The Elevator Goes Both Ways

I originally wrote this piece on the 27^th of May, 2019. It was circulated amongst my close contacts and I have followed the company ever since. Needless to say I am now satisfied that a short sale on Nuheara at that point would have been a profitable trade to make however it reasonably should have been closed out long ago.

I have noted on this site the many people talking up and down the prospects of this company ever since. I just thought to add my minor (and potentially error laden – so please forgive me for this) opinion given the fallacy that ‘you surely couldn’t see poor share price performance coming’ from years ago. The written text below, again copied directly from the source I wrote two and a half years ago, shows that you probably could have.

The Elevator Goes Both Ways

A guide for short sellers

Haven’t you ever wondered how some people can get rich when everything around them is going down the tubes? Not including the nice grandmothers who commit fraud, there are in fact some people who make money when the price of things turns down. At the end of this you’ll have a better idea of how they do it, and how you can to. A note of warning before we start though. These people are often called names, abused, marginalised, and largely discredited before they get it right. To pull this off you need to have very thick skin, a truck load on knowledge that your right and a lot of patience, not to mention capital.

What is a short sale?

At the heart of the matter, a short sale is an investment that makes you money when the price of the asset in question goes down. You think Enron’s share price might be high at $90? Hey, put a short sale on. Think McGrath real estate might have just sold shares at an IPO and cashed out at the top of the real estate market? You could always short them. In both of these cases you would have made a very tidy profit indeed. Enron went to $0 and McGrath current sits at 24c, a little way from the $1.86 listing price.

The mechanics of a short sale are fairly easy to explain. Let’s say, because you have a negative view on a company, you want to go short (or simply ‘short’) the shares of that company and make a bundle when they slide in price. In order to do this, you just call up your broker (I’m joking! Nobody calls their broker anymore; this isn’t a bad 80’s film) and borrow some of their shares in the company. You then immediately sell them and pocket the cash. So far, so good. Now, just like our mates at Tesla, you just wait around for the share price to fall. Once you are satisfied that the shares of Tesla have fallen far enough you go back and buy the same number of shares and hand them back to your broker. Your profit on the deal is the difference in the original price and the price you eventually bought them back at.

There is a great big multiplier effect of short selling too. In Australia, short sales need to be listed and registered with the ASX and they are released every day. As more investors see that more of their colleagues are becoming sceptical about a company’s prospects too, this creates a positive reinforcement cascade. All of a sudden shares are being short sold and the sentiment of the company’s future is driven lower. Groupthink takes over and before you know it, you were right and the share price has fallen. The book; The Crowd - A Study of the Popular Mind by Gustave Le Bon does a great job of describing this if that is your type of thing. Psychology majors will love it.

It must be more complicated than that! What are the risks?

This might sound obvious, but the one clear risk is that you’re wrong. You might be wrong about the timing or just flat out wrong in general. Being wrong when it comes to short sales is pretty well disastrous, but we will get to that in a moment. If you are right and the company is dodgy, but you are wrong on how long it will take the market to figure that out you still might be cooked. You could hold onto these short sales for so long that they bleed you dry before the bust comes. Again, I’ll explain how a little later.

You could also be flat out wrong. The thing about investing in companies is, your worst-case scenario is a 100% loss when the company goes bust. The upside, in theory, is infinite. Anyone that invested in Apple shares at 51 cents in 1982 knows exactly what’s up on that count. For what it’s worth, Apple is $179 a share now so old mate has made a compounded return of 16.2% p.a. Maybe a better way of saying it; our brave investor turned her $10k investment into $3.49m. The thing about short sales is, they work exactly the opposite way. That makes intuitive sense when you think about it. To win when the share price goes down, you need to lose when it goes up, right?

The problem here is that the maximum upside for a short seller is when the company shares got to zero. The theoretical downside is unlimited. Now imagine the world of hurt our short selling friends are in betting against Netflix in June 2005 at $2.04 a share. Yep, it never saw that price again and every share in Netflix is currently worth $354. To say our bearish mate is taking on water is a bit of an understatement.

Ok, so it’s risky, but what are the expenses?

This is where we get to explain how you can still lose money even if you are right about the company going down. When you borrow the shares at the very beginning and sell them, either from your broker or from a current investor, you must pay them a fee. This is you paying for the right to use these shares to the rightful owner. Seems fair since they now know you are trying to force the price down. That’s your first cost. Your next cost comes from the brokerage fees but in the scheme of things this isn’t too high. Often what will bring you undone are the ongoing fees. The biggest of these is the company dividend. You see, part of the deal you agree to when short selling is that you will make sure the owner doesn’t lose out while your trade is open. What this boils down to is that every time the company in question pays out a dividend, you need to send that same amount, in cash, to the lady you borrowed the shares from. This clearly can get expensive if your trade is on for a while and the share price refuses to go down.

