On January 3rd, I wrote an article titled “Pandora Is A Fundamentally Flawed Stock.” Between that date and yesterday, the stock fell 31.5%. The specifics of the one-month decline were not something I could foresee–I have no idea when the market participants will correctly reflect the true value of a security–but I could predict that Pandora shareholders faced two long-term problems. Pandora shareholders are perpetually suffering from dilution, as the company makes secondary offerings to receive cash to keep operations ongoing. Also, there is significant stock-based compensation for Pandora executives.
While this is a significant demerit, it can be overcome if the business model is strong enough. I have expressed doubts about Pandora because of the high cost structure of playing music. The cost of the raw material is $0.0017 per song before taking into account any of ongoing costs of hosting and streaming plus paying employees to work at the firm. Reasonable labor costs mixed with high labor costs make it difficult to see a path to wealth creation with near certainty, and the notoriously fickle ad industry tends to slash rates during recessions. Despite the easy scalability of the business model, it’s difficult to see how this stock could ever be a generational compounder like McCormick or Hershey.
This raises the question: If a stock is clearly overvalued, and faces long-term viability risks, then why not sell short the dang thing?
There are two reasons: unexpected good news that alters the dynamic of the investment, and merger/acquisition activity.
You may wonder: Don’t people that buy common stocks long expose themselves to the same risk in reverse–namely, “unexpected bad news.” Well, yes, but only in name only among established blue-chip stocks. If Coca-Cola encounters an adverse event, such as the destruction of its facilities in a Yemen airstrike at the end of 2015, the materiality of the bad news is often dwarfed by the deep pockets of the corporation. Considering that Coca-Cola makes $9 billion in profits per year, it can absorb a whole lot of bad news before it affects your ability to build wealth with the stock over the long term.
But when you short a stock, unexpected good news can completely alter the intrinsic value of the firm and cost you a lot of money in hurry. I now call this the “Oprah Winfrey” effect. On May 22nd, when Weight Watchers was trading at $6.16 per share, I penned an article that effectively argued Weight Watchers was either destined for bankruptcy or a significant corporate restructuring that would heavily dilute the shareholders. Then, Oprah bought the stock and became its spokeswoman, and the stock has climbed to $10.65. But worst of all, it shot up to $26 on news that Oprah purchased it.
If you were selling that stock short, you could have lost $40,000 for every $10,000 you invested because of the freak chance that Oprah purchased the firm. That is not an intelligent way to create an estate. That’s why I would never short stocks–you never know when an Oprah might come along. Now, the stock has declined back to $10 as people have realized “even if profits grow from the $100 million base, that $2 billion in 2020 is still a lot and Oprah might dilute shareholders heavily if she negotiates a deal to provide Weight Watchers capital to pay off the debt in exchange for something that converts into an ownership position. Or they might just issue stock outright and have Oprah buy it that way.”
Why would you want to expose yourself to any of this? The fruition of remote probability events in the short-selling universe is disastrously more consequently than the potential effects of buying a common stock long. With plain vanilla C-corp ownership, the worst case scenario is that you lose what you contribute, and even the probability of that happening is lower than the probability of something good happening to a stock that looks like a dog when you run the analysis.
The other risk is merger/acquisition activity. This is straightforward: Someone can always come along and buy the stock at a premium. In the past two days, Pandora has climbed to $9 from $8 for a short-term gain of 12.5% on the speculation that it may be acquired.
The Oprah effect, plus the potential of merger activity, is a reason why you should never consider shorting a stock. When you look at a poor company and eliminate it from investment consideration, nothing bad happens to you if your thesis later proves incorrect. What is important is that the theses you do find attractive and choose to invest in prove correct. Weight Watchers may still meet my May 22nd expectations of significant shareholder hardship, but it is clear the entrance of Oprah has changed the intrinsic value and, in the short term, but the short sellers in a squeeze that could involve significant losses. It’s such a needless risk–you can make a lot of money without ever exposing yourself to this ruckus.
Originally posted 2016-02-11 23:59:42.