Short Selling is Good

Short Selling is Good Dan Amoss

Get Ready to Profit from a Summer of Decline

First, let me make this perfectly clear:

Shorting a stock is NOT taking money out of someone else's pocket.

You are NOT doing anything to make the stock fall in value.

And you are NOT profiting from someone else's misfortune.

Instead, short selling is about taking a stand against unbridled greed.

Think about it - you buy puts or short a stock only if you think the price will go down. And the only reason the stock price will go down is if the stock price doesn't reflect the company's value. If a stock is overvalued, it's because investors believe the company's hype.

As a short seller, you're looking past the hype - glaring at the company itself. And if you see there's not as much value there as investors believe there is, you almost have an obligation to short the stock.

For one thing, shorting the stock may convince people to take a closer look...and see what others haven't. Short sellers publicized accounting frauds at Enron, WorldCom, and Tyco long before anyone else noticed. They prepared for the bursting housing and mortgage bubbles while everyone else was busy refinancing and flipping property.

So short sellers are really the market's early warning systems. And if investors refuse to pay attention, you can at least limit the stock's damage as it falls.

Remember, stocks are not a zero-sum game

There isn't a winner for every loser. If someone buys a stock at $20 and sells for $30, he's made $10. Nobody has lost any money, though, and his profit gets recycled into the economy.

However, if he buys the stock at $20 and it goes to $10, the $10 he lost is gone forever. At least, it is unless someone has shorted the stock. A short seller has a chance to recover some of that money. So instead of disappearing, it can be re-injected into other investments. Now then...how do we determine which stocks are in dire need of shorting? There are a handful of traits you have to look for...

5 Traits of an Overvalued Stocks

I've found that five things predict whether a stock is overvalued or not:

An expensive stock price A contracting customer base A history of making value-destroying acquisitions Aggressive accounting A very generous stock option program.

Let's take a little more in-depth look at these.

An expensive stock price

An accurate definition of an "expensive stock" is a stock that has increased far higher than the fundamentals justify.

Some bull markets, like the bull market in oil stocks, are justified. Earnings and cash flow have risen as fast, or faster, than the stocks.

Other bull markets are not justified. Consider the dot-com bubble. The huge runs in these stocks were not accompanied by growth in earnings and cash flow. Instead, momentum traders and psychological mania - hype, hope, and fear of missing out on the crowd's profits - held them aloft. (We saw the same psychological top in housing finance in summer 2005.)

You did not want to be shorting these stocks as long as the psychological mania and momentum held strong. Expensive stocks can always get more expensive. But make no mistake, the tide will eventually turn...and that's when you strike.

During the dot-com bubble, that turnaround came in spring 2000. The psychology turned, and momentum traders started bailing out. Experienced short sellers knew that these stocks had an awful lot of room to fall - in the range of 90 - 100% declines. You could have made a fortune shorting and buying puts on a basket of the most egregiously overhyped dot-com stocks. The classic examples: Pets.com, eToys, Ask Jeeves, TheGlobe.com, InfoSpace, Razorfish.

A contracting customer base

Obviously, companies need customers to survive. Companies that are suffering a contraction in their customer base will experience declining sales, earnings, and even balance sheet erosion. But the Street may often fail to recognize it, choosing to value a particular stock by assuming past sales and earnings trends will continue indefinitely into the future.

An example is this would be USG Corp., a leading manufacturer of Sheetrock for use in new home construction. It's a low-cost producer and has a good management team. It's owned partly by Warren Buffett's Berkshire Hathaway. As a result, it has long been a favorite of value investors.

But building supply companies have suffered a huge contraction in their customer base. And the stock has fallen from $120 to $30. As new home construction has plummeted, earnings estimates for USG have, as well.

Company financial reports often discuss the customer base...but don't expect them to highlight it if the news is bad.

