PG&E Redux…
August 24, 2020
Turbulence Ahead…
September 18, 2020

An ED Trade From The Road…

Event-Driven (ED) trading continues to perform well lately. As a result, rather than bemoan how value investing is stillborn, I’ve continued to shift more of my capital into what’s working. As I’ve noted previously; you can hope that the market reverts to a prior form, or you can evolve. With the number of active managers in terminal decline, the opportunities in the ED world continue to get better and one of my favorite strategies is the “short squeeze.”

With that in mind, it’s hard to ignore the evolving situation at Dillard’s (DDS – USA). The short thesis is that Dillard’s will become the next J.C. Penny (JCPNQ – USA) or Sears. Meanwhile, longs do have a valid point in that Dillard’s has suffered through multiple years of competitor liquidations and has still produced hefty cash flows. As Dillard’s gains market share amongst failing department stores, will cash flow continue or even increase? Fortunately, as an ED trader, I don’t have to care about who’s right. I’m not going to be involved long enough for any of this to matter. Instead, I only care about one thing, the free float.

You see, DDS has a hefty short interest of 6,819,568. As of August 29, there were 18,366,790 class A shares outstanding (ignore the B shares as they don’t trade). By my math, insiders own roughly 11.5 million shares.  As a result, the true float is below 7 million shares. But wait!! Isn’t the short interest almost 7 million shares?? Yep.

Add up all the Dillard family members, Matheny, Newport Trust and Board members to arrive at the insiders as a % of the shares outstanding…

DDS has been aggressive in buying back shares. During the month of July, they bought back 586,851. By my math, they bought back about 267,000 shares during August. I assume they have continued at a similar rate of ten to twenty thousand a day during September. In fact, this is likely the reason that the borrow cost has spiked over the past week. Clearly, someone is having trouble locating stock.

Now here’s the interesting part. Look at the holder list. I see roughly 2 million shares owned by ETFs. These guys won’t sell. If you remove the ETFs, the short interest is likely larger than the functional float which is under 5 million and rapidly declining. The ETFs will keep lending their shares out because that’s what they do, but it’s becoming something of a trap for the shorts. As DDS keeps buying in shares, eventually, something has to give.

I don’t know how this all plays out, but I have a hunch that it’s to the upside and figured I’d flag it for those with an interest in ED trading—particularly as the increase in borrow cost indicates that we’re approaching a tipping point.

Please remember, the goal of ED trading is not to swing for the fences—as you don’t have the downside protection that exists in value investing (though sometimes the two can overlap). Instead, your goal with ED trading is to identify as many high probability outcomes as possible and let the odds work in your favor. No individual ED trade should ever move the needle—rather, at quarter end, you’ll look at your P&L and know if you’re doing it right or not. Finding enough setups is the hard part—hence why I figured I’d toss you this one—especially as DDS may be juicier than your average ED trade.

Disclosure: Funds that I control are long DDS and short DDS puts.

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