Stock Online TraderBulls & Bears Make Money, Pigs Get Slaughtered…Let Us Not Be That Pig…

In general, people think of investing as buying an asset, holding it while it appreciates in value, and then eventually selling to make a profit. The exact opposite of that is short selling. You make money when the asset falls in value. Let us take a quick look at what is short selling.

A Review of Short Selling
When you sell X number of stocks that you do not own, but you promise to buy it back in future is called short selling. So how can you sell a stock you do not own ? Basically your broker will lend it to you. Sooner or later you must buy back the same X number of stocks (covering) and return them back to your broker. When you buy back the stock at the lower price than you sold earlier, you obviously made a profit on the difference. However if the stock price rises, you end up losing money. Most of the time, you can hold a short for as long as you want. However, you can be forced to cover if the lender wants back the stock you borrowed. This is known as being called away. If there was any dividend distributed, you need to pay it to the lender of the stock. Also because you have loaned the stock, you are buying on margin, which means you will need to pay an interest. Also go through one of my previous articles on The Art of Making Money in the Bear Market.

With the basic knowledge of short selling, let us look at a few important terms/concepts/theories surrounding them, Investors (especially beginners) should thoroughly understand them before beginning their journey in the world of short selling.

Short Squeeze
A short squeeze can occur when the stock price has risen to a point where short sellers decide to cut their losses and get out. To get out, the short sellers would buy back the stock, which in turn causes an even furthur rise in the stock prices. What this does, is it triggers even more short sellers to get out. This could eventually help the stock price to reach high levels. Short squeezes are more likely to occur in stocks with small market capitalization and small floats.

Questionable Practice
Traders at times takes advantage of a stock that has been short sold substantially by buying up large blocks of the stock. This causes the stock’s price to increase and forces short sellers to attempt to buy the stock in order to close out their positions and cut their losses. However, because the trader has bought up large blocks of the stock in question, the short sellers may find it very difficult to buy stock at a price that they prefer. The trader can then sell the stock to the desperate short sellers at a higher premium.

Example on Short Squeeze
Say a fictional company Danger Inc is priced around 10$/stock. Say one day due to heavy buying the stock price jumps 20%. Those with short positions may be forced to get out and cover their position by purchasing the stock. If enough short sellers buy back the stock, the price is pushed even higher. This is called short squeeze.

Short-Interest
Short interest tells you the total number of shares of a stock that has been shorted and not yet covered by investors. Short interest serves as a good market-sentiment indicator telling you how bearish investors/traders are about the stock. A high short-interest is an indicator that a high percentage of investors are bearish about a stock. This negative sentiment could bring the stock price crashing down. Buying a high short-interest stock should be done with extreme caution. However there are investors who think the exact opposite is true. They believe that if everyone is selling, then the stock is already at its low and can only move up. They are actually bullish on high short-interest stocks because they believe eventually there will be significant upward pressure on the stock’s price as short sellers cover their short positions.

Example on Short-Interest
Let’s assume Danger Inc. has 100 million shares outstanding in the market, with 15 million shares sold short. The short interest on the Danger Inc stock turns out to be 15 million / 100 million = 15%. In short, 15% of all the stocks of Danger Inc in the market as sold short. Now let’s say that Danger Inc. short interest increased by 10% in one month. This means that there was a 10% increase in the amount of people who believe the stock will decrease. What this does is, provides you an alarm to trade with caution. It helps understand market-sentiment to current news related to the company.

Short-Interest Ratio
The short-interest ratio is the number of shares sold short divided by average daily volume. This ratio tells you how many days it will take short sellers to cover their positions. The higher the ratio, the longer it will take to buy cover. Saavy investors/traders use this important ratio to decide whether to take a short position on the stock. Typically, if the days to cover stretch past 8 days, covering a short position could prove difficult.

Example on Short-Interest Ratio
Let’s assume 15 million shares of Danger Inc are sold short, and the average daily volume of shares traded is 5 million. The short-interest ratio in this case turns out to be 3, indicating it would take 3 days for all of the short sellers to cover their positions which sounds like a reasonable time.

The NYSE Short-Interest Ratio
The NYSE short-interest ratio is another great metric used to determine the sentiment of the overall market. The NYSE short-interest ratio is the same as short interest except it is calculated as monthly short interest on the entire exchange divided by the average daily volume of the NYSE for the last month.

