Short Stories: NovaStar's seven week 29% return

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. Short Stories discusses what works, what doesn't, and what some of the leading lights in shorting stocks think about its opportunities and threats. I describe possible short trades and I seek your comments and questions for story ideas. I don't offer any investment advice and I don't trade on any of the posts I write.

If you had followed my December 18th suggestion to sell short shares of subprime mortgage lender, NovaStar Financial, Inc. (NYSE: NFI) at $29 and covered your position -- by buying back the shares at today's $20.52, you would have made a 29% return. This is pretty good for seven weeks' work and 14 times better than just holding onto the S&P 500.

I could understand why an investor would close out a substantial portion of the short position right now. For those willing to keep open the short bet, here are four reasons that NFI could decline further:

• Increased short interest. Since my December post, NFI's short interest has risen from 32.8% to 37.6% as of January 9th. This represents 12.9 million shares betting on NFI's decline.
• Insider selling. During the last six months, insiders have executed seven sell transactions totaling 144,800 shares with no buys. Institutions have sold 1.5 million shares, representing a 13.9% reduction in their holdings;
• Weak industry outlook. A January 26th New York Times article [subscription required] higlighted some worrisome new trends. For example, liquidity is flowing out of the mortgage industry. Specifically, hedge funds that specialize in mortgage-backed securities had an outflow of $1.8 billion in 2006, down from an inflow of $1.8 billion in 2005, according to Hedge Fund Research. It was the only category of hedge funds to have a negative flow for the year. Another worrisome trend is rising foreclosures. Across the industry, 2.6% of the subprime loans securitized in the second quarter of 2006 had been foreclosed on or repossessed within six months. That is up from 1% percent for loans securitized in the second quarter of 2005, according to Moody's Investors Service; and
• Ominously missing data. In a presentation it made last week at the American Securitization Forum posted on the SEC web site, NFI left out data on its 2006 payment defaults and provisions for credit losses. Since it included loan production data for 2006, it is curious that NFI chose to exclude the credit loss data. In its most recent quarterly report, NFI's provision for credit losses was up 20-fold from $1 million in the nine months ending September 2005 to $20 million for the same period in 2006. NFI could have used this Forum to reduce investor concerns about credit quality by presenting updated numbers. Its decision not to include these numbers raises the question of why it chose not to do so.

NFI has an attractive 26.4% dividend yield. But in the most recent nine month period, it ended up with $82.5 million less cash than the year before. If that trend continues, NFI may decide to cut its dividend.

Peter Cohan is President of Peter S. Cohan & Associates, a management consulting and venture capital firm, He also teaches management at Babson College and edits The Cohan Letter. He has no financial interest in NovaStar.