Although short selling -- the practice of selling borrowed shares with the hope of repaying the loan by buying back the shares at a lower price -- goes against the American belief that stocks always go up, I have long been fascinated with it. My plan for my new blog, Short Stories, is to discuss what works, what doesn't, and what some of the leading lights in shorting stocks think about its opportunities and threats. I will describe possible short trades and I'll seek your comments and questions for story ideas. I won't be offering any investment advice and I won't trade on any of the posts I write.
A company's assets are available to pay the claims of customers, lenders, and stockholders. But when those assets are dwindling relative to the claims, there's a chance that not all the constituents will be paid off in full. For example, lenders are usually ahead of preferred shareholders, both of whom get paid before the common shareholders. In such cases, the common shareholders could be left with little or nothing.
This is the concept behind a trade that one of my Short Stories sources described to me last week. He sold short common shares of Quanta Capital Holdings Ltd. (NASDAQ: QNTA) when they traded at $2.50 and bought shares of Quanta Capital Holdings Ltd. -- Series A Preferred Shares (NASDAQ: QNTAP) when they went for $16.50.
Quanta is a Bermuda-based property/casualty reinsurance company founded in 2003. Translated into English, Quanta insures insurance companies that protect people and property against catastrophes. Thanks to the massive losses from hurricanes in 2004 and 2005, Quanta lost its claims-paying rating from A.M. Best, which it needs to write new policies. So now it's in run-off mode. That means it will keep operating until it fulfills its contractual responsibilities to previous policyholders but it won't write any new policies. Why would my source place such as bet on an insurance company in run-off?
Quanta's capital structure is complex. At the end of June 2006 it had $62 million in subordinated debentures (a kind of bond), three million publicly-traded preferred shares (QNTAP) with a par value of $75 million, and 70 million common shares outstanding. The subordinated debt holders have first claim on Quanta's cash flow, the preferred shareholders are next in line, leaving the remaining scraps for the common shareholders.
The preferred stock, which has a par value of $25 a share, now trades at $16.10 and the common closed today at $1.85. But according to its latest balance sheet, Quanta has a tangible net worth -- shareholders' equity minus intangible assets such as goodwill -- per common share of $4.45 -- providing a margin of safety for the preferred shareholders but probably not enough for the common shareholders in my source's view.
His idea was that the value of the preferred shares would increase as Quanta liquidated itself and the cash went to pay dividends and principal on the preferred. Buying the preferred at $16.50, he wagered would yield a 52% return when Quanta paid off the preferred at $25. And since this would leave little, if anything, for the common shareholders, the common stock would drop from $2.50 to virtually nil.
One risk that my source envisions is that QNTA may have not set aside enough money in its reserves to cover higher than expected insurance claims from its clients. But in his view, it would take hundreds of millions of such under-reserved claims to make a difference in his analysis of the opportunity.
I also pointed out to him that there are some very smart investors who have invested in the common stock. For example, Baupost Group, a $5.4 billion hedge fund run by Seth Klarman, a value investor, owned 6.6 million share of the common as of June 30. My source does not discount Baupost's investment savvy, he just thinks that the odds favor his preferred shares rising in value and the common tumbling below $2.50.
I don't understand how my source can bet without more precise estimates but as he said, "it's like poker -- a game of wagering based on incomplete information. You win some, you lose some, hopefully you end up with a good batting average."
Despite his mixed metaphor I guess that's how markets are made.
Peter Cohan is President of Peter S. Cohan & Associates, a management consulting and venture capital firm, and a Professor of Management at Babson College. He has no financial interest in any of Quanta's securities.
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