REVERSE MERGERS AND SHORT SELLERS

An interesting article from Bloomberg:

Sept. 20 (Bloomberg) -- Who likes wars, recessions, hurricanes, terrorist threats and corporate scandals?

Short sellers do, if you listen to their detractors.

Short sellers are investors who profit when a stock declines. Some folks view these renegade investors as antisocial. I have a more positive view.

Each year I run a contest in which the goal is to pick a stock that will go down. I call it ``Short Sellers Don't Have Horns.''

Christian Olesen, an analyst and trader at Xaraf Management LLC, a hedge fund in Greenwich, Connecticut, won this year's contest. He recommended a short sale of UAL Corp. (UAUA), correctly predicting that stockholders of the airline, based in Elk Grove Township, Illinois, would be wiped out in a bankruptcy.

For the coming 12 months, Olesen says his entry will probably be Delta Air Lines Inc. (DALRQ), which is currently in bankruptcy proceedings.

``The stock is up a lot in the last few days on unsubstantiated speculation,'' he said. ``I guess people are thinking the stockholders will get some recovery down the road, but I don't think so.''

Jonathan Kniss, a stock trader from Fullerton, California, came in second, after a first-place finish in 2004-2005. His pick, Net2Auction Inc. (NAUC), dropped 95 percent from Sept. 30, 2005, through Sept. 15, 2006.

Kniss won the contest the previous year when his choice, LFG International Inc. (LFGC), declined 99.9 percent.

Empty Shells

Kniss says he often finds short sales among companies that have done a reverse merger, in which a private company takes over a public one that has few, if any, assets or operations. ``It's a backdoor way of going public,'' he says. One stock that interests him as a short today is Conversion Solutions Holding Corp. (CSHD) of Kennesaw, Georgia.

A short seller borrows shares of a stock and immediately sells them, pocketing the proceeds.

At some point, he must buy shares to return those he borrowed. If the stock price falls, he makes money, because the replacement shares cost less than his original proceeds. If the stock price rises, he loses.

It's true that short sellers often benefit from adverse events such as military conflict or slumping profits. And critics are right in saying that the shorts have an incentive to spread nasty, sometimes untrue rumors about companies they have sold short. Then again, conventional investors have an incentive to hype the stocks they own.

Useful Purpose

In my opinion, the short brigade serves a useful purpose. By pointing out unpleasant truths, and by counteracting hype, the short sellers help keep all investors, especially the proverbial ``widows and orphans,'' from overpaying for certain stocks.

Short selling is considered a risky form of investment because the potential loss when you sell short is unlimited. (There is no ceiling on how high a stock might rise.) The maximum gain on a short sale is 100 percent, because a stock can't decline past zero.

With conventional investing, the maximum loss is 100 percent (same reason), while the maximum gain is unlimited.

For winning the eighth annual contest, Olesen will get some shortcake delivered to his home. Second- and third-place finishers receive no prize except prestige.

Other than UAL, airline stocks did well, confounding several contestants who picked AMR Corp. (AMR) or Delta as shorts. Fort Worth, Texas-based AMR rose 112 percent and Delta, based in Atlanta, advanced 47 percent.

Calpine, Delta

Third place goes to Jeff Lenamon, a portfolio manager at Diversified Credit Investments in San Francisco. His pick, Calpine Corp. (CPNLQ), an electric utility owner and power seller in San Jose, California, dropped 87 percent. Remarkably, Lenamon also finished third last year. He picked Delta as a short at the right time: It dropped 77 percent from Sept. 30, 2004, through Sept. 15, 2005.

Twenty-six people entered the contest, down from 39 the year before. Exactly half of them managed to pick a losing stock.

On average, their picks declined 4 percent, which is a good showing considering the Standard & Poor's 500 Index rose 9.4 percent in the contest period.

If you would like to participate in the ninth annual Short Sellers Don't Have Horns contest, e-mail me at jdorfman@bloomberg.net.

Please list your name, occupation, address and phone number. Then tell me your pick, its stock symbol, and (briefly) why you think it will decline.

Contest Rules

If you don't have e-mail, or don't like to use it, you can write me at John Dorfman, President, Thunderstorm Capital, One Federal Street, 18th floor, Boston MA 02110.

All entries must be postmarked or time-stamped by midnight Sept. 29. The next contest runs from Sept. 29, 2006, through Sept. 14, 2007.

I don't require that people put real money into their short picks.

Indeed, it isn't a requirement that the stock can be borrowed in practice. When a stock appears to be a possible fraud, seems deeply troubled, or is thinly traded, it is sometimes hard to borrow. A trader doesn't know whether it's easy or hard until he or she goes to do it.

To be eligible for inclusion, a stock must have a market value of $100 million or more at the time the contestant chooses it.

In discussing the merits of short selling, I may not be totally objective. I sell selected stocks short for certain clients who can tolerate high risk. When I look in the mirror, I haven't seen any horns yet.