A “valueprax” investment post-mortem explores the aftermath of a portfolio investment, successful or unsuccessful, with the intent of acknowledging the good, accepting the bad and attempting to find humor in the ugly. Success and failure alike carry valuable lessons; in support of the constant effort needed to avoid cognitive bias, the post-mortem is the table upon which all cards are laid and reality is fully embraced, rather than selectively avoided.
The Thesis
The thesis for this trade was fairly simple, as explained by an acquaintance in a post entitled “Time to Put the Energy Conversion Devices ($ENER) Capital Structure Trade Back On” over at CreditBubbleStocks.com:
an incredible short squeeze has taken place in the ENER stock, catapulting it from 20 cents to a high of 1.50 today. Meanwhile, the bonds have hardly traded, and are yielding nearly 80 percent. The prices of the company’s bonds and common stock are inconsistent and imply wildly different valuations for the company.
The nature of capital structure pricing and the legal force of competing claims within the capital structure dictate that discrepancies involving discounted debt and greater than de minimis common equity valuations can not be sustained over the long-run and the prices of these securities should eventually converge toward a common, non-contradictory narrative of the state of the business. Corporate debt trading at a significant discount to face value in the markets implies financial distress and a risk of insolvency, which further implies that common equity has no value, as the financial claims of debtholders are superior to those of preferred and common equity holders. Debt holders are due their principal at time of maturity, so if the bond market is saying they aren’t going to get all of their principal back it implies the equity holders have claims with zero economic value.
This particular trade centered around the capital structure of Energy Conversion Devices, a solar panel manufacturer, was enticing because of the following additional considerations:
- the solar industry is experiencing a severe, cyclical contraction as the solar industry is regarded as an uneconomic black sheep policy boondoggle in the US and Germany/Europe, resulting in the withdrawal of subsidy support
- the prior infusion of subsidies attracted a surplus of suppliers to the industry in the US, Germany and China, resulting in a massive capacity glut in an industry with no barriers to entry
- ENER was known to have the most inefficient, highest cost solar technology, making their product an inferior offering in the market
- ENER had a large debt overhang which had become unmanageable in the face of unprofitable operations
- there was no pressure to consolidate in the industry and, because ENER had ventured down a technological dead-end, there was minimal risk of a buy-out or takeover by a competitor interested in securing their capacity or technology
For more details on the thesis and reasoning behind the trade, I respectfully direct the reader to the ENER-tagged posts at CreditBubbleStocks, where my acquaintance has ably laid out the case for investment in a most thorough manner: CreditBubbleStocks.com – ENER post list
The Research & Analysis Process
The research process for this investment involved two primary activities: reading and considering the writings of my acquaintance at CreditBubbleStocks who is a subject-matter expert in the area of bankrupt solar company shorts and cap-arb plays due to previous investments made, and the conducting of gumshoe-style “scuttlebutt” investigations via ENER’s Wall Street analysts, competitor IR departments and CFOs, installers and even ENER IR contacts themselves.
Research-wise, I relied in large part upon my acquaintance at CBS to generate the idea and research and analyze the relevant financial information. “CP” is a veteran in this space with several similar, successful trades under his belt so far. My philosophy, therefore, was “trust, but verify.” I believe in doing your own homework and thinking for yourself, but I also believe you can save a lot of time and super-power your investment filter process by finding capable investors who have demonstrated repeatedly in the past that they understand a particular sector or trade and then unabashedly riding their coattails when they find something that makes sense to you.
However, I also worked with “CP” to conduct additional scuttlebutt on the company in an effort to find someone who could poke a hole in the idea for us or, conversely, help us to solidify our conviction, which I later learned is a critical tool in successfully executing an investment which requires short selling to complete.
