Empirical Finance Newsletter, August 2009 (plus Stock Screen Results)

August 1, 2009 Volume 2, Issue 7

Empirical Finance Newsletter Turning academic insight into investment performance Editor’s Note: The Empirical Finance, LLC team has been synthesizing, cataloguing, and writing empirical finance research for many years. Our investment programs integrate many of the research insights highlighted in the Empirical Finance Research Newsletter, but not all of them. This newsletter is meant to highlight ideas we look for and consider when developing our investment technologies.

The Good News in Short Interest Ekkehart Boehmer, Zsuzsa R. Huszar and Bradford D. Jordan working paper

Abstract: We study the information content in monthly short interest using NYSE-, AMEX-, and NASDAQ-listed stocks from 1988 to 2005. We show that stocks with relatively high short interest subsequently experience negative abnormal returns, but the effect can be transient and of debatable economic significance. In contrast, we find that relatively heavily traded stocks with low short interest experience both statistically and economically significant positive abnormal returns. These positive returns are often larger (in absolute value) than the negative returns observed for heavily shorted stocks. Because stocks with greater short interest are priced more accurately, our results suggest that short selling promotes market efficiency. However, we show that positive information associated with low short interest, which is publicly available, is only slowly incorporated into prices, which raises a broader market efficiency issue. Our results also cast doubt on existing theories of the impact of short sale constraints.

Data Sources: Data pertaining to short interest in stocks is available from the exchanges. All three major exchanges publish this data on their websites, Empirical Finance, LLC and there are also services that aggregate the 16192 Coastal Hwy. data. Return data in this study comes from Lewes, DE 19958 CRSP. The period tested is 1988-2005. T: +1.773.230.4727 F: +1.888.517.5529 http://empiricalfinancellc.com

Discussion: This paper is about the performance of heavily shorted stocks versus that of lightly or unshorted stocks. Market pundits usually assume heavy short interest is a bearish indicator because it signals that many investors anticipate the price to decline. But there are

other interpretations; One is that shorting is usually used for hedging or arbitrage and thus says nothing about the valuation of the stock. Another is that shorting implies future buying because all short sales will need to be covered at some point in the future, therefore it may in fact be a bullish indicator. On balance, though, the academic literature has shown support for the conventional wisdom and found underperformance of heavily shorted stocks. This paper is one of the first to actually compare the difference between high short interest stocks and low short interest stocks. The results are somewhat surprising. Page 1

The Good News in Short Interest Using the short interest data of the prior month, the authors rank all stocks based on the short interest ratio, defined as the ratio of total shares shorted divided by shares outstanding. They then observe the performance of those stocks in the subsequent month. The primary result is surprising: Heavily shorted stocks do indeed underperform, but the outperformance of lightly or un-shorted stocks is far more significant. Stocks in the 99th percentile (the highest short interest stocks) on average experience negative absolute returns of 0.1% per month. The stocks in the 1st percentile (the lowest short interest stocks) on average experience positive absolute returns of 2.1% per month. This is an impressive and interesting discrepancy. After controlling for various risk factors through multifactor regressions, the authors find that the 99th percentile portfolio produces -1.2% alpha monthly, and the 1st percentile portfolio produces +1.4% alpha monthly. This means that a theoretical long/short portfolio adjusted for risk could produce 2.6% alpha per month, or 36% annually. There is reason to believe that the results of this paper persist for periods well beyond one month. Figure 3 of the paper charts the cumulative returns in months t=0 through 5 for stocks sorted in month t-1. In other words, it appears to be possible to hold a portfolio for a period of up to six months and still generate some abnormal returns, although the authors do not fully test such a strategy in this paper. Empirical Finance, LLC 16192 Coastal Hwy. Lewes, DE 19958 T: +1.773.230.4727 F: +1.888.517.5529 http://empiricalfinancellc.com

The authors leave open the question of why low short interest stocks outperform. While they find that short interest in general is concentrated among large firms and that the lowest short interest stocks are typically small (a result not at all surprising considering the institutional dynamics of short selling), alphas persist even after controlling for this size effect. This is puzzling, as we might expect stocks for which short selling is difficult to be overvalued (and thus have low subsequent

returns) because the inability to short the stock implies that a disproportionate number of bullish investors are active in it. Further, the authors examine the small, low short interest stocks and find that the most undervalued among them are also the most actively traded, also a puzzling finding. In summary, this paper makes very interesting and useful empirical findings while raising more theoretical questions than it answers.

