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Shorts thrive on falling fortunes

Marc Cohodes is not the only short-seller who is respected for his ability to tear apart a balance sheet. And he is not the only short-seller known for his willingness to rip publicly into corporate executives.

But he is among the few who is both. That combination _ along with his recent triumph in helping to uncover hugely inflated sales at Lernout & Hauspie Speech Products, a Belgian software company that filed for bankruptcy in November _ has made him highly visible at a time when short-sellers are regaining their status in Wall Street's ecosystem.

Cohodes is a general partner at Rocker Partners, a hedge fund based in New York that manages $680-million.

Short-sellers sell shares they do not own, hoping to buy them back later for a lower price. By their nature, they are risk takers, flouting conventional wisdom, pridefully standing apart from the mass of investors.

While long investors want to buy low and sell high, shorts want to do the same, in reverse order.

Shorts dispense with Wall Street's niceties and break bad news to investors disposed to hear only the good. They are detectives, sifting through balance sheets as they hunt for hidden problems or inflated profits. And they must persist under pressure from executives at their target companies, who often accuse them of lying or breaking securities laws.

The late 1990s, when stocks soared, were tough on short-sellers. The average short-selling hedge fund fell in four of the five years from 1995 to 1999, according to Hedge Fund Research Inc. In 1999, the typical short fund dropped 24.4 percent; Rocker rose 39 percent.

With longs making fortunes on technology stocks, the shorts appeared irrelevant. Investors showed little interest in hearing shorts' complaints about dubious accounting practices. By early 2000, only a half-dozen funds dedicated to short-selling remained in business.

But the Nasdaq's plunge has brought new interest in shorting. Short-selling hedge funds gained 34.6 percent last year, according to Hedge Fund Research. This year, they are up 3.5 percent, and a new generation of hedge-fund managers is moving into the practice.

At the same time, regulators and investors have increasingly complained that Wall Street research analysts are too positive because they fear that their firms will lose investment banking business if they write negative reports _ and because they depend on companies they cover for information.

By contrast, short-sellers contend they are the ultimate independent researchers.

Cohodes, 41, is creative in his research. He focuses on smaller technology companies with financial results that appear stronger than their products. Then he combs balance sheets and income statements, seeking clues that a company is inflating profits or faking sales.

Is the company making a lot of sales to buyers that are also controlled by its executives, in what are called "related-party" transactions? Are receivables _ sales for which the company has not yet been paid _ piling up on its books? Do a lot of its sales originate in less-developed countries, where auditors may not be as strict? Has it found ways to hide its costs by categorizing recurring expenses as capital spending? Is it reporting profits even though its cash flow is negative?

Those possible tip-offs are visible on a balance sheet for investors who know where to look. If Cohodes sees them, he will look deeper, calling the company's clients and suppliers and asking questions: Do its products work? Does it pay on time? Has it asked customers to buy more than they need now in return for discounts later?

Then Cohodes considers a company's management. Does it have a history of puffery or fraud? Have executives sold shares even though they are publicly bullish?

Of course, even a company that meets all these criteria may have great products and a good business. But the more red flags Cohodes sees, the more excited he becomes.

"High short-interest stocks _ that list, over time, is the greatest set of disasters you've ever seen," he says, pointing to companies like Iomega, Solv-Ex and Tel-Save Holdings, all one-time highfliers that crashed, just as the shorts predicted.

Today, Cohodes' favorite short targets include Cree Research, a semiconductor manufacturer in Durham, N.C.: He thinks that prices for its products are dropping and that "the company is engaged in a lot of related-party dealings and that to me is always a red flag."

Rocker also is shorting Conseco, the insurer based in Carmel, Ind., because it thinks many loans in its finance portfolios are in trouble, and Take-Two Interactive Software, a New York video gamemaker. Cohodes faulted Take-Two as having a weak balance sheet, among other problems, and he noted that insiders have been selling their stock.

Short-sellers see Wall Street as a world of cretins and charlatans. Here is a sample of Cohodes' views:

n On what investors have learned from the Nasdaq crash: "They've learned nothing. It's just, "Rates are low, you don't want to hold cash, you have to buy something, it's going to get better.' "

n On the slowdown in technology: "No one knows where it stops. It could stop tomorrow. It could stop in a year."

n On research analysts: "The analysts, at the end of the day, are just major tools for their firms' banking business and their big holders."

n On investors' priorities: "People spend more time figuring out what restaurant they want to go to than they do researching their manager, their stock or their mutual fund."

Cohodes acknowledged he may be jaded because of the companies on which he focuses. "We're not talking about Exxon Mobil or 3M," he said.

