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“Persecution is the first law of society because it is always easier to suppress criticism than to meet it” - Howard Mumford Jones

Over the past year, there has been an outcry from company executives and the investing public about short-selling. Short sellers have been blamed for reaping profits from the downfall of good companies with their “bear raids” and “rumor mongering” while John Doe is left to suffer the losses. And if you believe that, you probably think that Bear Stearns and Lehman were fine institutions that would have prospered if not for those nasty bears. In an effort to educate the general public, I am going to discuss the mechanics of a short transaction, the rationale behind a short transaction, the benefits provided by short sellers to the markets, and why blaming short sellers for your losses is simply “passing the buck” and not taking responsibility for your own poor investment analysis. (See my article on taking control of your money and your life.)

1. Mechanics of a short transaction
The first question I always get is “How can you sell something you don’t own?” Well, let’s take a step back and examine a regular buy and sell transaction. First, assume that every share of XYZ stock is issued on a stock certificate. When you buy 100 shares of XYZ at $10 in the market, you send $1,000 and in exchange 100 XYZ stock certificates are sent to you. The following week XYZ is selling for $15 and you decide to sell your stock certificates. You send your 100 XYZ stock certificates to the buyer in exchange for $1,500 (nice trade!) This is not only pretty easy to understand it is also what happens when you buy stock except that the stock certificates are usually held at your broker. So, now let’s look at a sell short and buy to cover transaction. XYZ is trading at $25 in the market and you feel that the price is too high. You go to your broker and ask them if you can borrow 100 shares of XYZ that you will return to them at a later date. IF, and only IF, your broker is in possession of someone else’s stock certificates, they can lend them to you. Once you are lent the shares you can sell them (the shares you have borrowed from your broker) in exchange for $2,500 cash which goes into your account. The next week, XYZ is trading at $15 and you go back to the market and spend $1,500 to buy back 100 shares. You return the 100 borrowed shares to your broker and pocket the $1,000. This is how it works. As for “naked” short selling (shorting without first finding someone to borrow shares from), this has been illegal for years and continues to be illegal. I do not endorse it and no legitimate short seller practices it.

2. Why do it?
This is a personal preference question mostly. However, my answer is that it provides flexibility. If a stock is not cheap enough to buy, it may be expensive enough to short. You have effectively doubled your pool of investment options in equities. Oftentimes, the best shorts are companies that are frauds (think Enron), fads (Crocs and Heelys), and failing business models (Sirf, Sierra Wireless, Novatel). If you a smart enough investor to do the homework and realize that the value being ascribed to a company is fair beyond its intrinsic value, why shouldn’t you be allowed to profit from it?

3. What’s the benefit?
Short sellers provide a few benefits. First, they act as a check on promotional/fraudulent management. They make Dick Fuld and Jimmy Cayne back up their comments that their firms are fine (Lehman and Bear were fine the day before they went under.) Second, they provide liquidity that would otherwise not exist. This point is easy to make in the current market circumstances where the lack of bids and offers is making trading much more difficult. Third, short sellers provide natural future buyers. If you remove short selling from a market , you can effectively remove all bids. If you want proof, ask China. They saw their market go down 75% from the peak in a straight line essentially and they didn’t allow short selling either. I blame Christopher Cox and the SEC for creating an air pocket in September by banning short selling in financials that exacerbated the fall in October.

4. Caveat Emptor
The worst consequence of all this “shoot the messenger” talk is that people feel comfortable blaming short sellers for their losses in the market. Instead of taking responsibility for their losses or poor analysis, they feel they can attack those that have actually done some work. That is capitalism at its worst. Short sellers are providing a service to everyone by keeping markets honest - Warren Buffett has said as much if you need me to appeal to a higher authority.

I leave you with this thought: Of all the CEOs that have publicly complained about short sellers driving their stock price down, how many of them had a real business when the truth was finally out? Here’s a list to start your research with — LEH, BSC, ENRN, OSTK. If a company has an intrinsic value and a real business model, short selling can do nothing more than temporarily distort the value. So whether you choose to employ short strategies or not, please understand that it’s nothing personal. It’s valuation at work.

In 1933, Irving Fisher, possibly the first celebrity economist, published his paper titled “The Debt-Deflation Theory of Great Depressions. ” A thorough reading of which should be required by anyone who wants to talk intelligently about our current crisis. I believe that not only does it address the causes and effects of depressions but also discusses possible solutions.