I started by calling all the listed sell-side analysts who were supposed to be following the stock. Although some of the analysts were reluctant to talk with someone who was not a client, I did manage to have several lengthy, frank discussions which confirmed the following facts:
- the company had chosen a solar technology, “thin film” panelling, which was the least efficient in terms of transforming solar energy into useable electrical power, by a factor of 1:2, and their technology was the highest cost to produce, by a factor of greater than 2:1
- the company’s productive plant was likely worthless in a liquidation or sale because it was specialized to their technology, which no one wanted
- the company had experienced a lot of management churn in the last five years, indicating a hopeless situation, and while the analysts respected the various management teams, no one had an opinion of any of them as super effective miracle-workers
- the massive collapse in silicon prices, combined with the withdrawal of major government subsidies and turmoil in the Eurozone virtually guaranteed this company could not stand on its own economic footing in a competitive environment
- the other assets and IP of the company in the form of subsidiaries and patents were of dubious value
After speaking with sell-side analysts, I contacted a raft of commercial installers who had worked with ENER and competitor products, from whom I learned the following facts:
- ENER division UNI Solar was one of the first in the industry to offer commercially-installable solar energy panel products and the lack of initial competition was one of the primary reasons any of them ever did business with ENER
- the company had been stingy and technical about paying on warranty claims in the past, aggravating relationships with installers
- no installer would specifically recommend the products unless requested by the client because of the high cost-to-efficiency ratio; one installer specifically mentioned that he had installed ENER products extensively on US military installations only because ENER had aggressively lobbied the military procurement coordinators and “persuaded” them to ask for ENER products
- although the ENER “thin film” panel technology had an advantage in that it was lightweight and did not require additional, costly structural engineering for additional load-bearing, this cost savings was not overcome by the cost-to-efficiency ratio and the technology had a disadvantage in that it adhered to the roof, so if the roof ever needed to be replaced or repaired due to wear or leaking, the entire roof + paneling would have to be thrown away
Finally, I spoke to competitors in the industry and asked them why they weren’t purchasing distressed ENER bonds in order to get control over the bankruptcy process or even potentially acquire the assets. The response from each was, “We have our own distressed debt we could repurchase”, “We could repurchase our own shares, first” and “Why would we want to acquire a stake in the bankruptcy proceedings? We’d rather see the company disappear.”
Clearly, ENER wasn’t getting any respect from analysts, installers nor competitors. And the worst part was, it wasn’t going to get any respect from me, either– I tried contacting ENER IR several times over the course of the investment and never got anyone to pick up or call me back. That by itself seemed like a suspicious sign.
The Execution
The trade itself was theoretically simple but turned out to be technically complex. To set up the capital structure arbitrage the investor wants to buy the distressed convertible bonds and synthesize a short on the equity. The belief here is that the equity is over-valued (assuming it’s worth zero) and the debt is under- or fairly-valued.
If the equity turns out to be worth something, the investor will lose on the equity short but gain on the debt long due to a full recovery. If the company is in fact insolvent and seeks bankruptcy protection with a zero equity value, the investor will gain on the equity short and could potentially lose on the debt long, though in practice it’s more common for the debt, already trading at distressed prices, to not lose a whole lot more in that situation.
The difficulty in this situation was twofold. First, the debt was a convertible issuance, so I had to find a brokerage that dealt in convertible corporate bonds– not everyone does. Second, the stock was hard to borrow. A short could be synthesized by writing in-the-money calls.
This is what I did, though I will say in all honesty I did not fully appreciate the risk I was taking at that moment. An in-the-money call is already working against you because anyone who buys the calls would be able to instantly exercise them and force you to deliver the stock or cash equivalent to them to cover. Additionally, because you are shorting, your potential loss is unlimited while your upside is limited to a 100% gain on the premium from option writing (minus the transaction costs involved in paying the brokerage).
Writing an option is an inherently risky proposition to begin with because options introduce leverage into the equation by the nature of their operation. Writing naked options is even riskier, because you don’t have the stock in your possession to deliver if the options are exercised. And shorting is inherently risky because your potential loss is unlimited. An acquaintance advised me to at least cap my potential loss by buying some calls at the strike price above my position as a hedge. This was probably sound advice and in the future I know to spend a lot more time examining the full risk of what I am doing, but a little bit more on that below.
The Experience & Lessons Learned
The total duration of this trade was a period of a couple weeks. I conducted some of the initial due diligence and scuttlebutt mentioned above near the end of January which was complicated by the fact that many of the firms I was contacting were based in Germany, Hong Kong, Taiwan and China which resulted in time zone issues. As my conviction strengthened proportionally with the feedback I was getting from the fundamental snooping around I began searching for some converts to buy. It took me a few days to buy them because I wasn’t totally thrilled with the price that was being offered relative to the estimated recovery values my acquaintance at CreditBubbleStocks.com had worked out.
One lesson I learned in working with the bond desk at my brokerage is to always ask if they’re sure there isn’t a better deal out there. The bond market is less efficient than the stock exchanges because a lot of the trading is still conducted broker-to-broker. Additionally, you have to have a fairly large block of money just to play the game– it’s not like the stock market where even a guy with $100 can buy a few shares if he wants.