A history of value-destroying acquisitions

Some executives are "serial acquirers." They care more about building a personal empire than building shareholder value. They have the bad habit of constantly diluting shareholders with secondary stock issuances.

A classic example is Tyco Intl. in the late 1990s, when Dennis Kozlowski ran it. Kozlowski was a sweet talker who overpaid for a hodgepodge of industrial companies, yet he successfully marketed this conglomerate as "the next GE."

That is, until early 2002. That's when the seams fell apart as the Enron scandal and a recession combined to shed light on the real value of the hundreds of businesses Kozlowski had rolled up. All those acquisitions destroyed value because the negative of constant stock dilution more than offset any positive gained from the acquired companies.

Of course, expansion isn't a bad thing. Some of the warning signs to look for are acquisitions of companies unrelated to the business...paying a stiff premium for the acquisition...or acquiring a company that's on a downward skid.

Aggressive accounting

Companies work hard to make their earnings look as good as possible. But sometimes their number boosting schemes go too far.

Take Tyco. Its rollup strategy included an accounting tactic called "bootstrapping earnings." Here's how it worked: Tyco used secondary issuances of its high P/E stock to acquire low P/E companies in stodgy "old economy" industries. After the books closed of these acquisitions, Tyco would automatically show higher earnings per share. Throughout the 1990s, this conglomerate consistently produced investor-pleasing earnings growth.

How was this wave of acquisitions treated on Tyco's balance sheet? Whenever an acquiring company pays a premium above the target company's book value, the difference usually ends up as "goodwill," an intangible asset on the acquirer's balance sheet. Unlike physical assets such as plants, goodwill and other intangibles are hard to value and can, in fact, be worthless. Tyco's intangible assets swelled from $6.4 billion in 1998 to $35.3 billion in 2001.

This was a big red flag. How could investors possibly estimate the intrinsic value of the underlying businesses? Tyco is not a software company in which nearly all assets are contained in the minds of programmers and in lines of code. So the explosion of intangible assets was not justified.

"Bootstrapping" (and other merger-related accounting techniques) is just one of the many accounting red flags we'll look for in the Strategic Short Report. Others include capitalizing expenses, channel stuffing, related party transactions, and using off-balance sheet accounting to hide the true financial picture.

A very generous stock option program

Companies often offer stock options as an employment incentive - promising shares of the company in lieu of money. There's nothing wrong with that... in fact, giving staff a stake in the company is a perfect way to make sure it acts in the company's best interests.

But sometimes a company gets a little too generous with its options. It hands them out like candy, or backdates them to make them more attractive. Either way, it dilutes shareholder value.

Take the case of Broadcom. Back in 2000, the company issued many options when the stock was above a split-adjusted $100 per share. But when the market hit bottom in 2002 - 2003 and Broadcom's shares fell sharply, those options were worthless. So to make its employees happy, Broadcom repriced those options.

Forty-nine million options with strike prices in the range of $32 were tendered in exchange for options with strike prices in the range of $22. This ultimately amounted to $49 million less for future company operations or capital expenditures.

The result was a dilution of shareholder value and, ultimately, a lower stock price.

Figuring out if a company is playing games with its options can be tricky. But once you see the warning signs, you know you've found a company ripe for a fall.

Of course, a company doesn't need to have all five of these traits to be a potential loser. But it will have several of them. And once you've identified a target, it's simply a matter of choosing the best way to play it. In Strategic Short Report, we'll use one of two methods - shorting the stock or buying puts - and which will discuss in detail in coming issues of Whiskey & Gunpowder.

Regards, Dan Amoss June 4, 2010

Dan Amoss, CFA, is managing editor for Strategic Short Report and a contributing editor to Whiskey and Gunpowder. Dan joined Agora Financial from Investment Counselors of Maryland, investment adviser for one of the top small-cap value mutual funds over the past 15 years. As a buy-side analyst, Dan refined his value investing approach by meeting with corporate executives and sell-side analysts and writing proprietary research for the fund's management team.

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