As for causes, Fisher believes there are two major factors that lead to a major depression as opposed to a run-of-the-mill slowdown in the business cycle: over-indebtedness and deflation. He believes that other factors can play a role in business cycles but they are basically secondary factors when it comes to real economic upheaval. Over-indebtedness and deflation are the main players in any extended economic downtown. He cites 1837, 1873, and 1929-1933. (I encourage you to read about these periods in history on Wikipedia.) He then lays out the effects, which an astute reader will see are quite applicable to today.

Assuming, accordingly, that, at some point of time, a state of over-indebtedness exists, this will tend to lead to liquidation, through the alarm either of debtors or creditors or both. Then we may deduce the following chain of consequences in nine links: (1) Debt liquidation leads to distress setting and to (2) Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes (3) A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be (4) A still greater fall in the net worths of business, precipitating bankruptcies and (5) A like fall in profits, which in a ” capitalistic,” that is, a private-profit society, leads the concerns which are running at a loss to make (6) A reduction in output, in trade and in employment of labor. These losses, bankruptcies, and unemployment, lead to (7) Pessimism and loss of confidence, which in turn lead to (8) Hoarding and slowing down still more the velocity of circulation.
The above eight changes cause (9) Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest.
Evidently debt and deflation go far toward explaining a great mass of phenomena in a very simple logical way.

Now, it shouldn’t take very much to see that our over-indebtedness during this past cycle arose from expectations of large increases in the price in real estate. A broader statement would be that over the past ten years investors of all types (individual, corporate, government) have been willing to leverage their balance sheets in expectations of a better return on their investment. However, these same investors were not being adequately compensated for the risks they were taking. And now, we find ourselves in the midst of a massive deleveraging. And of his list of nine items, we can pretty confidently say that most, if not all, are playing out.

So, are we screwed? Is The Great Depression II about to begin? Well, let’s look at what Fisher views as the solution.

Unless some counteracting cause comes along to prevent the fall in the price level, such a depression as that of 1929-33 (namely when the more the debtors pay the more they owe) tends to continue, going deeper, in a vicious spiral, for many years. There is then no tendency of the boat to stop tipping until it has capsized. Ultimately, of course, but only after almost universal bankruptcy, the indebted-ness must cease to grow greater and begin to grow less. Then comes recovery and a tendency for a new boom-depression sequence. This is the so-called “natural” way out of a depression, via needless and cruel bankruptcy, unemployment, and starvation.
On the other hand, if the foregoing analysis is correct, it is always economically possible to stop or prevent such a depression simply by reflating the price level up to the average level at which outstanding debts were contracted by existing debtors and assumed by existing creditors, and then maintaining that level unchanged.

Fisher’s solution is simply reflation. If this sounds a lot like the playbook that Bernanke and the Fed are using, that’s because it is. It’s no secret that Bernanke has a profound understanding of the Great Depression. He has already lowered interest rates to 1% and provided liquidity to the markets in creative ways. He and Hank Paulson are trying to incentivize banks to lend again so that we can rebuild confidence in the system. With all that being said, it remains to be seen if any of this will work. Fisher wrote his paper in 1933 and thought we were emerging from the Depression then but it took a few more years. There is still a lot of pain to come for this economy in the near term. There are many years of excesses to be wrung out but we can take some solace in the fact that policy makers are studying their history books.

When speaking with friends and family recently, many of them are extremely bummed out by what’s going on in the market these days. Whether it’s an uncle who’s lost 40% of his net worth as he’s approaching retirement or a friend who bought her house in late 2006 and is now 15% underwater, the worries are the same. The troubles they are having made me realize this: if you want to have control of your life, you must control your money. You must understand the following:

1. where your money is coming from
2. where your money is being spent, and
3. where your money is being invested and saved

Not appreciating any one of these three fully will lead to problems at some point. Let’s work our way through each item to see how things can go wrong and how best to manage them.

