How do the short-sellers decide what stocks to short and what are the good reasons and bad reasons for choosing one stock over another? Let’s take a look at some of the various reasons offered for short selling (not in any particular order).
The first reason is fads or perhaps the latest fashion trend. There is not an individual who has not gone to the local mall or the Internet only to discover some of the latest fashions or wildly popular trends. They might be a type of shoe, phone, watch, etc. Think of Build-A-Bear Workshop Inc. (NYSE:BBW), Groupon Inc. (NASDAQ:GRPN), Zynga (NASDAQ:ZNGA) or Facebook (NASDAQ:FB), which have all undergone recent insider selling by management. These ideas are exhilarating when they first hit the market and can be quite profitable for an extended period.
The problem with fads is that they may last a very long time. Think of Mattel (MAT)'s Barbie. That could have been a one- or two-year phenomenon, but it has endured for decades. It is doubtful that Facebook is simply a fad or trend that may only last a few years, but no one knows the future. The next big thing may be taking place in someone’s home ready to replace it. Because of the uncertainty of the trend, it is unwise to simply choose a fad for short selling unless there are clear indications that the trend is about to change other than merely short selling due to overvaluation. Many investors have been stymied for long periods waiting for the market to recognize the true value of an overvalued stock. It is much better to wait for revenue growth slowdown, declining margins or growing inventories before making that decision to short the stock.
The second reason might be the failure of the business model or the decline of the business model. Consider PCs. There may be a considerable disagreement regarding the future of PCs; however, the current trend is undeniably slower. Short-seller James Chanos is banking on the concept of an industry slowdown, not necessarily calling for an end to it, but perhaps the industry will consolidate and change drastically.
Think of other industries that are seeing a decline or are on the eve of one: photofinishing, wired communications, formal wear such as tuxedos, manufactured housing or even record stores (DVDs), etc. A wise investor will watch for the decline of the industry as a whole and find the weakest link to take advantage of. Manufactured homes had a placement of both single wide and double wide units in the range of 196,000 units. For the last 12 years, the number has dwindled to around 52,000 units, a nearly 75% decrease in unit placement.
The third reason is frauds. These are extremely difficult to find and one must be careful in crying fraud, when in truth, it may be more manipulation as allowed by accounting practices rather that outright deceitful practice. Some explanation of that is to be forthcoming. Since the demise of WorldCom, Enron, Qwest and others, a great deal of study has gone into recognizing companies that are scheming to conceal the truth behind the possibly fast-growing stocks that may be nothing more than smoke and mirrors. Unfortunately, the average investor will probably discover the fraud too late, but there are ways to discover these in advance. A small checklist, which is also forthcoming, may help investors to separate the wheat from the chaff.
The fourth reason is pure and simple manipulation. With that said, manipulation does not equal fraud. The number of ways left to accountants for manipulation of numbers is quite large, and much discretion is left to the accountants whose job it is to make the numbers appear as good as possible without creating actual fraud. This may include some or many of the items below. They may also be found in items one through three above.
Aggressive inventory management
Aggressive revenue recognition
Aggressive enhancement to earnings
Increasing account receivables in relation to sales
Doubtful receivable allowance
Increasing SGA in relation to sales
Increasing COG in relation to sales
Day Sales Outstanding
Day Sales in Inventory
Days Payable Outstanding
Cash Conversion Ratio
Sloan Accrual Rate
Sales Growth Index
Gross Margins Index
Day Sales Receivables Index
Quality of Earnings Ratio
Capital Growth or Poor Capital Discipline
Effective Cash Tax Rate
ROIC vs. COC
Beneish M Score
Piotroski F Score
Heavy Insider Trading
Too Much Debt
Short Interest/Short Squeeze
Review of Shareholder letters
Coming: Examples of each, how to find them and an establishment of a checklist.
Disclosure: No positions in any stocks mentioned