It all started innocently enough…

Back in 2013, a friend e-mailed me: “Take a look at Lumber Liquidators (LL). You’ll like it.”

The moment I looked at this high-flying stock with a nosebleed valuation, I knew he was suggesting it as a short idea – in other words, a stock ripe for a fall.

He was right. I quickly uncovered numerous red flags. Margins had inexplicably doubled in the previous 18 months. Plus, two federal agencies had recently raided the company for buying Chinese flooring made from illegal hardwoods, harvested in Siberia by the Russian mob and smuggled over the border.

I put two and two together and concluded that the spike in margins was likely due (at least in part) to illegal sourcing practices across Lumber Liquidators’ supply chain.

If so, the feds would surely discover this and put an end to it, which would squeeze the company’s margins… and stock price.

So I made a big bet against the stock.

I thought the odds were in my favor, but I had no idea this would turn into one of the most profitable investments of my career.

While opportunities like my Lumber Liquidators short don’t come along every day, you can use some of the key takeaways today to find great investment opportunities – by spotting what the rest of the market fails to see.

Let me explain…

After 20-plus years on Wall Street, I’ve realized that all of my successful investments – both long and short – start with three key steps…

  1. Performing good, fundamental analysis

When I looked at Lumber Liquidators’ fundamentals in 2013, I saw a mediocre business that was a steady performer for two decades – up until 2011. Then, profit margins suddenly doubled, and investors bid up the stock until it traded at 50 times earnings.

And this was after two federal agencies had raided the company’s headquarters. Normally, that’s the kind of thing that would knock a stock down by 50%. But the share price hadn’t budged. Instead, investors had lost their minds over a flooring retailer!

At the same time, insiders at Lumber Liquidators were dumping stock like mad. Founder and Chairman Tom Sullivan sold one-third of his shares that year ($27 million) and CEO Rob Lynch sold every share he could ($11 million).

None of it made sense. I suspected widespread sourcing problems but couldn’t prove it… So I went public with what I knew, presenting my findings at the Robin Hood Investors Conference, one of the largest in the world, in November 2013. In doing so, I hoped that someone who knew the real story might contact me…

2. Developing an edge through “scuttlebutt” research

If you want to find out what’s really going on with a company, you have to talk to the folks with boots on the ground – customers, competitors, employees, and so on.

A few months after I went public with my questions about Lumber Liquidators, an industry insider came to me with exactly the information I was looking for. He had run a laminate flooring factory in China and told me that he tried to sell to Lumber Liquidators.

But the company would only buy from him if he matched the prices of his competitors, which were 10% lower. He knew such prices were only possible by cutting corners and selling illegal – and dangerous – formaldehyde-drenched flooring.

To test his story, I went out and paid a laboratory $5,000 to test three samples of the Chinese-made laminate flooring that Lumber Liquidators was selling. Sure enough, it was loaded with formaldehyde… two to six times higher than what was legally permitted.

3.Taking advantage of extreme investor sentiment

The most profitable investments come from betting against extreme investor sentiment… and, of course, being right!

In 2012-2013, Lumber Liquidators’ shares had soared more than 600%. Investors were euphoric. The stock was priced to perfection. Once people found out the truth, I knew sentiment would reverse in a big way… And it did. The stock ended up crashing by 90% in only two years!

Once I confirmed that the company was breaking laws and poisoning its customers, I had to decide how to share my findings broadly. I could have written an article or made another presentation at an investment conference. But that wouldn’t have reached a broad, national audience.

Then, I had a brilliant idea: “This is the perfect story for 60 Minutes,” I thought. It’s not only one of the most-watched television shows in America, it also has fantastic credibility, especially for exposing wrongdoers.

Whitney Tilson on 60 Minutes

Better still, 60 Minutes had the resources I didn’t. It hired a team that smuggled hidden cameras into a number of Chinese factories supplying Lumber Liquidators. Posing as buyers, they caught the managers on camera admitting they were selling Lumber Liquidators toxic product!

The episode aired the evening of Sunday, March 1, 2015. As word got out about the episode, the stock tumbled nearly 30% during the previous week. Then, the day after it aired, shares dropped another 25%… In total, over six months, the stock crashed more than 80%.

By uncovering and exposing this scam, I made more than $4 million for myself and my investors – one of the biggest wins of my career.

Now, I realize that most individual investors probably can’t call up CBS and take on a publicly traded company. But the lessons here still stand: Do good fundamental analysis, find an information edge, and take advantage of extreme investor sentiment.

If you can do these three things consistently, you’ll make a fortune.

Regards,

Whitney Tilson

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Source: Daily Wealth