I get a lot of questions about short selling, probably because most investors have never done it.
Short selling is the sale of a borrowed stock in anticipation that the stock’s price will decline. If the stock price goes down, the seller buys it back at a lower price and makes a profit.
(You can read more about short selling in this Mauldin Economics’ in-depth guide.)
If you can identify stocks before they fall, short selling can make you a bundle of money.
Now, I want to walk you through my most recent successful short sale to help you understand the process.
Red flags from Conn’s finance division
On April 7 of this year, I sent out this alert to my Rational Bear subscribers, telling them to “short” Conn’s, Inc. (CONN).
Conn’s is a large furniture and appliance retailer with an unusual business model. The company both sells furniture/appliances and loans its customers the money to buy its furniture/appliances.
Sort of like General Motors and General Motors Acceptance Corporation (GMAC).
On the surface, Conn’s appeared to be growing quite well; sales were increasing. Their own loans, however, financed most of those sales. The company was extending credit to just about any deadbeat that walked through its doors.
You and I may not need to borrow money to buy a washing machine or a color TV… but 80% of Conn’s customers do. Those are the kind of people I grew up with. While they may be decent people, they are not the kind of people I’d want to loan money to.
That strategy started to backfire when the Conn’s finance division reported a massive $43.2 million quarterly loss.
At the time, I said, “Those credit losses are going to get worse.”
How did I know that?
- The number of loans that were more than 60 days past due jumped to 9.9%.
- Most businesses reconsider their lending practices when bad loans skyrocket, but not Conn’s. Instead, it was loaning more than ever; accounts receivable increased by 16% to $743.9 million at the end of Q1.
- Conn’s increased its provision for bad debts by 11% to $64.8 million, but that wasn’t enough, considering the pace at which its customers were defaulting.
Those were serious red flags, but the biggest warning sign was the “creative accounting” Conn’s used to make its business appear better than it really was.
Accounting Trick #1: Re-Aging Bad Debt:
There is a little-used but legal accounting practice called “re-aging” debt. It is used to reclassify deadbeat loans into not-deadbeat loans.
Basically, when an account is re-aged, it is no longer considered to be past due.
In Q1 2016, Conn’s “re-aged” $21 million worth of loans—from $41.93 million to $62.29 million.
Accounting Trick #2: No-Interest Option Receivables:
A typical loan payment is part principal and part interest, just like a home mortgage.
However, when a struggling customer can’t afford to make the full payment, a loan company may let the customer get by just paying the interest.
But when a customer is really in trouble, a loan company could temporarily waive both principal and interest payments. In other words… pay nothing!
Why would a loan company do this?
Because otherwise the loan would be reclassified as a bad debt, which makes the loan portfolio look worse.
In Q1 2016, the percentage of Conn’s loans converted to no-interest loans rose from 32.8% to 37.1%.
But here’s what really counts: Its in-house credit business financed 80% of Conn’s sales.
Two possible outcomes
My expectation was for one of two things to happen… and both of them were very bad.
Bad (but Fast) Outcome #1:
Conn’s would tighten up its credit practices and extend much less credit. In that case, the 80% of its customers that couldn’t pay cash simply wouldn’t buy. Revenues would collapse, and Conn’s would report massive losses.
Bad (but Slow) Outcome #2:
Conn’s would continue to make loans to anybody that could fog a mirror, and its credit losses from bad loans would skyrocket. Revenues would continue to show modest growth, but Conn’s would report massive losses from massive defaults.
Conn’s sort of let the cat out of the bag when it told Wall Street to tone down its full-year expectations. The company expected revenues to grow by mid- to high single digits—well below Wall Street’s insane expectations for 13% sales growth.
I thought even that was too high.
Conn’s closed at $10.48 the day I sent out my trade alert. Its stock dropped like a rock on June 2 when it reported a much-bigger-than-expected loss of $0.31 per share—which shocked the Wall Street crowd that was expecting only a $0.06 profit!
The problem (no surprise) was an increased number of deadbeat loans that generated a $21 million operating loss and pushed the bad-debt ratio from 14.25% to 15.25%.
The result: a 21% gain
Conn’s shares plummeted on that news, and we closed out the Conn’s short sale with a 21% profit. That’s a fat gain, given that the stock market has stayed pretty much flat during this time.
Short selling, however, can be even more lucrative when the next bear market comes around.
My goal of showing you this short sale is to demonstrate how you can identity short selling opportunities and profit from them.
Short selling isn’t complicated. It’s a valuable diversification tool and a defensive bear-market insurance policy that every investor should make use of.
has worked in almost every part of the financial services industry, including a stint as a life insurance salesman for Prudential; a stockbroker at Merrill Lynch; and a portfolio manager at The Donohue Group. Later he switched to publishing and eventually became one of the most widely read market writers of the last generation. Click HERE
to learn how Tony uncovers the real story behind the week’s market news. To read more of his articles, GO HERE NOW.
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