Friday, June 10, 2005

3 Years of Getting It Wrong – The NFI Short Story

In July of 2002, the short interest in NovaStar Financial (NYSE – NFI) went from basically nothing, into multiple millions, all within a period of 45 days or so. Investors at the time had no idea what was happening, as they watched the stock of a tiny MREIT go from the mid-$30’s to $20 or so – and many sold, as they were retirees who depend upon their nest eggs to support them, and REITs are typically held by conservative, risk adverse folks on fixed incomes who can’t afford big changes in their NAV. The feeling at the time was that somebody must know something, insiders or institutions had to be selling, and that some crisis or calamity was looming on the horizon.


It was a network of short sellers that specialize in terrorizing small cap company investors, who had put NFI into play, to scare the widows out of their money, expecting to cover in the single digits.

That isn’t exactly how it played out.

This July marks the third straight year that these shorts have called every aspect of the company’s fundamentals wrong. They called the biggest increase in US housing history wrong, they called the company’s business strategy wrong, they called its prospects wrong, they called its growth potential wrong….every possible area, they got wrong.

The average 2002 shorts can be calculated to be roughly $25 or so, pre-split. That is $12.50 or so now, post split, and approximately 4.4 million shares post split. Those original shorted shares have paid out about $12 in dividends since then as well, meaning that even if the company went to $0, they would never make a dime in short sale profits – the math is impossible to reconcile any other way. Additionally, those shares have paid to be borrowed for 3 years, and have also paid for any margin lending costs – all in all an extraordinarily bad bet, as the costs are likely at least another $4 or $5 per share.

Through it all, the company’s detractors (the shorts, Herb Greenberg, and then a particularly ill-informed Forbes writer, as well as the WSJ’s C-section writers, and later Camelback) have gotten all the fundamentals wrong. They have ignored the MREIT truism that every company configured as an MREIT must obey – you pay out all your cash as a dividend, so you are always raising money via secondaries and preferreds and the like to fund growth – they all do it. Every one. They have to – it’s the business model. And yet all these detractors have studiously ignored that easily verifiable fact. They have also ignored the tax code’s requirement that MREITs pay out their dividends based upon Taxable Income (TI), and instead tried to make a story out of the fact that in the early, high growth years, TI will be considerably higher than GAAP, resulting in the dividend being higher than GAAP. They erroneously say that the company pays out more than it earns, when the accurate thing to say would be that the company pays out more than GAAP, but less than TI (Taxable Income, or EARNINGS) – instead they pretend that the company didn’t “earn” that TI, or somehow banish Taxable Income from the concept of earnings – a rhetorical dishonesty that is intended to deceive the dim, and the novice investor.

They have insisted that higher rates would damage the company irreparably. They have posited that by phasing out the branches that originations would plummet. They have stated repeatedly that defaults would imminently spiral out of control. They have taken provably false positions on every possible aspect of the company’s functions, and done so with a straight face, as though through repetition the lie would become the truth. Review Mr. Cuban’s gem here at Sanity Check from Mother’s Day as an example of incorrectly categorizing the basics of the company’s operations.

3 years of this. 3 full years of one of the worst shorts I can think of – even if the company went BK tomorrow, the short has lost tens of millions.

So happy anniversary on the third year of being wrong about everything about NFI. Astoundingly, the bashers are still misstating every aspect of the company’s fundamentals and ignoring the obvious fact that they have all been wrong about every single thing they’ve ever said about the company – except for when they have predicted price drops based on short attacks or manipulation. So what have we learned?

1) The manipulators are only good at predicting their manipulations.
2) They are 100% wrong when they predict anything besides that.

That’s been the history. For 3 years. They try to spin it as though they aren’t wrong, just early, but frankly even that tired old saw is getting no airplay anymore. If one goes back and reads all of the gloomy predictions of disaster from as far back as July of 2002 on the Yahoo message boards, one will find that other than some stock movement calls, EVERY prediction involving the company’s fundamentals has been dead, completely wrong.

Wonder how many years their investors are going to accept sub-par performance, and now the involvement in a badly aged fail to deliver position, which augments the legitimate short position and in fact is an even bigger, more desperate short bet? We have over 35% of the company’s outstanding shares sold short, an additional unknown number sold short as part of the old international arbitrage failure ploy, or naked shorted by the options market makers, or the international market makers, or the specialist (apparently none of which appear on the SI), and the guys that are leading the charge on this are the gang that couldn’t shoot straight – when it comes to calling the macro, the micro, or anything about the company’s business correctly.

Congratulations, my short friends. Nicely done, well played, bravo, hat’s off to you. It is rare to have such unrestrained, deliberate consistency of outcome as you have demonstrated – one would expect at least some of the fundamental predictions to have been correct just based upon the law of averages – but tut, tut, not for you. All wrong, all the time, that’s the game. And you’ve managed to sucker in every idiot with a buck and a jones to short – billionaires and day traders alike – and get them to not only ignore how incorrect you are/have been, but even better, to parrot your incorrect spin with the sincerity of the righteous - none of that round earth nonsense for them, it's flat, dammit, it's flat...

That is the real accomplishment here. Only when big money is being lost can so much effort be invested into maintaining a fiction of this magnitude for so long.

I raise my glass in salute.

Happy Anniversary.


Blogger docmon05 said...

nice summary, but it cannot be denied that big shorts have also made a ton of money on NFI, repeatedly, and even recently. So gloating over their "error" misunderstands the nature of their trading. (Long NFI myself, bigtime.)

6:52 PM  
Blogger bob obrien said...

I don't disagree that it can be very profitable to illegally manipulate stocks, playing the options game.

I have a very difficult time understanding how the math could work out where the big short who is so badly underwater on the original position, or indeed even short at $30 and $32 and such, can turn 9+ million shares shorted into a profitable position, especially if one considers the cost of borrowing for years, and the margin, and the dividend that has to be paid out. I think the best that can be said is that it is possible that they have made enough from manipulating the stock to offset a reasonable portion of the loss they have experienced from those costs - but I have yet to see a convincing explanation of how 9+ million legitimately shorted shares, and untold millions of FTD's, can cover and not cause a centi-million dolar hole in the shorts' net worth.

4:00 PM  

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