Where does it come from?
This is probably the item that people have the most control over. For most people, their money comes from one primary source: their job. Other sources of income include dividends, interest income, partnerships, tips, gambling or lottery winnings, or your blog, even. Taking control means being able to reasonably estimate the amount you’ll earn by taking into account the stability and quality of the income. For instance, interest that one earns on US government bonds is probably the most stable and reliable form of income you can get. On the other hand, gambling winnings are probably your least stable form of income unless you are a professional poker player. Your job falls somewhere in between these two and furthermore, various jobs have wide ranges of stability.  If you are a handyman with an established client base, you can be pretty certain that you’ll have a steady job with a steady stream of relatively predictable income as people need your services over the course of the year. If you are an investment banker, you can be pretty certain that it will be feast or famine. Your earnings will be highly variable, your bonus will be unpredictable from year to year, and (currently) you can’t even be sure that your industry will exist in the same form a few years from now. Taking control of the situation requires that you make an honest assessment of how stable your income is. Ask yourself these questions:

1. Who pays my paycheck? Is it the government, a private company, a public company, an individual, or my own business?
2. How much variability is there in my income? Is it commission-based, hourly pay, bonus heavy?
3. How strong is my employer’s ability to pay? Can they withstand a prolonged slowdown in business? (Think: homebuilders, bankers, retailers)

The biggest mistake people make is that they mistake their stellar performance at work for the stability of their job. You may be a star performer but still lose your job if you don’t see the end of the road for your company or industry as a whole. This happens often in the hedge fund world. It’s called netting risk. One guy makes a lot of money and everyone else loses money so at the end of the year no one gets a bonus. You would feel cheated if your performance was up to snuff and you were left out in the cold.

Understand the risks to your income and you can help yourself prepare for changes when they come.

Where do I spend it?
I won’t spend a lot of time talking about this because there are countless articles on the web about budgeting and spending on a daily, weekly, monthly, and yearly basis. My only insight here is to behave like a corporation when it comes to managing your finances, especially if you are a family. This means separating your expenses into fixed costs, variable costs, and one-time/extraordinary costs. Fixed costs are things like your mortgage, property taxes, and insurance; anything that you can’t avoid paying. Variable costs are those things which are easy to substitute for or cut out completely such as restaurants, travel, HBO, designer shoes, etc. One-time or extraordinary costs are things that may happen either out of the blue or very rarely or both such as a down payment for a house, a wedding ring, or a new car.

You should be able to categorize all your expenses into one of these categories. It’ll help you when you decide you need to cut back or you want to let loose a little bit.

Where am I investing/saving it?
You have two choices with money either to spend it now or spend it later. If you choose to spend it later, you have a choice of keeping it in cash or investing it in any asset you choose, preferably one that goes up in value while you wait.

In the case of keeping it in cash, here are a few rules to follow:

1. Find a bank with low fees
2. Make sure your accounts are fully-insured by the governmental agency in your country
3. Try to have a savings account that pays a high rate of interest (sometimes it even makes sense to keep money at a bank that will probably go under because it will probably pay very high interest rates in an effort to attract deposits but still be FDIC-insured - WaMu was paying 4% on all deposits right before the end while Chase was paying less than 0.50% so I never moved my money out of WaMu)

In the case of investing your money, it is your job to investigate every asset that you put your money into. You are voluntarily giving up control of your money when you allow someone else to make decisions for you without understanding the risks fully. As you all know, some people have found that their houses are worth 50% less than 2 years ago. Others have found that AAA-rated municipal bonds may not be so safe and so liquid as they once thought. I can’t stress enough how important it is to pay attention to where you are investing your money. It is not acceptable to leave the job to someone else and then be upset when the performance is not as good as you thought it might be. You have the final say.

One related anecdote: I hear 50-100 ideas every week about stocks I should buy or short for my portfolio. People always love one idea or the other. In the end, if I put on one of these trades, it is my decision. The worst kind of trader/investor is the one who blames others for his losses and take credit for his gains. Pointing to Jim Cramer or Suze Orman when you lose money and to yourself when you make money are no-nos. Be an independent thinker and take responsibility.

In conclusion, I hope I’ve motivated you in some small way to think deeply about your money, what you are doing to it, and what it is doing for you. Over the next few weeks, I’ll talk more about the investing side of the equation as that’s where my expertise lies.

Take control of your money.

Generally, if I have decided to link to a blog it satisfies the following criteria for me:

• The content is extremely informative
• The ideas/opinions expressed are well thought out and supported by facts

You will notice over time that blog links will be removed if authors suffer from “style drift” and begin to violate the criteria above.

