3 Ways to Avoid the Short Attack Epidemic in 2011

While market manipulations have traditionally been the domain of the tiniest micro-cap stocks, that’s been changing lately. In 2011, manipulative short attacks have jumped the shark, making their way to major exchanges without anything standing in their way. Today, short attacks are one of the biggest threats to any small-cap investor’s portfolio – here’s a look at how you can best avoid them.

First, a bit of background…

Yesterday, a group calling themselves “Copperfield Research” posted a negative article on Seeking Alpha about OCZ Technology Group (NASDAQ: OCZ), a small-cap computer storage firm based in San Jose, California. The article provided evidence that OCZ has significant financial discrepancies – and that the stock, which opened at $9.94, should reasonably be worth “between $2.58 and $4.98” per share.

There was just one problem with Copperfield’s analysis: according to major firms and a forensic accountant, it was based on incomplete and misleading numbers. To complicate things further, Copperfield disclosed in the article that they were holding a short position in OCZ, making them far from an objective observer.

But the damage was already done – shares of OCZ crashed, falling as low as $6.25 during Wednesday’s trading session as investors fled shares.

A Common Occurrence

This isn’t the first time that we’ve seen this sort of “short attack” take place against shares of a small-cap stock. For the last year or two, similarly damaging articles have been claiming fraud in dozens of Chinese small-cap stocks as their authors collected on their already-disclosed short positions. I personally got a more firsthand experience with short attacks when one of the stocks that Greg Guenthner and I recommended to our premium readers was accused of being a fraud on the same day that our recommendation to buy shares was sent out.

In the case of that Chinese stock, the blogger’s article was convincing – and pretty damning. Media outlets like the Wall Street Journal picked up the story, and shares fell double digits by the market’s open. As with the OCZ story, however, there were some major flaws in the author’s analysis and bias.

Because we’d done our due diligence on our Chinese company’s business, we were confident in the stock’s numbers. But retail investors without the same degree of fluency in financial statements unloaded shares of the stock en masse. We had to issue a point-by-point rebuttal to the blogger’s claims, explaining why the fraud allegations were the result of his misunderstanding the company’s business and missing some key GAAP accounting principles.

By reacting quickly, we were able to ultimately book gains of 40.7% on the stock by the time we recommended selling shares. Not all investors are quite so lucky…

Avoiding Short Attacks

Until anonymous short sellers are held accountable for poorly researched, slapdash analysis, investors should expect the epidemic of short attacks to continue. That’s a deeply troubling trend. Even so, you can significantly reduce your chances of getting caught up in a short attack by following these suggestions…

1. Do Your Due Dilligence

While doing in-depth research on a stock may sound like an obvious solution, it’s shocking just how many investors are willing to sink their money into a stock without having a complete investment thesis on the company. Due diligence means gaining an understanding of what the company does, what it owns, and what being a shareholder entitles you to. It also means fully detailing the risks.

That’s not to say that you need to be an investment expert to buy a stock – but unless you’ve got guidance from an independent analyst or investment advisor, it’s advisable to avoid recommendations you read online.

2. Avoid Obvious Targets

Some companies are more susceptible to short attacks than others. Historically, Chinese small-cap stocks have been the most obvious targets because they represented the low-hanging fruit; with many of these firms half a world away, and fraught with cultural and language differences to focus on, there are plenty of red herrings to divert investors’ attention to. Companies that went public through reverse mergers are especially prone to short attacks.

OCZ isn’t a Chinese company – that’s one of the most disconcerting elements of yesterday’s short attack. Hopefully, this isn’t the start of a wider net for short hit pieces.

3. Buy Stocks with Coverage

When stocks get hit with a short attack, it’s incredibly difficult to hit the brakes on selling without having some form of reputable analyst coverage in shares. In the case of the Chinese small-cap we recommended, we were able to debunk the poorly researched fraud story and share our research with others. In the case of OCZ, reputable small-cap centric firms like Stifel Nicolaus and Needham have already defended their analyst research about the company.

That sort of analyst coverage also lends itself to more convicted institutional buying that’s less likely to be susceptible to rumblings from anonymous “research” firms.

In the current market environment, it’s disturbingly easy for short-sellers with almost no understanding of financial statement analysis to make millions of dollars by accusing a stock of an accounting fraud. Any numbers – no matter how misapplied – can be compelling to Main Street investors who don’t fully understand them.

Until some regulatory oversight comes into the picture, regular investors are going to continue to be the biggest victims in these situations. Follow the suggestions above to avoid being one of them.

Sincerely,
Jonas Elmerraji
Penny Sleuth

April 21, 2011

3 Ways to Avoid the Short Attack Epidemic in 2011 was originally featured in the Penny Sleuth. Check out Wall Street’s 5 Most Profitable Penny Stock Patterns Report.

This story was originally featured on Penny Sleuth.

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