Urlocker On Disruption

DIY Investment Research

ShareSleuth.com recently posted its first scoop on Xethanol Corp. (XNL), a small-cap Ethanol manufacturer based in New York. 

Xethanol has lost money in each of the past four quarters and the past three years and has a host of tough statistics for investors, like negative ROE, negative ROA, negative margins. Interestingly, it has a high valuation with price to sales of around 22x and price to book of 24x, according to data on Yahoo Finance, which isn't always the best source of data on small caps, but a good starting point.

The stock was a rocket in last year, rising from $4 in the fall to $16 this spring , although things have come down to earth since then.

ShareSleuth digs into the history of the company chairman, management and a major shareholder, looking at past employment (or what it says was a lack thereof) SEC disciplinary action, idle plant capacity, some prior lawsuits involving the chairman, etc. All very interesting reading.

In a press release, Xethanol took issue with specific points raised by ShareSleuth about production at its Iowa facility, its outsourced R&D efforts, corporate governance and qualifications of management. The company also made a general statement:

Christopher d'Arnaud-Taylor, Chairman and Chief Executive Officer of Xethanol stated that "while it is generally our policy not to comment on articles or publications about our Company, the misinformation and disinformation contained in the ShareSleuth.com posting were so egregious that we felt we had no alternative but to respond."

ShareSleuth also includes the following:

Disclosure: Mark Cuban, the majority member of Sharesleuth.com LLC, sold short 10,000 shares of Xethanol’s stock at a time when the price was around $12.65. Cuban also has sold short about 25,000 shares of UTEK Corp.(UTK: AMEX), a Florida company that is a large Xethanol shareholder.

Some critics are uncomfortable with the idea of an investor shorting a stock, spreading bad news and then profiting from the stock's fall. Never one to pander to critcis, here are some things Mark Cuban has to say about that:

This already happens every day. All day, every day. The only difference is that the people creating and publishing the information arent “business journalists”.

Doesn't the foundation for responsible journalism come from transparency?

Setting aside the debate on Xethanol, it would appear that ShareSleuth is doing the kind of deep-digging investment research that has been largely absent from Wall Street and from financial newspapers for years.

Independent equity research firms have been trying to perform this sort of high-quality research for several years, but few firms have hit big success. For example, the WSJ recently reported on the retirement of Evan Sturza, an independent biotech analyst who gave up after 15 years: "Now he is closing shop -- frustrated with the lack of demand for quality independent research and with companies that retaliate against outspoken analysts."

ShareSleuth's entry into the business raises some questions for media and investment research firms:

• If major Wall Street investment brokers are not doing deep-dig research, are they simply producing commoditized research?
• Have independent equity research firms struggled because they have the wrong product, the wrong business model, the wrong customers or the wrong channel?
• Is there a market for superior quality investment research delivered through disruptive channels?
• Is there a new model for financial media to pursue new customers through new channels?

** Other Views/Late Addition **

Fortune's Business Innovation Insider draws a lesson for investors from the Xethanol business: "Always do your homework before investing in a company that claims to have tapped into the innovation motherlode. For example, a little digging and due diligence would have uncovered the fact that Xethanol actually spends little or nothing on R&D and has "an absence of scientists on its staff." 

Author Gary Weiss says Mark Cuban made a great trade, but he thinks ShareSleuth.com is "precisely the wrong way to go" in terms of journalism. He also has a brief commentary from former WSJ columnist (and once-jailed tipster) R. Foster Winans, who says relative to Street corruption, "Mark Cuban is by comparison a GD Mother Teresa. At least you know he's screwing you."

ShareSleuth: Profiting from Corporate Fraud

The WSJ today offered a few more details on Mark Cuban's new website, ShareSleuth.  The service will be focussed on busting corporate fraudsters. Cuban, who is a shrewd investor, hopes to profit from the detective work.

We examined Cuban's idea recently as an example of the creative new media services that can disrupt mainstream media such as newspapers. Says Cuban:

"I'm a firm believer that out of [the more than 10,000] public companies the odds are that there are more than just a few crooks and frauds," Mr. Cuban said Tuesday. "Finding them can be rewarding and entertaining..."

...Sharesleuth.com will launch next month and also carry work from a network of stringers that will include burned investors.