But Cohodes rarely lets his professional skepticism invade his personal life. He dotes on Leslie, 41, his wife of 17 years, and Max and Emily, 10, their children. His office, in Larkspur, Calif., in Marin County just north of San Francisco, is 10 minutes from their home, a large tile-roofed house tucked behind a gated fence on a tree-lined street.

In his home, Cohodes proudly shows visitors copies of an essay Max wrote, titled "Perseverance." Max, he said, motivates him, "and if you're feeling sorry for yourself, he takes care of that, too."

Cohodes grew up in Chicago, raised by his mother after she threw his father out of the family home. "He was a drunk," Cohodes said matter-of-factly. He remains close to his mother, 62, and grandfather, 91, who still live in Chicago.

Cohodes likes professional wrestling and the Oakland Raiders football team, in addition to stock-car racing. Besides the house, his three cars (including a BMW sedan with 400 horsepower) are the only clues to his considerable income or wealth, which he refuses to discuss. "I'm not into golf, I'm not a country-club guy, not a jet-set guy," he said. "I'm a husband, a dad, I've got a few pals, and that's all I do."

Cohodes and Montgomery, who also works in Rocker's California office, wear shorts at work and seem to know everyone at the local shopping center where they buy coffee each morning.

Even executives at some target companies of Rocker say they like Cohodes. "He's a wonderful guy," said Cynthia Merrell, chief financial officer of Cree, the semiconductor company whose stock Rocker is shorting. "He has really helped me out with my daughter," who is also handicapped.

Merrell added that Cohodes "does really good research on most companies," although she said she thinks he is wrong about Cree.

Bruce Nakao, the former chief financial officer of Adobe Systems, which Rocker shorted in the late 1980s and went long a few years later, said Cohodes "is definitely a tough guy when he's on your case, very unrelenting."

Cohodes said he shorted Adobe because Microsoft began including fonts, Adobe's primary product at the time, in its software. After Adobe shares plunged, he went long because he retained a respect for its management and felt that its new products would succeed.

During its battle with Rocker, Adobe tried to bar Cohodes from its meetings with investors. "He was very clever about trying to get in," Nakao said. But Adobe's strategy was a mistake, he said: "He thrives on that. It's best to be pretty open and upfront with these guys."

Now retired, Nakao counts Cohodes as a friend. "Once I got to know him," he said, "I thought he was pretty much a great guy."

A few weeks ago, Cohodes came upon a photograph that made him laugh.

He laughs easily, especially when he is with Montgomery. But he found this photograph particularly gratifying. He sent it by e-mail it to several pals, as he invariably calls his friends, under the subject line "Gaston's Holiday Weekend."

The photograph shows Gaston Bastiaens, the former president of Lernout & Hauspie Speech Products, being arrested by a pair of U.S. marshals.

Cohodes has worked for Rocker for 16 years, joining it two months after David Rocker founded it. Today, Cohodes, Montgomery and Terry Warzecha, a Rocker analyst, generate most of the company's leads. Rocker, while still involved with investing, spends more time dealing with the fund's investors from the Manhattan headquarters. The firm is typically short more than 30 stocks, focusing on about 10. It also has a few long positions. Like most hedge funds, Rocker takes 20 percent of the profits from its fund, in addition to an annual fee, which can leave tens of millions to be split among a few partners.

Lernout & Hauspie is the stock that cemented Cohodes' reputation. The battle between Lernout and Rocker was one of the ugliest ever between short-sellers and a company and it ultimately vindicated Cohodes. Based in Ieper, Belgium, Lernout is a software company that specializes in speech translation programs. Both Microsoft and Intel backed Lernout, which was traded on the Nasdaq stock market until December; at its peak in March 2000, when it fetched $65 a share, Lernout had a market valuation of $9.3-billion.

These days, Lernout's shares trade for 25 cents. Bastiaens, Jo Lernout, Pol Hauspie and Nico Willaert, the company's former top executives, have been charged with fraud and manipulating Lernout's stock price.

In 1998, Cohodes tried to buy Lernout's software for his son. He was told by a salesman that Lernout had shipped software that the salesman's company had not ordered. Cohodes looked deeper. He watched a Lernout demonstration at Comdex, the giant computer trade show, and concluded that it was unconvincing.

After examining the company's financial statements, he decided that Lernout had pumped up its revenue with related-party transactions. Later, he and other short-sellers helped point the Wall Street Journal and to problems with the company's sales in Singapore and South Korea.

The fight intensified throughout 2000. In January 2001, after several critical articles in the Journal, Lernout filed for bankruptcy in Belgium. In April, an audit by PricewaterhouseCoopers found that 70 percent of the company's Korean sales never existed. Over all, Lernout booked $277-million in fake revenue between 1998 and June 2000, one-third its total sales, according to the company's audit committee.