Example on the NYSE Short-Interest Ratio
Say there are 5 billion shares sold short in May and the average daily volume on the NYSE for the same period is 1 billion shares/day. This gives us a NYSE short-interest ratio of 5 (5 billion /1 billion). This means that, on average, it will take 5 days to cover the entire short position on the NYSE. In theory a higher NYSE short-interest ratio indicates a more bearish sentiment towards the exchange.

Conclusion: With the knowledge of short selling, you have added another trading technique to your toolbox. Additionally with the knowledge of short squeeze, short-interest and short-interest ratio, helps make an informed short selling decision. However short selling can be very risky and you should proceed with extreme caution. Short selling is especially not recommended for investors beginning their journey at the stock market.

(Source: Investopedia)

Investors and traders both use alot of ratios to deduce whether to buy/sell/short a security. With so many ratios to consider, it can get confusing, especially when 2 ratios almost look alike.

Consider return on equity (ROE) and return on assets (ROA). At first glance they do look similar. Both measure some kind of return and is some way are related to the company’s earnings from their investments. Obviously both ratios represent different things. A closer look at these two ratios reveals some key differences. Let us find out more.

Return on equity (ROE)
Of all the fundamental ratios that investors look at, one of the most important is return on equity. ROE is nothing but a measure of how much profit a company generates with the money shareholders have invested. In other words how effectively the company uses the money invested by investors. This tells you alot about how good the management of the company is.

Return on Equity = (Annual Net Income/Average Shareholders’ Equity)

The net income can be found out from the income statement, and the average shareholder’s equity from the balance sheet.

Example on ROE
Lets take an example of a fictional company Weird Inc. Say they had a net income of $5 billion in 2006, and their stockholder equity was $10 billion in 2005 and $30 billion in 2006. To calculate ROE, average shareholders’ equity for 2005 and 2006 ($10 billion + $30 billion$ / 2) is $20 billion. Dividing net income for 2006 by the average shareholder’s equity gives us the return on equity (ROE) of 0.25 or 25%. What this tells us is that in 2006 Weird Inc generated a 25% profit on every dollar invested by investors. Generally savvy investors look for a ROE of at least 15%, so in our example Weird Inc’s performance is impressive. Weird Inc’s management was able to acheive higher profits from the investor money, which speaks of an effective management.

Return on asset (ROA)
So now that we understand what ROE is, lets focus on ROA. ROA is nothing but a measure of how much profit a company earns for every dollar of its assets. Again this reveals how effective the company management is. Assets include things like cash in the bank, accounts receivable, property, equipment, inventory and furniture.

Return on Assets = (Annual Net Income/Total Assets)

Example on ROA
Lets look at Weird Inc again. You already know their net income was $5 billion in 2006. Say their total assets amounted to $200 billion. The net income divided by total assets gives a return on assets of 0.025 or 2.50%. This tells us that in 2006 Weird Inc earned 2.5% profit on the resources it owned. This is an extremely low number. In other words, Weird Inc’s ROA tells a very different story about the company’s performance than its ROE. Few professional money managers will consider stocks with an ROA of less than 5%.

A Look At Debt
The important factor that separates ROE and ROA is debt. Accounting 101 tells us, Assets = Liabilities + Shareholder’s Equity. Say if a company carried no debt (ie. Liability = 0), its shareholders’ equity and its total assets would be the same. It follows then that their ROE and ROA would also be the same. Now say the company took a debt to fund a certain project. What would happen to ROE and ROA ? By taking on a debt, the company increases its assets due to cash coming in. However that would reduce the company’s equity. With reduction in equity, ROE will rise. At the same time, when a company takes on debt, the total assets increases which makes ROA rise too. However ROE would rise above ROA giving us a good indication of the debt levels of the company. Warning: Because ROE weighs net income only against owners’ equity, it doesn’t say much about how well a company uses its financing from borrowing and bonds. Such a company may deliver an impressive ROE without actually being more effective at using the shareholders’ equity to grow the company. ROA because it includes both debt and equity can help you see how well a company puts both these forms of financing to use.

Going back to Weird Inc’s example we can see there is huge difference between its ROE and ROA, indicating an enormous amount of debt, which kept its assets high while reducing shareholders’ equity. In 2006, Weird Inc would have total liabilities of $200bn – $30bn = $170 billion more than 5 times its total shareholders’ equity of $30 billion.