There were odd lot sizes being offered when I first called: 8 bonds here, 14 bonds there and another seller offering 10 bond lots up to 100 total. It’s hard to get a sense of where the bond market is actually trading, as well. I saw from the FINRA website that the converts seemed to be trading hands at much lower prices than I was being offered, but I quickly found out these were inter-institutional sales at higher volumes. Still, I used this as something of a benchmark, anticipating that I shouldn’t pay an absurd spread like 10 points above these prices or something, and also trying to keep in mind what I anticipated was my probable recovery basis if the company went into bankruptcy and liquidated to pay the bondholders.
I asked the bond broker if he could find any other offers out there and he eventually came up with another odd lot and we were able to synthesize the position size I desired at a cost-basis closer to $40, which I felt more comfortable with.
I was traveling at the time and wasn’t able to write the calls until a couple days later but once I had a chance to settle in I put in an order to sell the calls for a total position size that was only slightly larger than my bond position in dollars committed.
The next few weeks were somewhat miserable. No sooner had I put on the trade did the stock start rallying, fiercely, and the bonds started falling, quietly. I was soon being LTCM-ed as this security price spread that was supposed to converge instead began to widen, dramatically. It was a junk rally-induced short squeeze that had initially created the opportunity by raising the equity price of ENER from a de minimis value in the first place, and clearly there was a secondary short squeeze tremor playing out now that I had gotten myself in.
I wasn’t too worried, though. The prior research, analysis and trading record of my acquaintance at CreditBubbleStocks.com, combined with my scuttlebutt efforts had given me a high level of conviction with regards to the veracity of our thesis. Previous research into the worthless stock inefficiency by my acquaintance at CBS (more commentary and research) also gave me confidence that our competitors in the market were uninformed, uncommitted over the long-term and quite likely unintelligent generally, as well. Subsequent inquiries into StockTwits feeds for ENER confirmed these suspicions. I’ll dive into that more below, but suffice it to say the quality of analysis of the people on the other side of this trade left something to be desired.
Finally, ENER was due to deliver an earnings report in the second week of February. The total radio silence at IR had me further convinced that they weren’t about to drop any bullish bomb shells (much to the chagrin of the StockTweeters, who were ecstatic about the potential for a buyout offer or news of big profits on sales of ENER’s solar-powered Kindle cover). This earnings release would serve as the necessary catalyst to unlock the value of this cap-arb trade. I figured what would happen would either be another disappointing earnings loss confirming the hopeless position the company was in, an outright failure to release the earnings on schedule or even a declaration of bankruptcy.
So, I was prepared to hang in there, assuming the week of February 14th would be showtime. But my willingness to hang in was similarly matched by the willingness of the momentum traders on the other side to be absolutely moronic. The tweet channels lit up as more and more daytraders, totally ignorant of the precarious financial and operational position of this company, proceeded to pile in en masse and seemed to be having a competition as to who could write the most obnoxious, uninformed bullish price prediction tweet. Somehow, they all managed to be winning!
Then, I started getting notices from my broker. The trouble was, I had recently opened the account and I wasn’t familiar with the broker’s trading systems and notification “language”, so I wasn’t entirely sure what they were trying to communicate to me. For a moment, my heart dropped into my stomach as I interpreted their notifications to mean that they had exercised my options, covered my position and locked in a real loss for me! I will be 100% honest, that experience was momentarily paralyzing and terrifying and it gave me an instant appreciation for all of the times I have heard other investor personalities talk about how they don’t do trades that don’t allow them to sleep peacefully at night! In fact, it was only a few days earlier that another acquaintance I had discussed the trade with had used those exact words in criticizing my risk management on the trade (rightly so!)
The ability-to-sleep factor, I soon learned, was a critical one. If anything it should be a simple litmus test for whether or not you’re doing something totally hare-brained. A really sound investment should never result in those kind of gastro-cardio discombobulations because a soundly executed investment should never expose the investor to the potential for unlimited loss. Lesson learned.
Luckily, a check of my account led me to realize the notices were simply to indicate that the options had been exercised and the brokerage had had to borrow and short stock in my account to make good. So, I had not locked in a realized loss, however, my cost of borrowing had now climbed as I was hanging on to a short in a hard to borrow stock. Not exactly ideal, but better than waking up to a forced loss. Clearly there were some crafty, sinister bastards on the other side of this trade trying to bully the shorts like me.
