John Dorfman—E-Toys Comes Up a Winner In Short-Selling Competition

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Jeffrey Newman, an executive with a mortgage security administration firm in Phoenix, won this column’s second annual Short Sellers Don’t Have Horns contest as his pick, eToys Inc., plunged 91 percent.

A short sale is a bet that a stock will fall. A speculator borrows shares in a company, usually from a brokerage firm, and sells them with the intent of replacing the stock later at a lower price, keeping the difference as profit.

EToys’ stock “should be around $8 to $12, not $70 a share,” wrote Newman, president of American Southwest Financial Group LLC, when he entered the contest last September. That comment proved prescient. Santa Monica-based eToys, the largest Internet toy seller, has posted losses in each of its four quarters as a public company, and its stock was hurt by news that Toys R Us Inc., the largest U.S. toy retailer, will team with Amazon.com Inc. to sell toys online.

E-tailers in general have been roughed up in the market as early high expectations have been punctured. EToys’ stock dropped from $66.56 a share Sept. 30, 1999, the start of the contest period, to $5.91 on Sept. 15, the end date.

As his prize, Newman will receive three classic investment books, “Caught Short!” by Eddie Cantor, “Crisis and Panics” by James Fraser, and “The Art of Speculation” by Phil Carret.

Negative views

Some people view short sellers as immoral, un-American or just plain distasteful. It’s negative, they say, to bet against companies instead of for them. And many investors blame short sellers for every nasty rumor that comes swirling through the marketplace.

I view short selling as a legitimate investment technique, and employ it for some of my clients. I’ve noticed that short sellers perform some of the most thorough and original research I see on stocks. As for spreading rumors, well, that allegation is sometimes true, but short sellers are far from the only ones on Wall Street who spread rumors and sometimes stretch the truth.

Twenty-four contestants entered the short-selling contest. Of these, 14 managed to pick a stock that declined. That’s pretty good, considering that the overall stock market, as measured by the Standard & Poor’s 500 Index, rose 14 percent in the contest period.

Ten contestants’ picks went up the wrong way, if you’re a short seller. Of these, nine actually beat the S & P; 500. One selection, Juniper Networks Inc. of Sunnyvale, rose 565 percent! If this had been a real investment, instead of a paper one, the person who shorted Juniper could have lost $56,500 on a $10,000 investment.

The Juniper example illustrates why short selling is a high-risk strategy. However, judicious short selling may lower the overall market risk in a portfolio. If the market slides badly, at least one portion of the person’s holdings should be rising.

Newman said he picked eToys as his short partly because of its extravagant valuation at the time. The company went public in May 1999 and leapt to a valuation of about 200 times revenue. The valuation has fallen to 4.8 times revenue.

“People forget,” Newman wrote last year, “that eToys’ profit comes from selling products for more than they cost, not printing e-money.”

For the coming year, Newman said his favorite short is Amazon.com Inc., the largest Internet retailer. “The heavy debt load should become a concern” during the next 12 months, he said. And the stock’s $14.4 billion market value “is a big multiple to revenue and a silly multiple to book.”

Amazon.com’s stock currently fetches 6.6 times revenue; book value (corporate net worth per share) was negative as of June 30.

Overvalued baker

Second place in the contest goes to Paul Conner, a retired physician in Dallas. His pick, Pacific Gateway Exchange Inc., which sells phone-network access to long-distance companies, fell 87 percent. Pacific Gateway dropped to $2.09 a share from $16.38 during the contest period. The company’s growth has slowed and its costs have increased.

For the coming year, Conner said his favorite short candidate is Krispy Kreme Doughnuts Inc., which he said is “way overvalued.” The company’s shares sell for 93 times estimated earnings for the year ending next January.

Daniel Huber, a mortgage broker in San Ramon, Calif., took third place as his pick E-Loan Inc., an Internet mortgage broker fell 84 percent. The stock declined to $3.50 a share from $21.56. Huber said last September that he disliked the stock because the loan industry had “few barriers to entry,” and because E-Loan’s services were mainly used by people to refinance homes.

“The refinance boom is over,” he wrote. That prediction proved correct, and investors punished E-Loan when it announced disappointing earnings. Huber said he personally made some money by shorting E-Loan.

For the coming year’s short-selling contest, he picked Key Energy Services Inc., an oil-service company based in East Brunswick, N.J.

“I believe that high oil prices will be a thing of the past within a few short months,” he says.

The next Short Sellers Don’t Have Horns contest runs through Sept. 15, 2001. Stocks selected must be U.S.-traded and U.S.-based, and must have a market value of $250 million or more as of the starting date.

Contest participants don’t have to have real money at stake. In fact, they don’t even have to be able to borrow the stock; in that sense, it is a theoretical contest. The contest disregards trading commissions and borrowing costs. If two or more entries go to zero, the one reaching zero first will be considered the winner. The prizes will be disclosed when the contest is over.

John Dorfman, president of Dorfman Investments in Boston, is a columnist for Bloomberg News. His firm or its clients may own or trade investments discussed in this column.

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