Investment Strategy: Each month, rank all stocks based on short interest ratio and assign each a percentile rank. Buy stocks in the lowest percentile and short stocks in the highest percentile. Rebalance monthly. Alternatively, rank the stocks as above but simply buy the stocks in the lowest percentile and rebalance monthly. This will reduce some of the costs of the long/short strategy, can be done without leverage and still produces significant alpha.

Conclusions: It is nice to see a Wall Street rule of thumb formalized by academic work. However, it is even better to discover new details (namely that very low short interest is more informative than very high short interest) about such a rule of thumb. It is important to note that this paper does not account for some very obvious costs, most noticeably the borrowing costs associated with short side of the long/short strategy, but also the mere transactions costs of rebalancing a large portfolio so frequently. Nevertheless, the paper provides convincing evidence that following short interest data is not a fruitless exercise. Another risk to investors is that short selling might be outlawed entirely. I would guess there is a nonzero probability of this happening sometime in the foreseeable future, and if it does clearly this strategy is worthless.

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Empirical Finance LLC Current Stock Screens

Empirical Screen #1 Piotroski F-Score and signaling factors This table highlights all companies that have the highest score possible on the Piotroski F-Score fundamental analysis screen (slightly augmented). We screen for small-cap companies that have book/price ratios in the top 20% of all companies traded on the NYSE/AMEX/NASDAQ. We add information on CEO ownership to signify ―skin in the game.‖ Finally, we highlight any open market repurchase activity that has taken place in the last 6 months (signals that shares are cheap). Ideas generated in this screen are not meant to be short-term trades, but represent long-term opportunities that, on average, have outperformed the general market by great margins. (Screened on July 31, 2009).

Company Name, Exchange, Ticker Comfort Systems USA Inc. (NYSE:FIX) Apogee Enterprises Inc. (NasdaqGS:APOG) Dollar Financial Corp. (NasdaqGS:DLLR) M&F Worldwide Corp. (NYSE:MFW) Pike Electric Corporation (NYSE:PIKE) Kensey Nash Corp. (NasdaqGS:KNSY) American Ecology Corp. (NasdaqGS:ECOL) DHT Maritime, Inc. (NYSE:DHT) Asset Acceptance Capital Corp. (NasdaqGS:AACC) AEP Industries Inc. (NasdaqGS:AEPI) Republic Airways Holdings Inc. (NasdaqGS:RJET) Spectrum Control Inc. (NasdaqGS:SPEC) Hawk Corp. (AMEX:HWK) Communications Systems Inc. (NasdaqGM:JCS)

Empirical Finance, LLC 16192 Coastal Hwy. Lewes, DE 19958 T: +1.773.230.4727

Mkt. Cap. ($mm)

Book/ Price

Recent CEO % Buybacks ownership

449.8

0.67

-

1.02

411.9

0.79

-

1.45

380.3

0.48

-

2.05

371.0

1.20

-

0.026

366.1

0.68

5.73

327.4

0.37

296.0

0.32

03/18/2009 Buyback 10/28/2008 Buyback

0.808

241.3

0.76

-

0.129

240.9

0.55

-

0.056

215.7

0.32

-

12.52

178.8

2.67

-

0.574

128.0

0.87

1.22

121.2

0.58

107.2

0.84

11/24/2008 Buyback 11/13/2008 Buyback

1.46

2.37 0.222

Screening Criteria: ►Market Value between $100mm and $500mm ►Book Value / Market Value less than 3 ►LTM Net Income greater than 0 ►LTM Cash from Operations (CFO) greater than 0►LTM Return on Assets % greater than 5% ►LTM CFO greater than LTM Net Income ►LTM LT Debt / Capital greater than LTM-1 LT Debt/Capital ►LTM Current Ratio greater than LTM-1 Current Ratio ►LTM Shares Outstanding less than LTM –1 Shares Outstanding ►LTM Gross Margin greater than LTM-1 Gross Margin ►LTM Asset Turnover greater than LTM-1 Asset Turnover.

