Responding to @LionHeart"'s question on how to identify good short candidate - "What is your thought process when determining good shorts, and what are some key items you look for?" Below describes my primary process.
There are numerous danger signs that could nearly allow me to write a book on the topic, so I will compress the answer to my key considerations and thought process when evaluating short candidates. I will also detail several key danger signs and/or irregularities I'd be looking for.
Stocks I seek to short often have good products, solid market share, perhaps even a strong brand name. But, one must always remember that a good product, company or brand does not always make a good investment. If I had the best tasting can of Pepsi in the world offered to me for $1,000,000 due to its special sugar formulation, it may be a great product, but it would certainly make for a terrible investment. Absent extreme circumstances, valuation determines whether a given investment is "good" or "bad" -- if buying at a price below that at which other participants are willing to pay (assuming market liquidity exists), then presumably, you're getting a deal (and thus making a good investment). Vice versa when the situation is reversed.
When trying to find stocks to short, I look for some common signs of fundamental business deterioration, coupled with a rigorous review of recent 10-Ks, 10-Qs, and other communications from management to identify irregularities in reporting or inconsistencies in statements made by the management team. Most of the time, I'm looking for questionable accounting practices, which can quickly distinguish a bad business from a good one.
Key Danger Signs I look for When Attempting to Identify Good Short Candidates:
- High Executive Level or Management Turnover, Scandal at the C-Suite
- A History of Restatements or Late Filings
- Excessive Debt coupled with Deteriorating Operational Efficiency
- Disproportionate Growth in Accounts Receivable relative to Credit Sales
- Disproportionate Growth in Inventories relative to Sales Growth
- Growing sales, EBITDA and even earnings without any cash flow to back them up - if EBITDA is growing, with the exception of a one-off period, cash flows from operations better also be growing, otherwise, something isn't right.
- If the company is growing, capex/depreciation may be on the rise, but depreciation should be rising in absolute dollars and should ultimately reach a 1:1 ratio (roughly) with capex
- Suspicious or seemingly unreasonable "non-recurring" or "one-time" add-backs to "adjusted" EBITDA and EPS, especially when they seem to recur nearly every period!
- MANAGEMENT QUALITY, COMPETENCE & VISION is key to GOOD stock investments; likewise, management teams who don't know what they're doing when dealing with investors can be great short candidates. Look out for those who have historically tended to over-promise (through aggressive guidance) and under-deliver -- you'd be surprised, often times, these management teams (those who are known for big promises) are virtually 100% consistent in delivering unachievable guidance, and subsequently missing when earnings are released. One would think analysts would eventually catch on and ignore or highly discount management guidance, such that consensus would better reflect the most likely outcome, but, often they don't.
Also, I try to stay away from the momentum names and would advise others do the same. These are companies who've become Wall Street darlings and are being pushed like crazy by Street analysts to buy, buy and buy more. Often these companies don't even make money, yet their market caps are far higher than those of the more boring (yet far more profitable), 30-year old industrial companies who've consistently generated positive cash flow and have brought reasonable if not generous returns to shareholders. One problem that frequently gets investors in trouble when shorting these posterchild momentum stocks is that of TIMING. Think TSLA -- although we all know the stock is wildly overvalued compared to the company's free cash flow potential over the coming ten years, it certainly isn't going to be sufficient to warrant the stock's current trading levels.
Sure, they make great electric cars and perhaps some cool battery storage products, but that's not going to drive the required growth that's implied in Tesla's stock value today. That's the fundamental problem with chasing momentum names -- herding in and of itself breeds herding, driving a stock up and up, creating a bubble that brings the stock to unsustainable, often outrageous, heights. This can be quite problematic for the leveraged investor who's short a rising stock and continues to receive margin calls requiring cash payment to shore up the maintenance margin, drying up cash in the portfolio or requiring the sale of other positions to cover the margin requirement.
Shorting stocks can be a risky endeavor, so ensure your thesis is rock solid and backed by visible catalyst(s) that you're confident will materialize in the near-term (or, as long as you can tolerate, depending on the size of your portfolio, the cash position, etc.). Being forced to keep putting up cash to shore up the maintenance account time and time again can be painstaking, so much so that it has led to the demise of some of the most successful hedge funds.
Key items to identify deteriorating businesses and potentially good short candidates include companies with high-pressure to maintain sales or earnings growth, but look to be showing some early signs of business deterioration. Early signals of a deteriorating business can often be identified by comparing the income statement to the statement of cash flows. If sales, EBITDA, EBITDA margins and earnings are positive and growing, while operating cash flows are negative, and this continues for several periods, it's time for a rigorous review of the company's accounting policies. It is critical to look at trends over time, and ratios relative to industry ratios. Effective forensic analysis, whether used to identify outright fraud or other factors that perhaps don't bode so well for the company's future, requires you spend significant time sifting through the company's 10-Ks and 10-Qs, and I find earnings call transcripts can also be particularly useful.
Mod Note (Andy): This comment from 5/1/16 was originally posted in the thread Are you good at shorting? and received 23 silver bananas so we thought it deserved its own spot on the frontpage
