RILYP - Thank A Short-Seller For Growing Your Income

2023-07-24 07:35:00 ET

Summary

• The Internet has changed how we communicate, in both positive and negative ways.
• Following COVID, meme mania spread across the internet, resulting in unreasonably high valuations.
• "Short reports" have been doing the opposite in a bearish market.
• Stocks targeted by these reports have rebounded from their bottoms, but great buying opportunities remain.

Co-authored with Beyond Saving

The Internet is a wonderful tool for spreading everything that is great about investing. Young investors today have advantages that simply didn't exist 10, 20, or 40 years ago. Gone are the days when you had to pay hefty trading fees, have high minimum balances, and had to read through paper 10-Ks that were sent to you in the mail.

Today, every retail investor has access to the information that the big Wall Street traders of the '80s and '90s could only dream of. Within seconds of any corporate press release or filing, you can access it yourself. You don't have to wait for a reporter to show up on TV to tell you the news or for a newspaper to publish it. Information is freely available on the Internet.

Among the other positives is the opportunity to instantly communicate with other investors and discuss ideas.

I like to spend as much time teaching investing knowledge as I do identifying particular picks. Give a person a pick, and they will profit for a trade, teach a person to pick, and they will successfully invest forever.

However, there is one drawback to information spreading too quickly: bad information spreads just as quickly as good information. Today, I want to look at how information influences the market.

The "Meme" Stock Mania

In 2020 and 2021, we saw the rise of the "Meme" stock – investments that would rocket up at the encouragement of vigorous promotion on various social media outlets. GameStop ( GME ), AMC Entertainment ( AMC ), Workhorse Group ( WKHS ), and Bed Bath & Beyond ( BBBYQ ) are all examples of meme stocks that rocketed to completely unsupportable valuations.

In an extremely bullish market, this type of enthusiasm can result in very large short-term gains but creates a lot of risk for anyone buying at those expensive valuations. Investors see others making tons of money, and they race to join in as Fear Of Missing Out ('FOMO') kicks in.

When markets are bullish, extremely optimistic outlooks are psychologically appealing to investors who feel invincible. They might realize a large gain from one Meme stock and roll it into another bet. After all, the source they got the first tip on was accurate, so it must be good, right?

The Short Report Mania

In 2022, the market had changed a lot. Former meme stocks were falling, the market was down a lot, and the optimism was sucked out of the market. When investors lose money, they become less susceptible to being swayed by overly optimistic outlooks. They become more cynical and less confident. That doesn't mean that they become more discerning about the information that guides their choices. It means they are more likely to believe overly pessimistic outlooks.

Over the past year or so, we have seen a significant increase in "short reports" spreading across the Internet. Like with Memes, some have had a greater impact than others. We've seen several stocks we follow impacted by short reports. Medical Properties Trust ( MPW ), Arbor Realty Trust ( ABR ), B. Riley Financial ( RILY ), and TriplePoint Venture Growth ( TPVG ) have all been targeted, among many others. Among these holdings, MPW has seen the longest and most sustained series of reports written about it.

Everyone Has an Interest

It is human psychology that how we interpret information will be influenced by how we feel. We aren't emotionless robots that make decisions on "just the facts". If we are in a good mood, we will tend to interpret the glass as half-full. If we are in a bad mood, we will interpret it as half-empty. Both promoters of Meme stocks and short reports take advantage of this reality.

In addition to those having an organized campaign to advertise for a long or short position, there is a wide array of writers who are stating their opinion, which could be bullish or bearish. When talking about investing, it is fair to say that a large number of the opinions on the internet are being stated by someone who holds a long or short position in the stock. This shouldn't discount any opinions – investors with capital at stake are more motivated to know things.

As an investor, you want to be aware of any valid counterarguments against your position. So no argument should be summarily dismissed. You always want to be open to absorbing information about why your investment might not be as strong as you believe.

How do you determine if the report you are reading is making valid arguments or whether they are just trying to scare you into selling for their profit?

