A Long Romp for the Shorts?

Short sellers say the bear market has a ways to go

On Apr. 19, Michael J. Saylor, the flamboyant chairman of Micro-Strategy Inc., sent a highly unusual and urgent letter to his company's shareholders. "Management believes that the current stock price is attributable in part to heavy selling pressure from short selling in the marketplace," he wrote. The stock's sharply diminished price--it traded as high as $313 a share in March, 2000, and as low as $3 in mid-April--no doubt led Saylor to point the finger at the diabolical short sellers. Truth is, MicroStrategy has been a short seller's dream for many reasons, including a Securities & Exchange Commission probe that resulted in a heavy penalty and aggressive accounting practices that forced the company to restate three years' worth of earnings.

Saylor's blame game reveals the success and influence short sellers are enjoying in a bearish market. Shorts sell borrowed stocks with the hope of buying them back as the stock price falls. They are famously discreet for fear of being kept off company conference calls or worse, attracting lawsuits and even death threats. These days, they have a glut of targets--some are tech companies, but many are in other areas such as biotech, energy, and retail. Typically, these are companies that should have never gone public, shorts say, or are simply suffering because of a severe downturn in capital spending. "Most marginal companies aren't getting financing going forward, so troubled balance sheets and negative cash flows are taking up more of our attention these days," says the famous short seller James Chanos of Kynikos Associates.

Short-selling hedge funds were up 13.4% in the first quarter of this year and 18% in 2000, beating out all other hedge fund categories, according to Zurich Capital Markets Inc. And short interest on the Nasdaq and New York Stock Exchange remains at record levels.

UNFAZED. Shorts are counting on a continuing bear market to bolster their bottom lines. They pay little heed to gurus who say the market has bottomed out and the tech slump is nearing an end. Shorts point to sour earnings projections, at least through year's end, and a weakening U.S. dollar that could spur inflation. The recent rally has left some shorts unfazed. "It was partly based on buyers' panic--investors who didn't want to miss the boat--and short-covering, making for a largely artificial advance and no lasting fundamental change in stock prices," says Douglas Kass, manager of Seabreeze Partners and Kass Partners, both short-biased hedge funds.

Just because shorts are strutting right now doesn't mean they won't stumble again soon. After all, not long ago they seemed as doomed as many of the companies they now target. The bull market led many big short sellers, such as the Feshbach Brothers of Palo Alto, Calif., and Brookline Capital's Alan Fenster, to abandon their short strategies or go out of business. In fact, says Harry Strunk, a Palm Beach, Fla., investment consultant who tracks short-only managers, the number of pure short sellers has fallen from 19 in 1991 to just 6. Shorting proved ruinous to even George Soros, who bet against tech stocks during the bull market.

But all that has changed--at least for now. "The excesses in the market took many, many years to build up, and people think it can be fixed in matter of months or weeks, but it will take time," says Marc Cohodes, a general partner in Rocker Partners LP, a short-biased hedge fund that was up 39% over the past 12 months. Meanwhile, companies continue to play new games, says Cohodes, who points to Cisco System Inc.'s (CSCO ) recent inventory write-off. "If you're in the meat business and you write off meat, you're still going to sell that meat. It's a total spin job," he says. A Cisco spokesman says, "We simply have no use for that inventory, otherwise we wouldn't be writing it down."

Cohodes doesn't usually short large companies such as Cisco because, he says, they will be around cycle in, cycle out. Instead, he looks for what he calls "fads, frauds, and failures." Some current broad themes: companies that supply the state of California with power and semiconductor companies that have run up in recent weeks. More narrow picks include shoe manufacturer Skechers USA Inc. (SKX ) Says Cohodes: "It's a fad--gym shoes trying to be high-fashion." Cohodes also notes that Skechers is run by Robert Greenberg, former chairman of L.A. Gear, which reorganized for bankruptcy in 1998. Cohodes has also been short on QLogic (QLGC ), a computer component maker, for some months. "In the last quarter they saw receivables and inventory go through the roof," he says.

Some shorts are focusing on what they believe are overvalued companies. Brian Rogers, manager of the Short Alpha Bear hedge fund, the top-performing short-only fund in this year's first quarter, says: "I think current valuations--the average price-earnings ratio is around 25--indicate we are nowhere near a market bottom." Rogers targets larger, more liquid companies and uses both fundamental and technical analysis. He says most other short sellers focus primarily on smaller companies that are likely to go out of business. "Most shorts tend to invest in the same small companies, so often there's a short squeeze and all the funds go down together," he says. Some past shorts include Motorola Inc. (MOT ) and Starbucks Corp. (SBUX ) A favorite target right now is the biotech industry. "The price-to-sales of the industry is very high," he says.

Kynikos' Chanos, whose fund was up 35% last year and 12% through March, is on the prowl for overvalued sectors. He says subprime lenders, which are trading at as much as five times book value, are a good target, as are energy traders along the lines of an Enron Corp. (ENE ) or a Dynegy Inc. (DYN ) While Chanos won't confirm his specific shorts, he points out that these stocks are essentially giant energy hedge funds that are trading at huge valuations. He's also interested in high-growth retailers that he thinks can't sustain 50% annual growth. Chanos has shifted his focus significantly from a year ago, when he was looking at the Internet and telecom ideas.

GUMSHOES. Good ideas don't come just from short sellers. Short researchers pore over balance sheets and sell their findings to hedge funds and money managers. For these financial gumshoes, who often charge into the upper five figures annually for their services, business is booming. "Hedge funds are realizing the only way they can make money and justify their fees is on the short side," says Howard Schilit, an accounting expert. Likewise, money managers who don't short are turning to Schilit to warn them of potential blow-ups in their portfolios. "People who said thanks, but no thanks a few years ago are now calling and saying, `Help me,"' he says. Schilit, a former accounting professor, is famous for ferreting out some of the biggest accounting blowups in recent years, including Sunbeam Corp. (SOC ) and Oxford Health Plans Inc. (OXHP )

Another prominent researcher is Mark Roberts, director of research for Off Wall Street Consulting Group Inc. He employs seven analysts, all of whom have accounting backgrounds or have run businesses. Roberts suggested shorting priceline.com Inc. when it was trading at $111--a prescient move, it turned out. One of Robert's current favorites is the medical sector. "A lot of these companies, especially biotechs, acquired a lot of financing and when that dries up they're toast," he says.

Some may argue that when the bear market comes to an end, short sellers will perish along with it. But at least for now, the bears are gleefully rolling around in the mud.

By Marcia Vickers, with David Henry, in New York

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