Challenge for Professional Short-Sellers : Hedging Bet on Viratek Recommended
The law of gravity doesn’t always apply to the stock market.
But when a stock runs up on takeover rumors, on speculation that the better mousetrap is in the works or on some other fuel for a short-lived buying binge, the steep climb is bound to be followed by a big drop.
That, says Mike Murphy, editor of the Overpriced Stock Service, a short-sellers’ newsletter, is why professional short-sellers ought to take a look at Viratek Inc. and its sister firm, SPI Pharmaceuticals Inc. These two subsidiaries of Costa Mesa-based ICN Pharmaceuticals Inc. have shot up sharply this year on speculation that the drug Virazole will win FDA approval as a treatment for AIDS, influenza and other viral diseases. Viratek manufactures Virazole, SPI distributes the drug and ICN holds majority positions in the other two companies.
From its low this year of $10.375, Viratek stock has gained a stunning 709% on the over-the-counter market, closing Friday at $84 a share. Viratek’s 1986 low is adjusted for a 2-for-1 split that took place in September.
SPI and ICN didn’t fare badly either. At a closing price of $30.50 a share on the OTC market Friday, SPI currently is trading 177% above its low of $11 a share for the year. New York Stock Exchange-listed ICN closed at $23.125 Friday, a healthy 125% above its low for the year.
Although the three are trading below their highs, they are still run up enough to make for some interesting short-selling, Murphy says. And by playing one against the other, savvy traders can make profits no matter which way the stocks move, he says. This is possible because Murphy’s shorting scheme emphasizes spreading the risk over the three stocks as they typically move up and down as a group.
A short sale is when an investor sells shares that he has borrowed from a broker, with the hope repurchasing them later at a lower price.
“Real aggressive” players can put 30% of their money into ICN, using the other 70% to short Viratek and SPI equally, Murphy said. “If you are real conservative, you go long on ICN with 50% of your money, then short Viratek with 20% and SPI with 30%.”
Either way, Murphy said, the investor is covered.
If the stocks fall, an investor bails out of ICN and covers the loss with the profits on Viratek and SPI. If the stocks rise, the player takes a profit on ICN and closes out his short positions on the other two.
“A lot of pretty sophisticated people are doing this,” Murphy said, stressing that buying ICN as a hedge is essential to the scheme’s success. Get caught in a Viratek squeeze without a covering position in ICN and “you are going to get killed,” he said.
Murphy, who is decidedly skeptical of Virazole’s potential as a treatment for AIDS and influenza, said that over the long term the prices of the three companies will fall dramatically if the drug fails to win wider FDA approval. Virazole is now approved only for the treatment of a sometimes-fatal infant respiratory disease.
“If Virazole doesn’t cure AIDS, herpes or the flu, Viratek is worth about $5 a share and SPI is worth $4 a share,” he said. “We have calculated that ICN could sell for about $10 a share.”
Murphy thinks that if the bottom is going to fall out of the three companies’ stock prices, that will occur within about a year. During that time, Murphy estimates, the aggressive short-seller can make just under 50% on his investment. If Virazole pans out and the stocks go up, the aggressive short-seller will do no worse than make a 14% profit, even after short covering, Murphy said.
The short-seller who correctly anticipates the big drop and bets the ranch on it--without a hedge in one of the sister stocks--will reap a windfall, Murphy said, the risk is enormous and the casual investor shouldn’t try this trick at home.
“I wouldn’t do it,” he said. “You can get absolutely cleaned out.”
