Short-sellers often come in for criticism from both the media and the wider world of finance – not least because their aim of profiting from the failure or collapse of a business rather than its success can strike many as somewhat contrary to the spirit of investment. However, as a recent coup by the colourfully named Gotham City Research illustrates, there is a lot other investors can learn from short-sellers.
Named after the place Batman calls home – which may offer some insight into how its founders view themselves – Gotham City is one of a relatively new breed of short-sellers that use the internet to publish damning critiques of particular business. If the market agrees with the criticisms, the target’s share price will fall and the short-seller will tend to profit.
Compared with long-only investors, successful short-sellers have to carry out a great deal more work per investment idea for the simple reason their potential pay-off is asymmetric. In other words, while their possible upside is 100% – if their target’s share price falls all the way to zero – their downside, should their target’s share price keep rising, is in theory unlimited.
Thus, claims Gotham City, it took some eight months of due-diligence work from the moment its eye was first caught by a little-known Spanish wifi provider called Let’s Gowex to the publication on 1 July of a scathing report, among the conclusions of which were “Over 90% of Gowex’s reported revenues do not exist” and “Gowex shares are worth €0.00 per share.
Gowex’s immediate response was to come out with all guns blazing but, within a matter of days, it had been forced to declare bankruptcy and admit that its chief executive and founder Jenaro García Martín had made up its accounts for the last four years. Channelling the spirit of its favourite superhero, Gotham commented: “It is not who we are underneath but what we do that defines us.”
As recently as February of this year, Gowex had a market capitalisation of almost €2bn (£1.58bn) and had seen its share price rise more than 1,000% since the start of 2013 – taking it to the fringes of Spain’s principal IBEX 35 market and making it one of the best-performing shares in the world. So what did Gotham City Research spot that all Gowex’s investors and other admirers apparently missed?
Like all good short-sellers – and indeed all good investors – Gotham City questions things that do not seem to make sense and some general alarm bells were set off by Gowex’s stellar share price performance as well as by revenues and operating margins that appeared to continue to grow even though its competitors were struggling to turn any kind of profit at all.
Another ‘red flag’ was the differing views as to just how many wifi hotspots Gowex actually ran. One investor claimed the company’s chief executive had told them it was 200,000 while a Spanish broker though it was 35,000. Gotham itself was told 100,000 and yet its own research could only pinpoint around 5,000 – hence the view that 90% of Gowex’s revenues were non-existent.
Then there was the identity of Gowex’s auditor. Plenty of investors will view an audit firm they have never heard of as a reason to dig a little deeper into a company’s finances but Gotham took the unusual step of comparing the fees Gowex paid its – yes, obscure – auditor with the fees five of its competitor businesses paid to theirs. The average was 87 basis points – Gowex was paying just four.
Gotham uncovered a number of inconsistencies in Gowex’s accounts by the simple practice of cross-checking facts. So, for example, when Gowex’s accounts showed the company was being paid $7.5m to run hotspots for New York City, Gotham reasoned there should be a reference to this in the municipal accounts. There was – although the real number turned out to be a less substantial $200,000.
The question marks were not confined to the financial accounts either – the fact Gowex’s head of investor relations also happened to be the chief executive’s wife did not sit well with Gotham, nor did the way the English and French ‘translations’ of the company’s press releases often directly contradicted what was being said in the original Spanish.
All of this is fascinating whatever kind of investor you may be but, here on The Value Perspective, the aspect of Gotham’s due-diligence really made us sit up and think concerns alignment of interests. Generally in investment it is seen as a plus that the managers of a company own a stake in the business as it suggests their interests are aligned with other shareholders.
Certainly it is something we look for ourselves as investors and yet Gowex’s chief executive – the man behind the four years’ worth of false accounting – also owned 51% of the business. So while it can of course be a positive sign when company managers ‘eat their own cooking’, as it were, there is the potential negative an owner-manager of a failing firm may be tempted to try and cover up bad news.
Maybe it just comes down to asking the right question whenever you come across a senior executive who is also a large shareholder in a business. After all, as those self-styled caped crusaders at Gotham City Research have shown, asking the right questions – and then chipping away till the right answers are found – is a crucial and potentially lucrative skill for any investor.