Welcome! After almost a year of posting (if 9-10 entries can even be called posting), I’ve decided to change the mission and focus of this blog. I will continue to write about individual stock ideas that I may be owning or shorting in my fund but I wanted to expand the subject matter to any of my musings on finance or the business world. I also decided to try and be a little more committed to writing at least one entry each week. I’ve changed the “about” page to reflect the new direction.

Likely topics include:

• Short-selling
• Use of leverage
• Politics as it relates to business/fiscal policy
• Personal finance including 401k and real estate
• Drafting a personal asset management plan
• Market dynamics including liquidity, volatility, and trends
• Market participants including hedge funds, mutual funds, and sovereign wealth funds
• Investor psychology and emotion

Feel free to suggest other topics. My aim is to make this informative for you and, hopefully, help you to make better decisions when it comes to your money and your assets. I think it will be particularly relevant over the course of the next few years as we brace for some difficult times in the economy. A bad economy does not have to be bad for you; in fact, if you’re well prepared, a bad economy is a great time to reap the benefits of managing your money wisely because there are deals to be had. Consider this: everything is getting cheaper - stocks, bonds, houses, gas, furniture, clothes. If you are in cash, you are in a prime position to take advantage of the nationwide “sale.” You are actually getting richer simply because things are getting cheaper and your wealth is staying the same. But, I digress. This is a topic for another day. Welcome to the new blog and happy reading!

After a tumultuous few weeks in the credit and equity markets, it seems that the US Treasury and Federal Reserve are finally on the right track. After some ridiculous jawboning about buying toxic mortgage securities above market prices, they have decided to use the Swedish playbook from the 1990s banking crisis in Scandinavia. This involves several steps:

1. Injection of equity capital into the banking system

2. Providing confidence in the banking system to investors by providing transparent marks to illiquid securities

3. Taking equity stakes in firms that are strong enough to survive and liquidating those that aren’t - this helps to remove moral hazard because there is a serious price to pay if you want to remain in business and you are a financial company

4. Providing incentives to banks to lend their newfound capital

For more information, I will point you in the direction of the Fed’s paper located at this link: Cleveland Fed Policy Paper

I think that investors, and the public in general, should breathe a sigh of relief. We have yet to deal with the recession that is coming but our policy makers are, for once, doing the right things to keep the foundation of our economy strong.

Titan Machinery is a distributor/retailer of new and used agricultural and construction equipment in the Midwest. They currently own 48 stores with the majority of sales occurring in North Dakota, South Dakota, Iowa, and Minnesota. They recently were brought public in December 2007 by Craig Hallum Capital and Robert W. Baird. Since then, the shares have skyrocketed due to a strong spending season by farmers (due to soaring ag prices) and the company’s ability to acquire dealerships cheaply. Furthermore, over the summer, the stock was not only added to the Russell 2000, it also found its way on to the IBD 100. As a result, TITN is priced far beyond perfection and time and a sanity check should see the stock fall over 50% from current levels.

First, I will provide some background. Titan is a company in an extremely cyclical industry and generally very dependent on farmer incomes and commodity prices as over 80% of sales are into the agricultural market. I’ll not waste time explaining why the construction market is slow for them right now. The first half of 2008 saw farmer incomes explode and for the first time in years, they were awash with cash and there was a mini bubble of capex spending as they replaced old equipment. Titan was a beneficiary of this. They claim to be the largest regional dealer of CNH equipment in North America. Note: they do not have an exclusivity arrangement with CNH. As a result, same store sales in fiscal 2008 vs fiscal 2007 were up 16% and for the first quarter of fiscal 2009 they were up 37.4%! We have seen commodities come off sharply and they are likely to continue lower – I think the days of 38% SSS are gone and very likely to go negative over the next 2-3 quarters.

From the 1Q 2009 10-Q:

“The increase in revenue for the three months ended April 30, 2008 was due to acquisitions contributing to current period revenue and same-store sales growth.  Acquisitions contributed $43.4 million in total revenue, or 59.6% of the increase while same-store sales growth contributed $29.4 million, or 40.4% of the increase.  Same-store sales increased 37.4% over the prior year, which is indicative of the strong market for our products, particularly in the area of equipment sales.  We believe equipment sales were strong in the three months ended April 30, 2008 due to the growth in global demand for agricultural commodities and the positive impact this commodity demand has had on farm income. “

So , the other component of revenue growth besides SSS is acquisitions and that came in at 60% of the increase. Simply put, TITN is a rollup and those have a poor history. They claim to be able to buy at 4x EBITDA and extract value. The banks that brought them public believe that they extract so much value that they deserve a 10x multiple! In fact, one analyst arrives at his price target by assuming a doubling of EBITDA through acquisitions (using money from the secondary) in the next 2 years. This is highly doubtful.