Another sneaky trick (or well-planned asset protection plan, depending on your perspective) that the company might play is to pay out even higher than usual dividends if they know a lot of people are shorting their shares. This drives up the cost of holding the short position and can force some short sellers to exit the trade with their tails between their legs. This is probably a good time to point out a risk that I didn’t put in the above section. You see, this high-cost share with its copious amount of dividends works against the short sellers. If it all gets to be too much, and much like the pile on of short selling we spoke of earlier, everyone wants to get out at once, we start to see problems. The trading term for this is called the ‘short squeeze’. A short squeeze happens when a large number of short sellers want to buy shares on market just to close out their positions but there aren’t enough shares for sale to satisfy the demand.

The basic textbook response to this huge lack of supply is for the price to shoot up in order to encourage existing shareholders to sell. Now our poor short selling friends are stuck. They don’t want to bleed cash through dividends forever, but it is costing them a fortune to buy the shares back and get out of this deal. Of course, there is a recent(ish) story that fits this perfectly. Remember around 10 years ago when Porsche got it into their heads that what they really wanted, instead of really fast cars, was to buy a really boring car company and pump out 1 billion Golf’s. So, with this lowly goal in mind, on Porsche went buying up 31.5% of VW shares while the German state of Lower Saxony held 20%. Funny side note; loads of European countries have a hybrid capitalist/socialist system where the companies are partly nationalised. Anyway, all of this buying action from Porsche just acts to push up the VW share price. Now this is where the story gets really fun.

Our short selling, risk taking, beer swilling mates take one decent look at the share price of VW and think: this is way over the top. I’m going to make a packet on its slide back down. Karate kick! So, of course, they go into the market and short sell VW shares. They short sell a bunch. At the peak, short sellers had put 12.8% of VW up for sale. Now if you are wondering who sold them those shares then you are thinking the right way. Porsche comes out and says; look we aren’t going to go to 75% ownership (where they would formally need to take over the company) because there just aren’t enough free float shares out there to do it. This made sense given they already had 31.5% and Lower Saxony had 20%, which they wouldn’t sell. That was in March. Then the short sellers started borrowing shares (from who? Oh, just wait) and dumping them into the market. This depressed the price of VW shares and more traders piled in, looking for easy money. Remember us speaking about this? You wouldn’t believe it but by October Porsche made another statement to the market. Because of the really low prices they had bought a few more shares in VW and increased their stake to 42.6% of VW. In addition, Porsche went out and bought a bunch of options to buy another 31.5% of the company in a few months’ time. Being the generally good guys that they are, they just wanted to let them market know that they would pay for, and expect delivery of, those shares around Christmas time. Remember, Lower Saxony still owns 20%. Basically, Porsche had stitched up 74.1% of VW and they knew that 94.1% of the shares on issue wouldn’t be traded on the public market.

Reading between the lines I guess you’ve figured out by now that Porsche had also made a bundle of cash selling their own shares to the short sellers for that fee we spoke about earlier. Even better, the entire list of short sellers now knew for certain that they had to buy 12.8% of VW shares back in order to close out their trades, while only having 5.9% publicly available. Now that is a classic short squeeze.

Basically, every short seller of VW shares raced for the exit at the exact same moment and they all got jammed in the doorway. The huge demand for VW shares did some pretty crazy stuff to the share price too. The day before Porsche dropped its bombshell VW shares traded at €200. The day after they traded at €1,000. So, our short seller friends got burned on the squeeze, Porsche sold them back their own shares at 5 times the going rate and they ended up owning 74% of the company anyway. This was probably the worst short deal going while the whole world was imploding and short sellers were making out like bandits on Lehman Brothers, Bear Stearns and pretty much everything else that was going down the tubes in 2008.

So, does anyone do this sort of thing on the regular?

As it turns out, there are plenty of people who make their livings by finding crappy businesses to invest against. One Australian example is John Hempton and his hedge fund Bronte Capital. You might be familiar with Mr Hempton from his role in the Netflix series Dirty Money. He is from the episode Drug Short and was a key short seller of Valeant Pharmaceutical stock. Another famous short seller is Andrew Left, from Citron Research. The problem with short selling is, as perfectly explained by Mr Hempton on Insider Business, that if a short sale goes bad on you (goes up in price) it can consume a huge amount of your fund. Say you take out a short sale and you use 5% of your fund to do it. The current share price is $1 but within months the company declares a special dividend of $1 and the share price rockets to $4. So now, the all-in cost for you to get out is $5 and that 5% of your fund has now burned through 20% of your assets just to exit this badly timed deal. Yep, things can turn on you pretty quickly.

