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 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.
Last December, I urged investors to consider selling short shares of NovaStar Financial (NYSE: NFI) when they could be had for $116 a share. And in August, I asked whether NovaStar would file for bankruptcy. It's not quite there yet -- but at $1.72 a share -- it's getting close. (It borrowed $95 million from Wachovia Corp. (NYSE: WB) and now can't pay it back after posting a $64.05 a share loss.) If one were to buy back the shares at Friday's $1.72 sold short at $116 -- it would represent a 66-fold return on investment. (Actually slightly less when taking into account the cost of collateral required to hold the short position during the last 11-months).
Meanwhile the New York Times reports on NovaStar's creative management compensation and the message board boasts of Howard B. Hill, a member of the quantitative management group at Babson Capital, a unit of MassMutual. NovaStar paid its top executives dividends on their stock option grants -- they got paid dividends on shares they didn't even own. Specifically, NovaStar reduced shareholders' equity by $2.2 million in 2006 and $4.1 million in 2005 to cover those dividends.
And that self-serving NovaStar creativity extended to institutional investors in the company. My original post in December 2006, led to the following comment: "Do you understand why Babson Capital has increased their position in NFI from 0 to 508,000 shares and $15m (making it one of the top 10 positions for Babson Capital aka Mass Mutual) in 2006. I think Babson would like to know more about what is motivating your AOL blog. Doug Walker"
I have some questions for "Doug Walker" -- as a defender of Babson Capital's $15 million investment in NovaStar, Why did you write this comment? How much did Babson Capital lose on its investment? What explanation does Babson Capital have for why it was so disastrously wrong on NovaStar? I welcome his comment on this post.
Meanwhile, I think it's too early to cover the short position -- at this point I would be very surprised if it did not file for bankruptcy. Then it will trade -- for reasons that I do not understand -- on the so-called pink sheets probably at pennies a share.
While I feel badly for individual investors who lost money in this stock, I would expect institutional investors to have done a bit more homework before sending message board stock boosters to put lipstick on this pig.
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 or Wachovia.
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Reader Comments (Page 1 of 1)
11-18-2007 @ 10:18AM
milty said...
I believe you are incorrect on making a mistake when you claimed a 66 fold return on your short sale. The most you can make on your investment is 100% if the stock goes to zero. If you sell one share short at $116 and it goes to zero you make $116 dollars on a $116 investment.
11-17-2007 @ 7:18PM
Peter Cohan said...
Many people think that the returns on selling short are limited to the amount sold short. But in a short sale, the investor is borrowing shares -- getting the cash proceeds from the sale up front and then is required to repay the loan by buying back the shares sold short in the open market. The investor's return is the difference between the initial proceeds from the short sale and the amount the investor pays to buy back the stock in the open market.
If a short seller sold one share of NovaStar short in December at $116 and repaid the loan by buying back the share at $1.70 last Friday, the investment profit would be $114.30 which is the difference between the $1.70 the investor paid for the share and the $116 the investor sold it for in December.
In reality, a short seller has to keep a certain amount available in escrow in case the short bet goes the wrong way. The cost of holding this collateral -- the lost investment returns that the collateral could have earned -- should be subtracted from the investment returns.
11-18-2007 @ 10:32PM
Hassan Darouie said...
I lost lot of $ on NFI , I bought at $9.35, what is the futures of this stock?
11-21-2007 @ 2:03PM
Larry said...
Isn't it illegal for NFI to pay a dividend on unvested stock options to it's executives when NFI made the decision not to pay dividends to existing shareholders of common stock?