Conclusion: Before trading in a stock, always keep an eye on the ROE and ROA. They are different, but together they provide a clear picture of management effectiveness. If ROA is sound and debt levels are reasonable, a strong ROE is a solid signal that the company is doing a good job of generating returns from shareholders’ investments. ROE is certainly a hint that management is giving shareholders more for their money. On the other hand, if ROA is low or the company is carrying a lot of debt, a high ROE can give investors a false impression about the company’s fortunes.

For the first time China has decided to make a direct investment in a U.S. private equity fund by investing $3 billion from its currency reserves of $1.2 trillion in private equity firm in U.S. called The Blackstone Group.

The Blackstone Group
Private equity firms buy companies or take controlling stakes, cut costs, restructure the businesses and sell them later for a profit. They usually borrow two-thirds of the money needed to finance their purchases, making for a high-risk, high-return investment strategy. A record $911 billion was invested globally in private equity deals last year, up from $471 billion the prior year. Blackstone group is the second-largest U.S. private equity firm.

Blackstone has invested in over 100 companies in a variety of industries, geographies and economic environments. Blackstone’s current holdings include such diverse companies as Cadbury Schweppes, Center Parcs UK, CineWorld, Deutsche Telekom, Extended Stay America, Michaels Stores, The Nielsen Company, SunGard, Universal Orlando, Vanguard Health Systems and many more. In many of its investments Blackstone has partnered with leading corporations around the world, including Time Warner, AT&T, General Electric, Northrop Grumman, Sony, Time Warner, Union Carbide, Union Pacific, USX and Vivendi. These corporate partnerships have been a key element in Blackstone’s approach to investing.

What Is China Upto
The reason for China’s investment is to gain higher returns from their investments. Investing currency reserves in the U.S. stock market is an aggressive move from China, which has the U.S. Govt worried. Many believe that with higher gains from this investment would tempt China to invest alot more than $3 billion. Blackstone co-founder suspects that Blackstone is just the first one of many more investments China will make in the future. However supporters of this investment argue that it symbolizes that China believes in U.S., consequently playing a role in strengthening the U.S. dollar, atleast short term.

China – Blackstone Bonding
Blackstone has expanded its planned $4 billion IPO to $7 billion to accommodate the Chinese investment. This investment gives China a taste of the booming private equity market. China will take 9.9% non-voting stake in Blackstone, leaving it under the radar screen from U.S. govt scrutiny. China has agreed to hold their investments for atleast 4 years for which they bagged a 4.5% discount. This whole deal is a win-win proposition for both parties. For China it means a role in the global private equity market and higher profits, where as for Blackstone it means increase in access to Chinese markets.

Blackstone IPO Pricing

Labor Federation Makes Noise
In other news the largest American labor federation asked regulators to force changes to the Blackstone IPO. The labor federation told the SEC in a letter it believed Blackstone deliberately structured its public offering to hide the fact that the Blackstone Group LP is actually an offering of interests in pools of investment securities.

Conclusion: The Blackstone IPO is being closely watched by the markets as one of the first from a large U.S. private equity and hedge fund firm.

• The IPO plans to raise $7.75 billion, pricing the stock at $29 – $31/unit.
• Blackstone has already racked up $400 billion in deals. The IPO will help it tap new sources of capital for multibillion-dollar acquisitions.
• Blackstone’s private-equity funds have returned an average 23% and its real estate investments have gained 29%.
• Blackstone’s Q1 profit more than doubled to $1.13 billion from $487.2 million a year earlier.
• Revenue totalled $479.4 million and investment gains totalled $3.78 billion, each also more than doubling.
• Blackstone group has $88.4 billion of assets under management as of May 1.
• China has shown confidence in the Blackstone IPO and will invest $3 billion.

Cash loaded private equity market, successful multibillion-dollar acquisitions, good management, high return rates, higher profits, higher revenue, support from China, all makes Blackstone IPO one of the most attractive investment opportunity in recent times.

Recommended Books:

• Journal of Private Equity
• The Rise of Private Equity and the Future of Investing – By David Rubenstein
• Private Equity as an Asset Class – By Guy Fraser-Sampson
• Private Equity: Transforming Public Stock Into Private Equity to Create Value
• Private Equity and Venture Capital – A Guide for Investors – By Ronald Lake

(Source: DailyFx, DNA)