ShareSleuth appears to be setting up to perfrorm an important job that media consumers and investors are likely to value. This looks disruptive especially because many newspapers are faced with staff cuts due to declining readership and slumping ad revenues.

• Helps investors understand their investments;
• Creates value uncovering opportunities for short-sale of stocks;
• Different business model;
• Taps an underserved market;

It  looks like ShareSleuth disrupts some elements of the investment industry, which showed  weaknesses in research and independence in light of the wave of corporate fraud that occured since 1999. 

Although one or two isolated analysts may have raised tough questions about Enron (or any other corporate fraud) early on, by and large, the industry dropped the ball on this kind of work, with the exception of a few specialty shops like Behind the Numbers.

**Late Addition/Other Views**
June 19, 2006:  Mark Cuban says being "right is its own defense" with regard to perceived conflicts of interest at ShareSleuth.com. He knocks j-school purists for saying the service is a good idea but that he is “ruining” it by trading on the information. In Cuban's view, any new journalism service has to offer viewers a 'payoff' to make it worth their while, whether it is ShareSleuth or a venture he is trying to launch with veteran broadcaster Dan Rather. Although the word payoff may sound like some form of corruption, it is not. Cuban recognises that the media has to deliver something new and of value to consumers.

June 19, 2006: Chris Carey, the St. Louis Post-Dispatch reporter who is heading up ShareSleuth, offered some details on his plans and showed his track record in discussion at Paul Kedrosky's blog. As for ShareSleuth's plans, prospects for the quality of the journalism look good based on his past experience with reports on rogue brokers and their multinational boiler rooms.

June 15, 2006: The New York Times reports today that AOL's Netscape is refashioning itself as an online newspaper of sorts, compiling news reports, user-created content and adding its own content from a staff of bloggers, modelled after tech site Digg.com

June 14, 2006: Maybe Mark Cuban and ShareSleuth don't entirely disrupt the media market on their own, but these enterprises are not the only threats. As a reader points out, several web-based services are focussed on the business and investment news market, each offering something substantially better-focussed, better informed and more timely than daily newspapers:

• The Deal,
• The New York Times' DealBook,
• Breakingviews, formed by ex-FT columnist Hugo Dixon,
• The meta blog Inveslogic,
• Hedge-fund driven Seeking Alpha Network.

Each comes at the market from a slightly different but equally valuable perspective and each has a business model that is vastly different from mainstream media.  From the other side, many other web properties are focussed on disrupting the advertising market, including craigslist, and of course Google's local ads (in beta.)

Research Disruption Discussion

Paul Kedrosky has an interesting post and discussion about Lehman's new desk-analysts, which we posted on recently. Paul is a former tech analyst and his take is that analysts are salespeople, so he sees this as just a more realistic positioning.  Read the discussion if you want to learn about the friction points in the equity research business.

Lehman Disrupts Investment Research

Most of the brokerage business is very slow in how it adjusts its business model, which is basically to trade shares and float new issues. Big bucks are at stake and regulatory issues severely limit flexibility. Typically research analysts spam commoditized reports to clients who never read them. Then they follow up with a blast voice-mail that never gets listened to.

In fact, information overload is the top issue for many fund managers, according to a survey our firm conducted last fall.

Yet today's WSJ shows how Lehman Brothers is tweaking its business model in a small way in equity research to generate a big change: No more reports. This is a disruptive strategy in a consensus-driven industry.

Instead, the analysts move to the trading desk, where they operate as traders' left-brains, generating instantaneous analysis for their own desk for for clients on the phone. 

Net effect for Lehman is:

• reaching clients in new ways
• helping solve the information overload problem
• focussing where the value is
• not playing the commoditized research game
• reducing regulatory constraints

Wall Street Journal excerpt:

<<Desk analysts -- the name for analysts who now sit on client-trading desks -- don't publish stock research...

There are 15 people on Lehman's desk-analyst team, including three former stock analysts. Lehman says its decision to move analysts to the trading desk is aimed at bolstering the advice it is giving to its best trading clients and firm traders, which mainly facilitate client trades but also take positions for the firm.

Staffing trading desks with top research analysts long has been common in the bond market. That corner of the financial world caters almost exclusively to institutional clients, and many firms have done away with virtually all of their publishing bond analysts in favor of the desk-analyst model. >>

**Other Information**

CEO Guide to the Benefits of Disruption (pdf) and other tools for managing disruption at The Disruption Group's site.