"That's the grandfather of all of them," Cohodes said of Lernout, because the company's market value grew so large before the situation was exposed.

Cohodes was by far the most vocal short-seller who attacked Lernout & Hauspie. He lambasted Lernout on a short-lived Webcast radio program, for which he was anchor on the former In turn, Lernout executives accused him of leading a conspiracy against them. On Yahoo message boards, small investors criticized Cohodes even harder. One made a death threat.

Still, Cohodes did not back down. (He does, however, own dogs, two 130-pound Rhodesian Ridgebacks named Otis and Redding, to guard his family's security.). Now he savors his victory. If the inflated sales had not been uncovered, Lernout's executives might still be raising money from investors on the basis of what auditors say were false financial statements.

"The shorts, at the end of day, protect the little guy," he said.

From the start, short-sellers work at a disadvantage to longs, because stocks tend to move higher over time. The Standard & Poor's 500 index of big U.S. stocks has risen by an average of nearly 8 percent since its inception. A long who outperforms that return by eight percentage points _ no easy task _ will earn an average annual return of almost 16 percent. But a short must beat the market by 8 points just to get even.

Short-selling is also far riskier than going long. Long investors can lose only as much money as they have put into a stock, while their potential gains are infinite.

For shorts, the equation is reversed. At most, they can make only as much money as they receive when they initially sell a stock. But their potential losses are infinite. An investor who shorts 100 shares of a company at $10 will make $1,000 if it goes bankrupt and its shares fall to zero. But if the company rises to $110, he will lose $10,000 _ $100 a share times 100 shares.

Those are the Economics 101 reasons that short-selling is daunting. In the real world, short-sellers face more serious obstacles, as the Lernout fight shows. Many companies and investors dislike short-sellers intensely, since a falling stock price costs shareholders money and can get executives fired.

Companies whose stocks are heavily shorted often try to engineer "short squeezes," pushing their stocks higher so that short-sellers face margin calls and have to cover their positions. The wave of buying from short-sellers pushes up the stock's price, leading to more margin calls and buying pressure. When a squeeze ends, the stock may drop again, but by then, many shorts may have been forced to cover at or near the peak. So short-sellers can be correct and still lose money.

In early 2000, when Lernout stock nearly tripled in two months, Rocker was forced to cover most of its position and at a cost of more than $10-million. Rocker re-established its short over the next few months, as Lernout stock sank, and wound up with a profit on Lernout, but Cohodes is still angry about what he thinks was a squeeze.

And the battles can become even more personal. Death threats are rare, but companies regularly accuse shorts of spreading misinformation about them. Sometimes they threaten to sue for slander, although they rarely do. Companies and short-sellers occasionally hire private investigators to look for damning information about each other.

Yet short-sellers are far less powerful than their foes may think. The $680-million that Rocker oversees is less than one one-thousandth as much money as Fidelity Investments manages. If short-sellers are wrong about a company, if its fundamentals are good and its business is growing, they can cause no more than a momentary disruption in its stock price.

Short-sellers are "an ant compared to the other capital that's out there," Montgomery said. America Online, a favorite target of Rocker Partners in 1995 and 1996, was a prime example. At the time, Rocker and other shorts complained that AOL was hiding its marketing expenses by putting them on its balance sheet as assets, instead of expensing them as ongoing costs. In November 1996, America Online acknowledged the point, taking a one-time

charge to write off $385-million in marketing costs from its books. The charge wiped away all the profits the company had ever earned.

But in their fury over the accounting, and the busy signals that plagued the service in 1996, the shorts were blind to the franchise the company was building. Since AOL changed its accounting, its stock has risen 25-fold, and it has bought Time Warner to become AOL Time Warner, the world's largest media company.

Rocker lost millions of dollars shorting America Online, "but we learned something," Cohodes said. "We learned we do not want to short these open-ended type of names," he added, meaning companies with unlimited growth potential.

Most top short-sellers share that attitude. Professionals rarely short companies simply because they think their stocks are overvalued. They prefer to focus on companies with financial statements that they think are misleading or fraudulent, companies that may be booking nonexistent sales or selling products to themselves in sham deals.

That attitude enabled Rocker to survive, even prosper, in 1999 when the fund rose 39.2 percent, before fees, in a year when the Nasdaq composite surged 86 percent. But it hurt Rocker last year when Nasdaq stalwarts that had traded at 100 or more times annual profits collapsed. Last year, when the Nasdaq plunged 39 percent, Rocker gained only 8 percent before fees.

"What made a successful 1999 was a complete and total missed opportunity in 2000," Cohodes said. "But again, we do not want to short legitimate companies."