Short Seller: "We Did the Unthinkable…"

John DV

Anyone that lived through the 2002 and 2008 bear markets can tell you: nothing quite rattles you like seeing these positions you’ve built up for months, or even years, get wiped out in a flash. There’s even been a few scary times in between when investors have had to hover over the sell button.

So, if we were entering a new bear market, Harry wanted readers to know there was another strategy you could use other than just buy stocks and hope they don’t get swept up in the carnrnage.

That’s why, besides joining the team to help analyze financial statements and look for profit opportunities to the downside, he asked me to present a high risk/reward trade to Boom & Bust subscribers.

I knew from my experience as a short seller that having a few shorts in your portfolio can help buffer against big declines. It’s also possible to catch many stocks that lead the way down before the general market collapses.

So, per Harry’s request, I chose to make a trade that, up until a couple of years ago, many investors would’ve called crazy. We did the unthinkable, and decided to short shares of one of the titans of American industry: Internrnational Business Machines Corp. (NYSE: IBM).

As you can probably imagine, short selling often gets a bad rap. And I’ll admit, it’s a bit of a strange transaction. You sell something you don’t own in the hopes of buying it back cheaper at a later date and collecting a profit. It’s odd, and people tend to shy away from things they don’t understand.

There’s also the concernrn that short selling can really cost you. A stock can only go down 100%, but it could go up to infinity.

Of course, no stock goes up to infinity. If it did, we could just buy that stock, go have drinks on the beach, and hit refresh on our brokerage account while we retire and watch the money roll in.

Many people also think it’s simply un-American to bet against a company in anticipation that its stock price will fall. That goes double for betting against a major American company like IBM.

The fact is though, that in a capitalist system like the United States, there are far more losers than winners. And for those that do win, no one stays on top forever. All companies hit a bump in the road in their business.

The question is whether management is open and honest about it, or whether they try to pull the wool over investors’ eyes and hide the deterioration in their business?

Sure enough, IBM was up to some weird stuff.

In the old days, the saying was you’d never get fired for buying IBM. Recently, I’ve told people that if money mangers had bought IBM stock for their investors, they should be fired.

I had been following IBM’s stock price back when it hit a high around $215 in 2013, knowing it was a disaster waiting to happen. The underlying business was imploding.

First, IBM was having problems exceeding its revenue estimates. Quarter after quarter, the company was missing revenue estimates by $500 million to over $1 billion. Per quarter!

While that was happening, the company’s receivables were growing quarter after quarter. That made me think there was aggressive revenue recognition at play – which is fancy accountant speak for making revenue seem better than it is.

In this case, IBM offered its customers incentives to buy a product today they otherwise would buy at a later date. This overstates current growth. Worse, it means they were basically stealing their own customers from the future.

On top of that, IBM was reporting a volatile tax rate that often was below what Wall Street analysts had been expecting.

Basically, they were using tax management as a low-quality source of earnrnings. Instead of going on the offense and growing the business to generate strong earnrnings per share, they resorted to financial engineering.

IBM also assumed billions of dollars in debt to buy back stock. Buying back stock reduces the share count and increases earnrnings per share. But not all share buybacks are equal.

So finally, while the business was coming under pressure – and the company’s cash flow was plummeting – I watched as IBM used debt to buy back loads of its stock near all-time highs thinking it would make a difference.

And truthfully, if IBM hadn’t taken on that debt to buy back stock and defend its dividend, the stock probably would have tanked sooner than it did.

But what did that really change?

The reality soon became evident that IBM’s growth initiatives were too small to offset the damage happening in its larger business units. It’s sort of like trying to steer the Titanic away from the iceberg.

Shares of IBM recently hit a low of $118. I don’t know how much more downside there is to the stock at this point, and I certainly don’t recommend adding to short positions (Boom & Bust readers have gained about 27% on this trade and I’ve recommended they hold).

But, it’s a good illustration that high risk/reward opportunities do exist.

And I can assure you, there will be plenty more in the future.

I’ll be hosting a webinar this Thursday, January 28, at 4 p.m. ET (and again at 8 p.m. if you can’t make it). It’s called Earnrnings Exposed, and in it I’ll show you how you can spot accounting gimmicks like IBM used. You can sign up for it here.

With that knowledge in hand, you’ll be able to find many companies just like it that have a lot of risk to the downside, leaving plenty of room for you to profit when their financial manipulation finally comes back on them.

No matter what strategy you use, it’s always good to consider some hedges against your portfolio to reduce risk and volatility.

That way, when we get into a period like we’ve had recently, you can feel a little better about these bumps and bruises, knowing you’ve got some skin in the game when the market makes a turnrn for the worst.

John Del Vecchio

Editor, Forensic Investor 

John Del Vecchio

Using his proprietary forensic analysis, John does all the hard work of digging, weeding out and analyzing the few rare stocks that most of the market has overlooked, but are set to pay out handsomely in the months and years to come.