Short Stories: How to profit from the pending plunge

Posted Jan 22nd 2008 11:25AM by Peter Cohan
Filed under: Short Stories, Citigroup Inc. (C), JPMorgan Chase (JPM), American Express (AXP), Merrill Lynch (MER)

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.

BusinessWeek reports that the consumer is tapped out. Can you profit from the combination of a falling market and a cash-starved consumer?

I was scheduled to appear this morning on CNBC's Squawk Box to discuss ways to profit from problems with consumer finance. Last night, my appearance was canceled -- I think it might have had something to do with the global market crash. But CNBC's loss can be your gain. Here's why I think the consumer will be the next shoe to drop in the economy and a few ways to profit.

Unemployment rate rising (to 5% in the most recent report)
Wage growth slower than inflation
Declining value of homes makes home equity borrowing a non-option
Savings rate -0.7% -- the worst since 1929
Consumer installment borrowing at record $2.46 trillion

People pay their credit card bills last. A 1,000 household consumer survey (12/07) which said that their credit card bill would be the last of eight categories that they would pay back -- with mortgage and insurance being first and second respectively
Banks raising their provisions for bad consumer loans. For example, Capital One (NYSE: COF) set a $1.9 billion provision for bad loans for Q4 and $5.9 billion for 2008. American Express (NYSE: AXP) set a $440 million provision and expects charge-offs to rise from 4.3% in Q4 to 5.3% in 2008
Banks reporting worse than expected earnings. Citigroup Inc. (NYSE: C) was expected to lose 97 cents a share and it actually lost $1.99. Merrill Lynch & Co. (NYSE: MER) was expected to lose $4.57, it actually lost $12.01 a share, and JPMorgan Chase (NYSE: JPM) was expected to make $0.94 and it made 86 cents.

To profit from this trend, I have three stocks in the pawn shop/payday loan sector. These companies charge interest rates as high as 140% for loans in the $300 to $1,000 range. For example, payday lenders charge $2 for every $20 borrowed. Based on a 30-day repayment period that's 120% annual interest. With pawn shops, the loans are backed by items like gold jewelry, watches, etc. For payday loans, the security is the paycheck. Fees are huge -- one borrower took out a $400 loan and paid $2,500 in fees.

Of these three, the first is by far a more interesting candidate for shorting than the other two.

World Acceptance Corp. (NASDAQ: WRLD). At $20.76, this stock is down 52% in the last year, 21.1% of its float was sold short as of 12/11/07. This payday lender had $6 million in cash as of 9/30/07 and is due to pay back $69 million of its debt in 2008, according to its 2007 10K. But it generated only $84,000 in cash in the last quarter and its provision for loan losses rose 33% in Q3.
Advance America (NYSE: AEA). At $7.21, this stock is down 41% in the last year, 7.5% of its float was sold short as of 12/27/07. This payday lender had $32 million in cash as of 9/30/07, and is due to pay back $173 million of its debt in 2008, according to its 2007 10K. But it burned through $35 million in cash in the last quarter and its provision for loan losses rose 25% in Q3.
Cash America (NYSE: CSH). At $27.26, this stock is down 33% in the last year, 7.4% of its float was sold short as of 12/27/07. This pawn shop/payday lender had $26 million in cash as of 9/30/07 and is due to pay back $49 million of its debt in 2008, according to its 2007 10K. But it generated only $689,000 in cash in the last quarter and its provision for loan losses rose 149% in Q3. If not for a $16.8 million one-time gain from sale of notes from a Swedish subsidiary, its earnings would have dropped.

I am not completely convinced that each of these stocks is a strong short candidate. But I will be watching their next financial report to see if conditions for those at the bottom of the economic ladder are damaging their prospects.

Peter Cohan is president of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter. He owns Citigroup stock and has no financial interest in the other securities mentioned.

Tags: Advance America, AdvanceAmerica, AEA, Cash America, CashAmerica, CSH, featured, payday lenders, PaydayLenders, short, short selling, ShortSelling, World Acceptance Corp., WorldAcceptanceCorp., WRLD

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Reader Comments (Page 1 of 1)

1-22-2008 @ 12:20PM

Scott Cacciatore said...

Scott Cacciatore talks huge drop in te DOW Jones followed by 3/4 rate surprise cut and gives his opinion on the market:

So early Tuesday morning investors tuned in to Bloomberg TV to see that the asian markets have plunged by over 7 %. The DOW futures were down 530 points and the S&P futures were down 68. The DOW Jones was sure to open gap down around 500 points. The Down actually dropped as much as 464 points early this trading session but rallied strongly on the surprise 3/4 rate cut by the Federal Reserve. Honestly, though, how much of a surprise was this rate cut. We all expected the Fed to cut rates 1/2 point next Tuesday at the latest so how much will the extra 1/4 actually matter to the market. Yes the Down did initially rally close to 400 points on the knee jerk reaction to the rate cut but has since lost ground and at the time of this article stands at down 147 points. The financial sector and the retail stocks seemed to benefit the most from the rate cut with stocks like JPM, MER, Bank of America, Home Depot, Bed Bath and Beyond, and American Eagle all gaining at least 3.5%. Of course in a surprise rate cut the financial stocks usually benefit the most, but I was surprised to see the retail sector rally so strongly. I was also surprised to see Bank of America rally so strongly considering their earnings dropped 95% from the 4th quarter of 2006. Yes the Fed took necessary action to help the economy and stock market, but how much will this rate cut actually matter? Watching Bloomberg TV early Tuesday morning, I saw expert after expert from all over the world say that they dont believe we are anywhere near a bottom and they expect the DOW to drop at least another 1000 points before we reach a bottom. If we were in such terrible shape at 9:30 this morning and we all expected the Fed to lower rates by 1/2 by the latest next Tuesday then is this extra 1/4 rate cut really that significant?? I dont expect the bears to go away just because of this action by the Fed. I believe we will continue to see strong short selling and we will continue to see the market fall. We will not reach a bottom until we see something optimisitic from the housing and credit and retail sectors. The unemployment rate is also rising which is obviously not good for the ecomony. Until all of these factors turn positive the economy will continue to suffer and so will the stock market.

Scott Cacciatore on the stock market.