufactures computer storage systems but has mainly been getting attention in recent months because it sells software aimed at correcting computer-clock problems that are anticipated at the beginning of 2000. Zitel's shares have quintupled in the year to date, with much of the heat beneath the stock generated by postings on the Internet and Motley Fool message boards of America Online, where hype runs rampant.
One stock that has drawn scant attention online--but has nonetheless moved up powerfully this year--is Quigley Corp. Its shares have climbed more than 1,000% this year, largely on the strength of a lozenge that is supposed to lessen the severity of cold symptoms. Enthusiasm over the ''Cold-Eeze'' zinc-based lozenge has sent Quigley shares zooming from as low as 5/8, where they were trading in early April, to a recent 16. Not surprisingly, Quigley has begun to get attention from short-sellers, who feel that the company's prospects have been overestimated by the market. They are betting that someday soon, the market in such high-flying stocks will emit a violent sneeze--and nobody will be around to say, ''gesundheit.''
By Gary Weiss in New York
Updated June 13, 1997 by bwwebmaster
Copyright 1996, Bloomberg L.P.