Red Flags That Shorts are Trying to Dupe You

• Allegations of illegal activity: Sometimes, short reports will go as far as outright accusing management of illegal activity. When a short-seller accuses a company of falsifying SEC documents, setting up a Ponzi scheme, or other outright illegal activity, that should raise a red flag. Yes, there have been public companies that have been guilty of breaking the law, but it is very rare. Furthermore, if a particular person did have knowledge and evidence of illegal activity, it would be appropriate to contact the SEC to report it for investigation – something that short sellers never seem to do. When a short-seller is making very serious charges like this, demand evidence. It is these kinds of statements that caused MPW to file a lawsuit against Viceroy, a company that has produced and promoted several "short reports".
• Intense focus on minor details: Another common red flag is if the writing focuses on small details. A short seller often focuses on a particular deal that didn't work out and extrapolates that to cast doubt on the entire company. When you actually do the math, you often find out that even if they are completely right, the financial loss isn't material. For example, when we covered the RILY short report, we noted that the bulk of RILY's revenues and earnings stem from services and fees, while the short report focused on a single trade in a niche market. RILY's future as a company is hardly tied up with the fate of its investment in GREE.
• Conflating GAAP and non-GAAP measures and other questionable accounting methodologies: Publicly traded companies are required to file their financials with the SEC using GAAP accounting rules. Most companies also offer alternative "non-GAAP" metrics that they believe provide better information for investors. GAAP rules are rigid and "one size fits all", which frequently isn't useful since businesses have different strategies. Therefore, companies are allowed to provide non-GAAP metrics but are required to provide a reconciliation so that investors can see the adjustments made from the nearest GAAP metric. Short sellers are not bound by such rules, and we've frequently seen them create new metrics without a detailed reconciliation or flip back and forth between GAAP and non-GAAP metrics. It is important that you have a basic understanding of the metrics that companies report and what those metrics are telling you. For example, many of the short reports on MPW relied on GAAP book values or tax assessments to determine that MPW "overpaid" for properties. Nobody in the real estate industry uses GAAP book value to estimate the value of properties. In the RILY short report, the author focused on a potential loss of an asset carried on the balance sheet if a SPAC was dissolved while ignoring the offsetting liability that would be removed from the liability side of the balance sheet.

Seizing The Opportunities

In our portfolio, we have several ongoing opportunities that have seen their prices depressed, at least in part thanks to short-sellers.

RILY Bonds & Preferred

RILY common shares have fully recovered from the impact of the short report in February, and the price is approaching a year-to-date high. Nonetheless, the yield-to-maturity on the baby bonds remains in the 11-12% range. This is a fantastic opportunity to add to your fixed-income portfolio before the Fed pivots.

MPW Common Shares

MPW common shares have not yet recovered. While they have climbed 40% from their bottom, MPW remains extremely cheap, valued at 6x FFO. For context, in March 2009, the absolute bottom of the Great Financial Crisis ('GFC'), MPW was trading at a valuation of 4x FFO after a 25% dividend cut and a 26% decline in FFO. The GFC was certainly a difficult time for most REITs, MPW included. Yet those who ignored the fear and were buying at that time saw immense upside in the coming years.

From that low to today's low, MPW still provided a total return that beat the S&P 500, even though the S&P 500 is trading at a higher than average price/earnings ratio, while MPW is trading at its lowest P/E ratio since 2009.

It is true that MPW has some tenant issues. They discussed them extensively in the last earnings call, along with their plans to deal with them. The largest one, which had an impact on expected earnings for 2023, was Prospect. That situation is being resolved with a series of transactions that look exactly like management said they would at the Q4 earnings call.

Conclusion

Issues happen in business: revenues get disrupted, customers skip out on their bills, the cost of capital increases, etc. Even the best of plans only survive until they come in contact with reality. The businesses targeted by short campaigns usually are facing some real problems. Yet a business hitting a speed bump is hardly a reason to panic and sell at any price. In the short term, the market voting machine can have viciously negative sentiment that impacts share prices. This is the emotion that short reports attempt to target, just like the meme trend targeted FOMO and greed.

As an income investor, one of the most powerful tools you can have in your belt is the ability to evaluate the risks of a stock with a clear head – to be able to recognize the actual financial impact of a piece of bad news and to make a reasonable estimation of whether that means your income is safe and what a fair valuation for the investment is. Historically, the best time to buy is when fear is at its highest. March 2009, there were a lot of really good reasons to be fearful. March 2020, there were a lot of reasons to run for the sidelines. Yet in both cases, investors who kept a clear head and were net buyers did best.

So while the shorts are stoking fear, I say thank you, buy a few more shares and grow my future income!

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