F: +1.888.517.5529 http://empiricalfinancellc.com

*Please Note: This newsletter is published by Empirical Finance, LLC, which serves as the general partner for various investment vehicles. Empirical Finance, LLC may purchase or sell securities and financial instruments discussed in this newsletter on behalf of its clients. Empirical Finance, LLC is not an investment, legal, or tax advisor, and none of the information available through the newsletter is intended to provide tax, legal or investment advice. Nothing provided through this report constitutes a solicitation by Empirical Finance, LLC for the purchase or sale of securities.

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Empirical Finance LLC Current Stock Screens

Empirical Screen #2 Top 10 Long/Short Net Operating Asset companies These tables highlight the companies with the lowest net operating assets and the highest net operating assets. We screen for small-cap companies having 8+ years of operating performance. Low NOA ideas generated in this screen are not meant to be short-term trades, but represent longterm opportunities that, on average, have outperformed the general market by great margins. High NOA companies are good short-sell candidates. (Screened on July 31, 2009).

Long: Company Name, Exchange, Ticker Insmed Incorporated (NasdaqCM:INSM) BioSpecifics Technologies Corp. (NasdaqGM:BSTC) China Distance Education Holdings Limited (NYSE:DL) Energy Recovery, Inc. (NasdaqGM:ERII) ATA, Inc. (NasdaqGM:ATAI) Sulphco Inc. (AMEX:SUF) Facet Biotech Corporation (NasdaqGM:FACT) Agria Corporation (NYSE:GRO) OncoGenex Pharmaceuticals, Inc. (NasdaqCM:OGXI) China Education Alliance Inc. (AMEX:CEU)

Mkt. Cap. ($mm)

NOA

CEO % Ownership

129.4

-8.50

-

155.8

-2.52

23.71

282.4

-2.47

-

350.0

-2.31

1.04

180.4

-2.15

0.10

110.6

-1.64

0.00

218.0

-1.58

-

130.8

-1.53

-

173.0

-1.28

0.55

110.6

-1.08

57.93

Short: Company Name, Exchange, Ticker

Empirical Finance, LLC 16192 Coastal Hwy. Lewes, DE 19958 T: +1.773.230.4727 F: +1.888.517.5529 http://empiricalfinancellc.com

Domino’s Pizza, Inc. (NYSE:DPZ) Valence Technology Inc. (NasdaqCM:VLNC) KapStone Paper &Packaging Corp (NasdaqGM:KPPC) NPS Pharmaceuticals, Inc. (NasdaqGM:NPSP) Crown Media Holdings Inc. (NasdaqGM:CRWN) Raser Technologies, Inc. (NYSE:RZ) Dynex Capital Inc. (NYSE:DX) Revlon, Inc. (NYSE:REV) ICO Global Communications Ltd. (NasdaqGM:ICOG) Freddie Mac (NYSE:FRE)

Mkt. Cap. ($mm)

NOA

CEO % Ownership

478.1

3.43

0.66

222.3

1.85

0.00

144.7

1.76

8.83

187.6

1.64

0.26

212.2

1.61

0.00

146.1

1.52

1.11

111.1

1.43

4.86

313.3

1.43

0.05

104.0

1.27

0.03

388.9

1.07

0.00

Screening Criteria: ►Market Value between $100mm and $500mm ►NOA=[(Total Assets -Cash and Equivalents)-(Total Assets—Total Debt)]/Total Assets year prior) *Please Note: This newsletter is published by Empirical Finance, LLC, which serves as the general partner for various investment vehicles. Empirical Finance, LLC may purchase or sell securities and financial instruments discussed in this newsletter on behalf of its clients. Empirical Finance, LLC is not an investment, legal, or tax advisor, and none of the information available through the newsletter is intended to provide tax, legal or investment advice. Nothing provided through this report constitutes a solicitation by Empirical Finance, LLC for the purchase or sale of securities.

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