Monday, April 17, 2006

In Defense of Herb

I have at my fingertips a litany of scandal: a dozen companies or more, all exaggerating earnings, hiding inventory, secretly cutting prices, watching their businesses implode while they dump stock on an unsuspecting public.

I speak of significant companies, all publicly traded, with market caps north of $500 million. I could tell you the names of these companies, and, if I was still a working journalist, I would. But now that I’m a hedge fund analyst, why would I?

The risks of being openly skeptical of a company have never been greater. As the Securities and Exchange Commission looks on, critical investors and short sellers are being ignored on conference calls, refused access to company management, lied to by executives, and, of late, sued into submission. The victim, ultimately, is the investing public, inured from any frank discussion of risk.

In the financial press, seldom is heard a discouraging word. On rare occasion reporters, writing in their own voice, are critical. But money managers rarely are. Did you ever wonder why is it that we Wall Street pros, a generally bitter lot, sound so positive in print?

Look what’s happened to my friends Herb Greenberg and David Rocker. More than any other business journalist, Greenberg has made a career trafficking in information about troubled companies. David Rocker, meanwhile, has made a career selling short the shares of such companies. On rare occasion, Rocker has openly shared his views with Greenberg’s readers. For this, Greenberg’s records were subpoenaed by the SEC (a subpoenaed later withdrawn), Rocker is being sued by, accused of being part of a vast conspiracy to bring the unprofitable retailer down. The threat of such actions has critics of stocks slinking even further into the shadows.

Rocker should be commended for the courage of his convictions, a rarity on the short side (a few times in my days as a reporter, he’d be quoted in my columns or in my television reports, but too rarely). But without protection from the SEC, few dare to join Rocker, airing public doubt. And Greenberg’s most difficult problem today isn’t finding the right story ideas. It’s finding people like Rocker willing to go on the record – a task made all that more difficult thanks to the SEC’s bone-headed prosecution.

That leaves journalists with only ill-informed Wall Street analysts and promoters happy to go on CNBC or be quoted in the press. Here’s what too few business journalists know: short sellers are the very best of sources. Why? Because buying stocks is easy. Shorting is hard.

When people ask me the secret to great stock purchase, I tell them the story of Thin File. My parsimonious boss bought a single file cabinet fourteen years ago when he had some $2mm under management. With assets bulging at more than $800 million today, he refuses to buy another file cabinet. So the folder for each investment is kept to less than half-an-inch. File “thinning” is a regular chore for his analysts. And woe to the young analyst caught hording information. “This,” the boss will say seizing an offending full-figured folder from a desk, “is a money-losing file. Thin it.” Refuseniks are fired, ritualistically.

But just as simplicity is the friend of an investment, a short sale thrives on complexity. The more convoluted a story is, the more that can go wrong and, therefore, the more likely the stock will decline.

Warren Buffet wrote in 2005: “If only one variable is key to a decision, and the variable has a 90% chance of going your way, the chance of a successful outcome is obviously 90%. But if ten independent variables need to break favorably for a successful result, and each has a 90% probability of success, the likelihood of having a winner is only 35%.”

So while a thin file makes a good long, a good short can have a fat file. Short sellers need to know where the ghost in the machine may lie. So short sellers tend to do more research than long investors, because they have to.

But rather than being known as researchers, short sellers are known as financial buzzards; bird-brains circling and hoping for the worst. After church one Sunday, an otherwise financially-savvy parishioner told me “it’s un-Christian to short stocks.” I wonder: would I be a better Christian if bid for overvalued stocks? Should my Lenten observance be 40 days of Google purchases, the higher the price, the greater the absolution. Indeed, why don’t I secure a place in Heaven once and for all, buying forlorn Kodak at four time next years earnings, no, Jesus, let me pay five time earnings to obtain His eternal salvation!

Short sellers are in need of a public rehabilitation. But we need the protection, not the persecution or the blind eye of the SEC.

And short sellers need to end their silence. We need to speak up. Every short seller should call up a journalist today and share with them the tales of woe and intrigue that we know so well. Because the public needs to know that even as Adelphia, Tenant and Enron fade into history, corporate skullduggery runs amok.

But I fear these are stories that will never be told.

Cory Johnson, an analyst for Cannell Capital LLC in San Francisco is a former investigative reporter and CNBC’s former technology correspondent. Most of his files are thin.