An article in today’s Wall Street Journal titled, Mysterious Stranger’s Dog Controversial Insurer’s Critics, tells an unusual story that sounds like a scene from a spy novel.
AmTrust Financial Services, which is listed on NASDAQ and has a market cap of $2.5 billion, is an insurance company which has lately been the focus of short sellers. Over the past 12 months, shares sold short has increased from 5.5 million to over 16.2 million. (As a review, a short seller borrows stock and sells it, believing the stock will decline, with the goal of buying it back at a lower price in order to make a profit.) Short sellers of AmTrust were alleging accounting irregularities and it is rumored that the US Securities and Exchange Commission is examining AmTrust’s accounting practices.
In order to generate alpha an investor must have a variant perception. The investor must be able to identify a genuine mispricing and have a view that is different than the consensus and that view must be right. As we discuss in Chapter 8 of our book Pitch the Perfect Investment there are three types of advantages, an informational advantage, an analytical advantage or a cost or trading advantage. On page 285 of the book we state:
Because pure informational advantages are rare and pure analytical advantages require decades of experience, the most common way successful investors identify mispriced securities to outperform the market is by blending the two, combining an informational advantage with an analytical advantage.
This process usually begins with the analyst digesting all publicly available information. An experienced analyst knows where to focus his efforts, which makes this process quick and efficient. If the idea is sufficiently interesting, the analyst will do a deeper dive, which usually entails collecting additional pieces of information, most of which is nonmaterial and nonpublic, or quasi-public. The analyst applies his analytical process to all the information with the goal of reaching a conclusion that is material, nonpublic, but legal. Judge Walter Roe Mansfield of the United States Court of Appeals for the Second Circuit summed up succinctly his views on this approach in 1980, in his decision in Elkind v. Liggett & Myers, Inc.:
A skilled analyst with knowledge of the company and the industry may be able to piece together seemingly inconsequential data with public information into a mosaic to produce a meaningful analytical edge.
What the short sellers examining AmTrust are trying to do is extract non-material nonpublic information and meld it with public information to arrive at a conclusion that is material, nonpublic but LEGAL. In this case, the short sellers believe that AmTrust stock is mispriced because there is information about AmTrust that has not been properly disseminated as seen in the figure below:
The short sellers believe that when the information they have is adequately disseminated, it will be processed by investors and incorporated into the stock price thereby correcting the mispricing (the stock will fall to reflect the new information). This is shown in the following figure:
Back to the WSJ article. The story asserts that AmTrust short sellers and others who have published negative stories or reports on the company have been contacted by individuals holding themselves out to be potential investors or consultants with business opportunities. But it appears that these individuals are not who they say they are and are really trying to extract information on what the short sellers know about AmTrust.
The story details an account of one short seller who met a woman who, “identified herself as a London-based consultant to a European software multi-millionaire seeking contributors to a new investment website” at a restaurant in Philadelphia. The story goes on to say, “…the woman, [who was] described as gorgeous, plied him with drinks and slipped in several questions about critiques of AmTrust and its accounting methods.” The story details other instances where reporters and short sellers have been approached by mysterious “consultants” who were trying to obtain information.
When a public company is attacked by short sellers, they often don’t stand by idly watching. Rather they take action to prove the short sellers wrong or if they are engaging in illicit activities, try to cover-up these activities. The story infers that these “spies” are proactively trying to find out what the short sellers know in order for AmTrust to take action to clear up any misunderstandings or cover-up any questionable activities.
It will be interesting to see the final outcome. Stay tuned…