Shadow Stocks - Investing, with a focus on small stocks

Back on January 19th, when the Dow closed above 10,700, I posted this on the Short Screen message boards,

Had limit orders in for puts on two companies I found on Short Screen’s screener. One idea behind my Short Screen put basket is that when the market corrects, I expect financially-distressed stocks will fall further and faster than the broader market.

A few minutes before the close today, my limit orders still hadn’t filled, but with the Dow hitting highs I felt it was an opportune time to short something. So I picked up a few of the 87 strike JUN 10 puts on the Dow-tracking ETF DIA.

Those DIA puts, which I bought for $0.95, didn’t trade today, but show a bid price now of $1.82.

One Day Chart for Alloy Steel International

The company announced today that it expected its pretax profit for its fiscal first quarter 2010 (which corresponds to the fourth calendar quarter of 2009) to be about $2.24 million (or about 12.9 cents per share). Looks like this could be about 8 cents in after tax profits for the quarter.

On the old blog last month, I wrote about the problem of quasi-hedging a micro cap stock such as Alloy Steel International (OTC BB: AYSI.OB). As I noted there, since Alloy Steel doesn’t have options traded on it, it’s impossible to hedge it against idiosyncratic, or company-specific risk. My main concern though isn’t company-specific risk but the exogenous risk of a drop-off in Chinese demand for iron ore, since Alloy Steel’s main clients today are iron ore miners (though its technology has applications in other kinds of mining and in infrastructure and energy production as well). The quasi-hedge I had in mind in that post last month was to buy puts on a particular Chinese steel company. I didn’t end up doing that, because the day I came up with the idea, the puts I was going to buy shot up in price 50% on news of that Chinese company’s dilutive secondary offering.

In hindsight, that idea was flawed anyway. What if demand for steel in China remained strong, but iron ore prices declined (perhaps because of previous, over-zealous stockpiling of it in China)? Conceivably, that could benefit the Chinese steel company and negatively impact Alloy Steel and its iron miner clients. So, a month later, I have come up with a much simpler idea: buying puts on AYSI’s biggest iron mining client, BHP Billiton. Today I bought a few of the $60 strike, AUG 10 puts on BHP: BHP100821P00060000, in the new options symbology.

Shorted sheet rock  company USG today at $12.45. As I mentioned on the old blog last fall, I regretted not shorting this when I was first bearish on it back in ‘08. Would have been a better bet to short USG back then, but we’ll see if I can make money shorting it now. I suspect that when the market corrects significantly, USG will drop further than the market. We’ll see what happens if I don’t get stopped out before then. Short Screen shows an Altman Z-score of about 0.65 for USG. Scores below 1.81 indicate distress. Note that there isn’t much chance that USG will actually go bankrupt again — if it got to that point, Warren Buffett would almost certainly bail it out (as he has done previously) — but any rescue financing in the future would likely further dilute current shareholders.

I have been thinking about Brigham Exploration Co. (Nasdaq: BEXP) off and on since last August, when U.S. Energy Corp (Nasdaq: USEG) entered a drilling participation agreement with Brigham in Brigham’s Bakken oil properties. Today I shorted BEXP at $13.11. Because BEXP was in financially dicey straights back then (it had an Altman Z”-Score¹ in the distress zone. ), and was coming up on a drilling deadline, cash-rich, prudently-managed USEG was able to enter this deal on favorable terms. As I have mentioned on my previous blog, USEG has a number of other irons in the fire besides its drilling participation deal with BEXP (e.g., its geothermal investment, its molybdenum property, its uranium properties), but it’s been the BEXP deal that has largely driven USEG’s stock price since the deal was announced. See how USEG’s stock price starts moving at the end of last August:

USEG versus BEXP

Since I shorted a dollar amount of BEXP equivalent to my long position in USEG, and since both stocks have been moving in recent months mainly on news of their shared Bakken deal, this is essentially a pairs trade (USEG was trading at $5.07 when I shorted BEXP today, but my average cost on USEG is about $2.80). Currently, USEG has an Altman Z”-score of about 12.4 and BEXP has an Altman Z”-score of about -2.6. Scores above 2.6 are considered to be in the safe zone, and scores below 1.1 are in the distress zone .

¹Recall that Professor Edward Altman created his original Altman Z-score model to predict the default risk of manufacturing companies. In its initial test, the Altman Z-Score was found to be 72% accurate in predicting bankruptcy two years prior to the event, with a Type II error (false positives) of 6% (Altman, 1968). In a series of subsequent tests covering three different time periods over the next 31 years (up until 1999), the model was found to be approximately 80-90% accurate in predicting bankruptcy one year prior to the event, with a Type II error (classifying the firm as bankrupt when it does not go bankrupt) of approximately 15-20% (Altman, 2000). The Altman Z”-Score is Professor Altman’s modified formula designed for application to non-manufacturing firms. For more on the Altman Z”-Score, including an example of it in action, please see Applying the Altman Z”-Score Model to a Non-Manufacturing Company.

There has been some caterwauling lately about the relative paucity of press releases by Alloy Steel International (OTC BB: AYSI.OB) on the stock’s Yahoo and Investor Hub message boards. Some of this caterwauling seems to have been emanating from disgruntled former shareholders who dumped the stock after the company’s 10-k , which featured lower-than-expected Q4 earings, and before its Jan 12th press release announcing a 37% sequential growth in revenues from Q4. Today the company issued another press release, just a couple of weeks after the last one. After the jump is the text of that press release, followed by a few notes on the conversation I just had with the head of Alloy Steel’s North American operations, Bud Sprouse.

More…

This took forever, but here we are. Thanks for stopping by.

My plan is to occasionally blog about specific securities here going forward, and then blog about pretty much everything else over on Steam Catapult, though there will probably be some overlap here and there. As I mentioned on Steam Catapult, we’ll figure that out as we go.

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