For the above example the math looks like this: $100 fund size and a 5% investment = $5. Current share price $1 so you short 5 shares = $5 (this goes in your pocket). You now have $100 + $5 = $105. Now you need to pay a $1 dividend to the lady you borrowed the shares from. 5 * $1 = $5 and you get $105 - $5 = $100 and the shares have now shot up to $4. You decide to exit the position and pay 5 * $4 = $20 to hand the shares back. This ends with $100 - $20 = $80. Congratulations, you’ve blown up your fund on one trade, in only a few months. This is probably the leading example of why firms normally only place very small, compared to their fund size, investments in any one short sale. Each one has the chance to multiply on you and get way out of hand.

Do you have a real-life example of a company to short?

I do, but also, I don’t. There is a company that a very savvy investor brought to my attention a little while ago and I did some poking around. What I found was a little troubling and even worse, there isn’t a great chance to profit from it. You see, some shares are so lightly traded or there aren’t any sellers in order for the shorts to perform the very first step of the deal. So, the example I’m going to walk you through is just an illustration of what you might want to look for if you decide to enter the world of short selling.

Nuheara (ASX:NUH) is a Perth based company that makes hearing devices and noise cancelling headphones. Now unlike most companies, Nuheara didn’t start its life on the listed exchange by conducting an initial public offering (IPO). That, of course, would involve a little too much paperwork and, for example, a pathway to profitability for the prospective investors. What they did instead was actually really clever. The founders of the company cobbled together their money and found a private backer and went and took over an already listed company, Wild Acre Metals Limited (ASX:WAC). That must explain why, 3 years later, Nuheara still has 5 mineral leases on its books that it just can’t seem to get rid of. In any case, the beginning of this company as a listed venture paints a pretty interesting picture of the Perth fishbowl effect. You see, their very first independent non-executive director was a fella called Dr Michael Ottaviano.

Now you might not know who this is, but I can guarantee everyone who ever put money into Carnegie Wave Energy sure does. Dr Ottaviano was the CEO of Carnegie (ASX:CCE) from 2006 to 2018 and from all reports did an excellent job raising equity and getting government bodies to open their cheque books. This is exactly the sort of person you need in a start-up. This leads me to how Nuheara found out about Wild Acre Metals just sitting in the corner of disallowed doing nothing much at all. Turns out that the Chairman of Wild Acre was also on the board of Carnegie. So, Perth really is that small.

Rounding out the board positions are the company founders Justin Miller and David Cannington, acting as the CEO and chief marketing officer (CMO) respectively. According to themselves, these two are very accomplished Silicon Valley big wigs and so are perfectly placed to run this technology start up and see it blossom into the next big thing in hearing. To give it some scope, Nuheara is currently a $66m company and the hope is, one day, they might overtake a dinky little outfit called Cochlear (ASX:COH) who are only worth $11.5b. So far it is easy to see how short sellers might get squeezed with only 174 x growth to go...

With this explosive growth potential in mind let’s take a look at the books for things that might raise some eyebrows. First things first, shares listed in March of 2016 after the reverse takeover finalised. With a 130% surge on the first day of trade things were looking up as the shares finished the day at 3.2 cents. Now here is where we need to separate the hype, magic and anticipation of the share market from the reality of running a business. For all of 2016, Nuheara managed to lose 2.09 cents per share or a loss of $6.7m. Yeah, I know; not a great start. Fast forward to 2017 and we can see that they only lost $4.8m for a per share loss of 0.69 cents. Looking at the 2018 figures and Nuheara has managed to lose $7.4m or 0.83 cents per share.

Now at this point you are probably asking the same question as me: “How the hell are they losing almost twice the amount in 2018 compared to 2017 and the per share loss hasn’t lifted nearly as much?!” Well, it probably has everything to do with Nuheara diluting out existing shareholders in order to fund their operations. Sort of makes sense because you can only lose money for so long before you need more of it to fund your business. Oh, this brings me to the next thing.

The company spins this as a good thing but it always makes me really cautious. “We don’t have any debt” just screams out ‘we are rock solid, and you should approve!’. But yeah, we ain’t that stupid. You see, if a bank is willing to give you money as debt, then they have run the numbers and decided that they have at least a half decent chance to get paid back. Given how loose banks are with lending out money, the mere fact Nuheara can’t get a bank loan in absolutely frightening! Yes, I hate debt but if you are so risky that our Wild West bankers won’t throw a few million your way then you really do have issues. So, we come full circle and end up here again. Nuheara will issue more shares and dilute every one of their shareholders. This won’t be a good thing if they keep losing money and will be a disastrous thing if the capital markets finally turn the taps off and Nuheara finds itself losing money while not having equity backers to prop it up. Ok, so strike one.

