Five year summary of PDCO stock price. From 2012 to 2018

Written by:

Noam Ganel is the Managing Director of Pen & Paper, a value-oriented stock research publication. Subscriptions are now available. He also serves as  Vice President in Capital Markets at Silvergate Bank and holds the Chartered Financial Analyst (CFA) credential.

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Say what? An interest rate of 52.5%?

The Time Charles Schwab Asked for a Loan From Me

September 8, 2018

When certain stocks are in high demand, Charles Schwabborrows shares from customers and lends them to other clients. On Monday of this week the brokerage firm wrote to me a request: they would like to borrow the shares I bought in Orchid Paper Company.

What really got my attention was the rate of interest Mr Schwab offered: an annual interest rate of 52.5%. Let me write that number again in words: Mr Schwab wanted to borrow my shares in Orchid Paper at an interest rate of fifty-two and half percent. A shockingly and unreasonably high interest rate. I had to call their customer service number to find out more.

Working out of Phoenix, Arizona, a friendly customer representative who identified himself as Joe, explained that the hefty interest rate was simply due to demand. Apparently there was a high volume of institutional clients who wanted to short the stock.

The loan terms were straightforward: Mr Schwab, aka the borrower, may repay the loan at any time; I, aka the lender, may sell the stock at any time of my choosing; and the interest rate of 52.5% translated to an expected $437 per month (4,000 shares @ $2.50 times 0.525 divided by 12 months.) There was a tricky issue related to taxation of dividends paid out. But since Orchid Paper eliminated dividend payments in 2017 it was, in fact, a non-issue.  

The shorts rationale

The short sellers are betting that the company will soon file for bankruptcy. Management had recently announced that a major customer who represented 23% of the 2017 annual sales, had terminated the relationship. And that Orchid Paper's lenders are now demanding the company to be sold to a competitor (and to return the $210 million in outstanding liabilities).

There was also the variable debt issue. In 2016, Orchid's cost of debt was 2%; it went up to 7% in 2017 and as of the second quarter of this year, the company was paying a whopping 9% interest rate.

The long rationale

There are enough buyers that will happily pay for Orchid at full retail price in my opinion. In the second quarter earnings call with analysts, Jeff Schoen, boss of Orchid, referred to transactions of paper mills over the past three years that showed buyers who happily paid roughly $4,500 per ton of paper.

Since I mentioned Jeff Schoen, it is worthwhile to note his interest in the company had increasingly grown since he became its boss. His cost basis is in the double digits (see for yourself in a Bloomberg terminal) and while I cannot argue that an increased ownership stake is a sign of a promising future, it surely is better than if Schoen had been selling his shares.

In short, Schoen and I are long the company while the market is short. And there is enough interest out there that short sellers are willing to pay an interest rate of 52.5% to prove Schoen and I wrong.

One great invention: the stock market  

"The market exists because of differences of opinion among investors, " wrote Seth Klarman in Margin of Safety. "If securities could be valued precisely, there would be many fewer differences of opinion, prices would fluctuate less frequently and trading activity would diminish.”

If you think about it rarely do you find in real life a difference of opinion in value as in Orchid Paper. Say you walk to your local coffee shop, expecting to pay two dollars for a large cup of coffee. Imagine that the person behind you says to his friend that the coffee is way-over-priced and that he intends to wait until the price of coffee cools off (no pun intended).

And as you leave the coffee shop, let us say that a white bearded gentleman approaches you and offers to pay you an interest rate of 52.5% to borrow that cup of coffee you just bought.  

But this the peculiar way in which the stock market acts at times. The market allows stocks to fluctuate in price because of reasons that reason does not understand. The market is an arena where opinions of belief rule over economic reality.