Valuation:

EV = 400mm (including 80mm of cash raised in a secondary offering this past May – I am also including 95mm of floorplan)
Trailing EBITDA 21mm (19x)
Forecast EBITDA 29mm (13.8x)

While CNH, DE, and AG all possess multiples in the single digits, they also manufacture the machinery they sell. TITN is simply a distributor of machines without exclusivity in its regions and low barriers to entry for competition. I believe it should receive an EV/EBITDA near 5 based on other distributor models (car dealers/tech distributors) and certainly not a multiple higher than its suppliers. Using a high end of 8x and allowing for EBITDA to be 35mm for 2009 for no other reason than margin of safety, we arrive at an EV of 280mm or a stock value of $9. I happen to think that with commodities selling off and the unlikelihood of farmers spending as strongly as they did this past spring combined with further M&A activity unlikely at 4x EBITDA, that a strong case can be made that EBITDA can remain flat/fall year over year. The returns on capital of the business are extremely low and I think the market will understand that over the next quarter or two as same store sales growth becomes unsustainable.

• Market Wizards: Interviews with Top Traders - Jack Schwager
• Reminiscences of a Stock Operator (Wiley Investment Classics) - Edwin Lefevre
• The Education of a Speculator - Victor Neiderhoffer
• Valuation: Measuring and Managing the Value of Companies, Fourth Edition - McKinsey and Co.
• Inside the House of Money: Top Hedge Fund Traders on Profiting in the Global Markets - Steve Drobny
• Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets - Nicolas Nassim Taleb
• When Genius Failed: The Rise and Fall of Long-Term Capital Management - Roger Lowenstein
• Peddling Prosperity: Economic Sense and Nonsense in an Age of Diminished Expectations - Paul Krugman before he became a part of the media that he ridicules in this book
• The General Theory of Employment, Interest, and Money (Great Minds Series) - John Maynard Keynes
• Option Volatility & Pricing: Advanced Trading Strategies and Techniques - Sheldon Natenberg
• Against the Gods: The Remarkable Story of Risk - Peter Bernstein
• Extraordinary Popular Delusions & the Madness of Crowds - Charles Mackay
• Liar’s Poker: Rising Through the Wreckage on Wall Street - Michael Lewis

I am currently short GRMN. I believe that while the current years earnings/revenues may be achievable, the company is headed down the wrong path in the wrong industry.

Garmin trades at about 10x consensus FY08 expectations of $3.95. Many will argue that this is simply too cheap for a company with such promising growth prospects and that remains underpenetrated. I, on the other hand, believe that while revenue may continue to increase, margins will continue to be under heavy downward pressure. The onslaught will come from all sides: lower ASPs, more competition, the inability to reduce the bill of materials quickly enough, and the commoditization of GPS (iPhone, Blackberry).

Furthermore, Garmin doesn’t own any of the valuable assets i.e. the maps themselves. In this scenario, Garmin simply becomes a producer of hardware. And now, they find themselves in an unenviable position: what features can we add to our GPS devices that will make them more attractive to consumers? MP3 player? Removable media cards? I, for one, would rather be a handset maker who decides to add GPS to my devices than the other way around.

The problem with something that becomes ubiquitous is that generally it becomes not very profitable unless you have a strategy to prevent others from entering (think iPods and iTunes).

To add insult to injury here. It certainly isn’t helping that the US consumer is hurting or that it seems as if Garmin may be coming close to a saturation point. Add a few missteps relating to the nuviPhone (which really is an absurd idea) and I’m not sure if Garmin will ever find its way again.

One more thing… it frustrates me to no end when I see a management buying back shares as their business deteriorates. Essentially, they are taking shareholder money and burning it.

As for trading this stock, the short interest is high and it tends to find GARP buyers. My strategy has been to short the stock on rallies and leave enough dry powder to scale into a larger position as the valuation becomes more and more untenable. Good luck!