Next is the business operations. In the most recent year, 2018, Nuheara had $3.9m in revenue. How much did it cost them to make those sales (think building the headphones)? $3.6m. Now we can see the benefit of having Dr Ottaviano of the board. Yep, a cool $1.2m government payment, right on time. Although that helps, it doesn’t really touch the sides when it comes to some of the big-ticket expenses Nuheara has. With salaries, at $4.5m, marketing, at $1.9m, and general expenses coming in at $2m, the cost structure at Nuheara really does pile on the pain. So, for the three listed years on record, Nuheara hasn’t had a profit and has, so far, burnt through $18.9m of cash. This isn’t great but so long as they can keep those government payments coming in and equity partners pushing cash in the front door, things will be OK. Of course, a change in government sentiment and a credit crunch could put these guys under a decent amount of pressure. You guessed it, strike two.

For me, the most concerning part is what I’ll finish with. The fearless leaders of Nuheara, having come from Silicon Valley to conquer Perth and the world, are making sure they don’t suffer too much for the cause. In fact, just last year, fearing that these start-up founders weren’t being looked after correctly, the directors (the founders make up 2 of 3 board seats) asked for a salary comparison review. Funny thing happened; the people the CEO and CMO paid to review their salaries recommended they should be paid more. Oh well if you insist! So now we are here. The CEO is on $340k with a shot at a 30% bonus ($102k). And the CMO is on $340k and has a shot at a 30% bonus. The only upside is that there is almost no chance they get their bonus money. But again, they do make up most of the board members… I guess that’s the funny thing about financial statements, it is really hard to hide. The directors of Nuheara, in 2018, collected $966k in pay, bonuses, fees and benefits. This doesn’t exactly feel like a business that is bootstrapping itself to get the product to market. It sort of looks like the top guys are doing just fine but they are being bankrolled by a growing list of equity holders.

There is one other small thing that bothers me about Justin Miller and his position as CEO of Nuheara. See, I get that he is the big boss, and he’s obviously very qualified but he is currently the owner, founder, and principle of three more businesses. Now one person might say that shows how good he is but a more cautious one might ask just how thin is he stretching himself and does he have Nuheara shareholders interests at heart?

Something else a little disturbing about the chief executive duo: throughout the 3 years where all the extra equity money that has been injected into this business, the CEO and CMO have not purchased one single extra share. Yep, they’ve collected over $1m each in wages and just let themselves get diluted. I mean hey, if I knew the full picture maybe I wouldn’t buy in any more than I had to either. This brings me to the share registry. Every year the company lists its top 20 shareholders. The only good thing I can say is, every year the CEO and CMO don’t sell their shares. They are just about the only ones. Company insiders, initial investors, and trustee custodians all shift around wildly from year to year. This isn’t a great sign as most stable companies have a core of equity that bands together. This indicates that Nuheara convinces new money and sells them the dream once or twice a year in order to fund the next round of business and another year of decent salaries, while existing shareholders bail out. Another thing caught my eye. You know how Nuheara brags about having no debt and I thought that was a bit of a publicity spin? Well, buried in their financial statements you can see how much it costs Nuheara to acquire its equity capital. Like, say BHP wanted to raise capital in the equity market. They would probably go to Goldman Sachs and just say, “I’ll pay you 0.1% of the total raised, just find me $5 billion worth of equity.” To be honest, this is probably harsh on BHP as the dividend reinvestment plan (DRP) brings in about $1.5 billion in new equity every year. We can actually see, in the Nuheara financial statements, what it costs them to issue new equity. According to page 20 of the 2018 annual report, Nuheara pays its investment bankers 5.9% of the money raised. So, for the business owners it means they sell $16.6m in shares of the company but only end up with $15.6m in cash. Just for mercy I’ll call it; strike three.

So, what happens now?

Like most things we talk about, probably nothing. Just like all short positions, this could blow up in my face. Nuheara might be the next big thing. They might claim 100% of the medical, non-surgical, market and roll over the competition with the current shareholders writing me postcards from sunny islands, mocking me. Yeah, that could happen. But I think I’ll just sit back and content myself with a decent dose of schadenfreude when the very well-paid executives go back to the market, again, to get even more cash, because they can’t stop losing money. After all, you don’t go up against Bose, Apple, Sonos, Sennheiser, Harman International or Bang and Olufsen, to name only a handful, and expect to come out of that fight without a black eye.

You now know the broad-brush strokes of how some people make money when companies fail and some of the things you might look at if you wanted to join in. You also understand the huge risks that come with this sort of trade. Good luck to you and even if you don’t participate, maybe you’ll have an appreciation for the sort of conviction some investors have that there really are dud companies out there. There’s an old maxim within investing circles; slowly up the stairs, quickly out the window. Short sellers just want to make the fast fall a profitable experience, albeit frightening for everyone else.