The technical confusion of the trade execution itself aside, nothing had occurred which managed to shake my resolve. I was looking forward to the announced earnings release date, confident it was bringing good news for me and bad news for the bears.
The Outcome
On the morning of Tuesday, February 14th, Valentine’s Day of all days, I awoke earlier than normal to the sound of my telephone ringing. It was my acquaintance at CBS, with a short message:
Hey, Energy Conversion just filed for bankruptcy and the trading is halted.
The best case outcome for this trade, the one I had semi-seriously joked about only the night before, had just materialized!
The stock opened down 80%, instantly crushing tens (if not hundreds) of utterly clueless technical-oriented daytraders. The tweets that followed were of cosmically comical proportions, witness (names withheld to protect the naively innocent):
And i was bitching last week I only made 2cents on a $ENER trade …phew. Great chart going into today, who knew.
Who knew? How about the people who treated the stock as something belonging to a real company with real horrific fundamentals?
Who files for bankruptcy on Valentine’s day anyway? $ENER
Sorry to tell you, but Valentine’s Day is not a special holiday in the financial world calendar. I assume this comment means the trader figured his risk of loss was limited on V-Day, so he proceeded to trade with abandon on the 13th?
SOB….now I can’t sell $ENER :-( what a great BD gift 4 me huh
Yeah, that’s called liquidity/exchange risk, and you typically want to make sure that when you get into a trade you are confident you can eventually get back out.
However, that wasn’t even my favorite. My favorite was posted several weeks before ENER declared bankruptcy, when the second short squeeze was just hitting its stride:
$ENER won’t be this cheap forever…
Yes, because it turned out it was only going to get cheaper.
The best part of the bankruptcy announcement was that it came with an announcement of the sale of one of the divisions of ENER to BASF for a concrete dollar figure, which, when combined with the certainty of the bankruptcy announcement, resulted in the converts trading higher even as the stock got crushed.
The ENER capital structure arbitrage was a smash hit success, and I am indebted to my acquaintance at CreditBubbleStocks for turning me on to the idea in the first place. However, the point of this post-mortem is not to gloat when victorious and deny responsibility when vanquished. Rather, the point is to try to explore all aspects of the investment and derive as many objective lessons as possible. To summarize my experience and education with the ENER trade, I would say this:
- I got lucky in that I did not have to learn another expensive lesson in how to NOT invest soundly and how to NOT manage risk; I am grateful I was paid to attend class this time and will put a lot more emphasis on capping my risk in the future
- That being said, I learned the value of conviction when investing– it’s possible I might’ve panicked out of the short during the technical kerfuffle and short squeeze had I not been fully committed to the robustness of our thesis
- I gained a newfound respect for people who have made careers of shorting; your research and due diligence should ALWAYS be impeccable when putting capital at risk, however, the shorts really do have to be extra sharp because their upside is limited while their downside is infinite
- The market truly is inefficient, especially with regards to small cap, distressed and under-followed securities; opportunities do abound and there is a lot of money sitting on the table if you have the capacity simply to see it for what it is
- Informational disadvantages almost make playing against clueless technical traders unfair!
That last one is a joke.
The Other Observations
I had a few more observations I thought worthy of sharing before I end this post-mortem review.
First, the valuable role short sellers play in the market is not well understood by many market participants, particularly the least-informed, most speculative players such as the daytraders. Their ignorance of the mechanics of short-selling are so ghastly it almost makes you wonder how they have enough intelligence to open a brokerage account and execute a buy order.
Rambunctious bulls hate short sellers because they’re convinced that they not only single-handedly control (manipulate) security prices, but that their actions alone can destroy an otherwise sound enterprise and put it out of business.
I won’t spend too much time debunking this again because it’s already been done by abler minds than my own, but I will make a few more obvious observations. To reserve a special circle in hell for short sellers is to ignore that what short sellers do, and what anyone who owns a stock who no longer wants to does, which is entirely the same– they both sell. Yes, the short seller borrows the stock first, but all this evil little gremlin does afterward is sell the thing to a willing buyer.
And it is, therefore, the willingness of the buyer to pay a certain price which ultimately determines the success of the short seller. If the short seller has his facts wrong and attempts to short a security belonging to a strong, well-capitalized, profitable and honest enterprise, the buyers will eat his lunch a hundred times over. They will demand higher and higher prices until the short seller is underwater and cries “Uncle!”
