Quindell – and how to avoid the shorters

Quindell, a company operating in the insurance sector, came under attack yesterday by Gotham City Research LLC, an investment analysis firm. Quindell’s shares ended down on the day by 39% and were down more than 50% at one point.

Gotham City make numerous allegations in a 74-page document which is available from their web site. Without a lot more knowledge of this company and a detailed study of these allegations, it is impossible to comment on the substance of them, but some of the main claims are about the quality of the profits, the fact that cash flow as a result is lower than one might expect, and that some of their acquisitions seem to have little substance.

Quindell immediately issued an announcement rejecting the allegations as being “highly defamatory” and “deliberately misrepresentative” and rejecting the conclusions that are made. They will be giving a more detailed response later this week and in the meantime are consulting their legal advisors. They also stated they were confident of meeting or exceeding market expectations in 2014.

Without doubt this is a shorting attack by Gotham City because their document says “You should assume that as of the publication date of this report, Gotham City Research LLC stands to profit in the event the issuer’s stock declines“. Other shorting specialists have also apparently jumped on the bandwagon.

Who are Gotham City Research you ask? Is this some arm of the Bruce Wayne empire of Batman fame? Not quite. Very little seems to be known about it. The company was incorporated in Delaware in February 2013, but no phone number or street address is given on their web site, and all it says about the business is that “Gotham City Research LLC focuses on due diligence-based, special situation investing. As of the publication date of our articles, we may have long or short equity positions in the companies covered.”

However it is known that they have been involved in other such attacks on EBIX (for tax reporting), on Tile Shop and on Blucora (a.k.a. Infospace) which was also attacked by Prof Edelman of Blinkx fame for alleged click fraud.  The owners or principals of Gotham City are unknown.

It seems pretty clear that these kinds of attacks, which first came to public notice by the activities of Muddy Waters, will continue on vulnerable companies unless the SEC and FCA takes steps to reign them in. As the Editor of respected journal Techinvest had this to say about the Blinkx affair: “The ferocity of the blitzkrieg-style assault launched by the coordinated shorters was a first-ever novelty shock for London market participants. Having tasted blood once, you can bet the attackers will be back, except this time it will be a different victim“. He was certainly right there.

How do you avoid becoming a victim of such shorting attacks?

You can use stop losses to ensure you minimise the impact when such an event occurs, but as the editor of Techinvest found out, you only have to be absent from monitoring your portfolio for a very short period of time for the damage to be done (a few minutes in the case of Quindell). You might try an automatic stop loss but they are very tricky unless monitored closely.

The real key is to avoid investing in stocks that are likely targets for shorting attacks. These are typically smaller companies with high liquidity (i.e. a high volume of trading). It is no surprise that Quindell is one of the most actively traded stocks on the London market, and a favourite of speculators.

Shorters need liquidity in a stock or they won’t be able to acquire and close out their positions. Smaller stocks are preferable because they are less likely to attract the attention of regulatory authorities. AIM listed UK stocks are ideal because of the “light touch” self-regulation of the AIM market by the LSE. But the market cap cannot be too small or it’s not worthwhile for the shorters.

Stocks that are favourites of momentum traders and have been driven up to high levels on fundamental ratios as a result are also ideal for shorters. If they can be tipped into negative momentum then the same traders will drive the stock down.

Any companies with questionable cash flow (e.g. profits not turning into cash), suspect revenue recognition, changes of auditors, or chequered past histories are also ideal to attack, even if the shorters can only raise doubts rather than actually produce evidence.  So investors really do need to study the companies they invest in and do analysis of their financial accounts. An in-depth understanding may help you to avoid those companies that may be the subject of shorting attacks, and enable you to determine whether the allegations have substance if you do happen to hold them.

One obvious risk control approach is never to let your high risk investments exceed more than a certain percentage of your overall portfolio. You may then be able to weather any storm that appears. This is not the first time Quindell has been the subject of a shorting attack – it recovered from a previous one in 2013.

Comment: there does seem to be a problem in that claims can be made by those out of the easy reach of UK libel laws, for both legal and practical reasons, and where any rebuttal is going to take days at least to publish. That is all the shorters need to generate large profits. So the substance of the claims can be weak but still enable them to make money.  With any largish business, particularly one that has grown rapidly and by acquisition, it’s not difficult to pick holes in its accounts or operations. One only has to look at the problems of FTSE-100 companies in the last few years to see this. Numerous allegations of mis-selling and fraud in banks, criminal activities and environmental disasters alleged against oil companies, dubious associations with foreign individuals or organisations in mining and oil companies, bribery in pharmaceutical and aerospace/defence companies, one could go on at length on this subject. It’s only because these are powerful and wealthy businesses with some innate trust in them by investors that enables them to avoid shorting attacks.

Some people consider the activities of shorters as healthy to control excessive up-side speculation in inherently poor quality companies, but that is not solely this writers view. Shorting is one thing and should not be made illegal, but when it is combined with public attacks which no responsible analyst or newspaper would allege then it goes beyond what is ethically reasonable. When made by anonymous authors beyond UK legal jurisdiction, it is dubious in the extreme.

Such activities effectively encourage the view that the stock market is only for speculators rather than investors, which damages everyone in the long term.

For the avoidance of doubt, I have never held an interest, short or long, in Quindell and have no views on the claims made by Gotham City.

Roger Lawson

Postscript 24/4/2014: the Financial Times reported some more information on Gotham City subsequently. They suggest that it is linked to a person named Daniel Yu. They also said “It’s the Muddy Waters  model – go short then go public”, which well summarises their modus operandi.