Yet, the short is hated because he is believed to add volatility to security prices, and not just any old volatility but downside volatility, as if volatility could go only one way. Which leads to my second point…
The average technical trader really is nothing more than a gambler, but in many ways he’s even worse because even a gambler knows that risk means loss, whereas the technical trader is confused like many other market participants into believing that risk is volatility.
It’s hypocritical verging on the absurd, but most daytraders celebrate volatility as a junk security rises in price but just as quickly curse it as the security’s price moves to the downside. It’s as if they truly believe volatility only goes one way and they’re somehow uniquely entitled to benefitting from that uni-directional movement. That’s why they kick and scream and resort to distrusting ad hominem towards the shorts when their positions go against them– they’re convinced the natural order of the universe (them effortlessly profiting on volatility’s upside) has been upturned, and short-sellers are the titans responsible for this blasphemous state of affairs.
And nevermind the fact that it is the shorts covering at the end of one of their (the daytraders’) failed trades that allows them to get out for a greater than zero price! They’re as ungrateful as they are ignorant. They have no idea they lost their money as soon as they put it in the pot, not the moment when the short seller sat down at the table. That tends to happen when you don’t know the rules of the game.
Anyone who might accuse me of being too harsh on these people in not giving them any credit, whatsoever, for being actual investors rather than just uninformed speculators, may want to consider the following quote from an ENER daytrader captured on the Yahoo!Finance message boards, following the BK:
Not like its much of a gamble at this point. Even I am willing to throw a quarter into a slot machine just in case I hit a jackpot.
These people truly see the stock market as an actual casino where they’re playing the slots or participating in a lottery. Not even a BK announcement, equivalent in this metaphor to a big, red sign on the slot machine that says, “Sorry! This machine is broken!” is enough to dissuade these people from hurting themselves.
I don’t think they’ve given any consideration, philosophically, to where their gains are coming from. At the end of the day, investing is a zero-sum game, financially speaking. And in many ways, due to the effects of inflation and regulation-driven financialization of the economy, it can be a zero-sum game economically speaking, as well.
When I was making my investment, I checked my premises by asking myself, “Where is the value coming from that I think I am producing?” The answer was, my superior research and consideration of reality, which allows me to more efficiently allocate capital for the economy through my trading decisions.
But I don’t think daytraders ask themselves this question. And if they did, they’d likely puzzle at an answer because there isn’t one. They aren’t creating any value. They add nothing to the equation. They just pass securities back and forth to one another at higher and higher prices, adding nothing to the equation but their manic enthusiasm for the game of hot potato until one of them pisses the bed or reality hits like a piano dropped from five stories up and they all suddenly realize how broke they are. Their role was never to create value, but to voluntarily redistribute it into more capable hands. Society would gain much more if they learned how to wash dishes, or flip hamburgers.
If you ever meet someone who says their primary analytical tool is technical in nature, grab a jetpack and accelerate yourself to the nearest delousing chamber immediately.
Sadly, the daytraders continue to pick up pennies in front of the steamroller as the StockTwit feeds are now full of “scalpers” trying to grab a penny here, a penny there as this bankrupt company’s stock swings by 10% a day (literally, 3 cents!) before it is DELISTED AND EXTINGUISHED. Think about how outright careless and/or stupid you’d need to be to play musical chairs buying a stock that the company has already announced its intent to extinguish from the financial market universe.
For my final, sobering thought then, I will leave you with this: I wonder if I was picking up pennies in front of the proverbial steamroller myself with this trade? ENER was a pretty juicy short at $40 if you take a look at what happened afterward. This was not a cheap cap-arb to execute, though that might come with the territory due to the small cap, relatively illiquid nature of the securities involved. I wonder if I was scalping a bit myself here, shorting what amounted to a penny stock. It’s something I am undecided on at the moment, but what I definitely do know is I was almost made the fool by not paying sufficient attention to how I was managing risk.
The risk for me was not in the thesis behind the trade, but in my less than experienced attempt at executing it. The trouble with investing is, it doesn’t really matter what kind of risk you take nor what error you make. Any error will do the job when it comes to catalyzing the loss of money. I hope I don’t ever find myself writing a post-mortem where I reflect on how I had managed to forget that simple lesson.
