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
...is this the table of contents from Financial Shenanigans?
You always need a catalyst when framing a short
Thanks for putting this together. I'd say after talking to a PM that manages a short-selling only fund on the street, timing is most important. If your catalyst is over a 6 months time horizon, don't waste your time. Problem is things can move in a hurry once the market reacts to something.
Good Shorts? (Originally Posted: 02/04/2011)
Ok I want to reduce the net long exposure in my fund slightly so I'd thought I'd see if anyone here has any good ideas as far as stocks to short.
Any industry is fine, though brownie points for shorts in energy, consumer discretionary/retail, industrials, and/or transports.
I care more about the why than the actual recommendation, but no need to write something long.
Something like: "OPEN, the valuation means the stock is priced to perfection and unless growth is stellar, the stock will fall, especially because it relies so heavily on momentum yet has limited growth opportunities going forward."
I just want a teaser, I can do my own due diligence from there (I already have some ideas, want to see if you monkeys have anything better).
NFLX - outrageous valuation, move from mail model to streaming model will kill their margins as they renegotiate contracts with studios, increased competition on streaming (hulu, amazon VOD (rumors giving unlimited streaming with prime), apple, google, cable companies, etc)
tilson does a good job discussing the short case
http://seekingalpha.com/article/242320-whitney-tilson-why-we-re-short-n…
[quote=iambateman]NFLX - outrageous valuation, move from mail model to streaming model will kill their margins as they renegotiate contracts with studios, increased competition on streaming (hulu, amazon VOD (rumors giving unlimited streaming with prime), apple, google, cable companies, etc)
tilson does a good job discussing the short case
http://seekingalpha.com/article/242320-whitney-tilson-why-we-re-short-n…]
Yup, already did that one; small position, because although it's definitely overvalued in my opinion, this one could stay irrational for a while (I'm short the Jan2012 230 call).
[quote=iambateman]NFLX - outrageous valuation, move from mail model to streaming model will kill their margins as they renegotiate contracts with studios, increased competition on streaming (hulu, amazon VOD (rumors giving unlimited streaming with prime), apple, google, cable companies, etc)
tilson does a good job discussing the short case
http://seekingalpha.com/article/242320-whitney-tilson-why-we-re-short-n…] Except he got fucking crushed with recent earnings. I don't think it's a good idea to short stocks that have strong momentum, and with that recent 13%+ gain, NFLX is squeezing all the short sellers. Not a good play right now.
What about St. Joe's? When Einhorn gave his presentation to short JOE, the stock was trading at $24~, now it's rebounded all the way to $27~. If Einhorn's valuation is right, then you should be able to make even more money at this price.
Here is the link to the presentation: http://www.businessinsider.com/david-einhorn-presentation-joe-2010-10#-1
[quote=iambateman]NFLX - outrageous valuation, move from mail model to streaming model will kill their margins as they renegotiate contracts with studios, increased competition on streaming (hulu, amazon VOD (rumors giving unlimited streaming with prime), apple, google, cable companies, etc)
tilson does a good job discussing the short case
http://seekingalpha.com/article/242320-whitney-tilson-why-we-re-short-n…]
My original thought as well although I think this is still a few months out...
[quote=iambateman]NFLX - outrageous valuation, move from mail model to streaming model will kill their margins as they renegotiate contracts with studios, increased competition on streaming (hulu, amazon VOD (rumors giving unlimited streaming with prime), apple, google, cable companies, etc)
tilson does a good job discussing the short case
http://seekingalpha.com/article/242320-whitney-tilson-why-we-re-short-n…] If I was going to short a stock NFLX would be one of the first to come to mind.
But shorting stocks is not in my game plan right now. The stock market usually goes up 9-10% per year, so in my mind, shorting stocks is kind of like swimming against the current. I never short something, unless I have really solid information.
If I had more resources at my disposal, I would look for pink sheet stocks, that I think are scams/bullshit and short them. The problem with that is I would I have to spend thousands of dollars on the investigation, and devote a few days of my time to actually going out and physically investigating the company. If there is very little correlation to the content in the press releases, and what I see with my own two eyes, then the company is ripe for a short position. At this point in time, I don't have enough capital in the market to make the investigation worth the investment of time and money.
The first three stocks I invested in were pink sheets. All three companies had sound business plans, innovative ideas, and a killer PR department. That, along with the fact that I made a shit ton of money in the beginning , was all they needed to trick an overly ambitious 12 year old, such as myself. To make a long story short, I did not sell when I should have, and all three companies eventually went to shit. I've come to the conclusion that most pink sheets are scams, and aren't going anywhere, no matter how talented there PR department is. However, the few that do succeed, usually go up a lot in value, which is why I will never short a pink sheet, without solid information, and/or a thorough investigation.
lol
vineyard vines has some good ones
i think the way to play the NFLX short is buying long dated puts (jan 12 170s look nice) or selling some OTM long dated calls like alex has done. shorting the stock outright is insane.
theres a bunch of other overvalued companies like open and lulu, but they are momo plays right now which have proven extremely difficult to short. lulu reminds me a lot of crox, we all know how that one played out.
im toyed with the idea of shorting rimm with the iphone move to verizon as i think they are destined to fail, but i have a hard time shorting a tech stock with a 10 p/e
DMD will be available to short in about two weeks, and that's like stealing. They have so much monkey math going on in their balance sheet I'm amazed they were allowed to register. Plus Google can throw the switch on them at any moment, and has already made moves to do so. That's a $2 stock if I've ever seen one.
APOL - find me one good thing about for profit education and I'll change my mind
I'll look into JOE, DMD, and APOL, thanks guys.
@mike55555
I almost always have a net long exposure and still will after this. I just wanted to lessen my net long exposure (if Tepper says the easy money's over, I listen). Also, you can sense a change in sentiment today, particularly in the energy space.
I sold some covered calls on some oil service names; I think they'll pull back a little over the next month. I'm looking for one or two non-energy shorts, that's all.
More on DMD, and why it might be the short of the century:
http://www.observer.com/2011/tech/demand-media-ipo-how-desperate-are-in…
[quote=Edmundo Braverman]More on DMD, and why it might be the short of the century:
http://www.observer.com/2011/tech/demand-media-ipo-how-desperate-are-in…]
I really like this, I remember looking at them and thinking that it was weird for a co. with a few middle-of-the-road web sites to be IPO-ing. Hopefully I can get access to some shares; that's the tricky part about shorting co.'s soon after IPO.
[quote=Edmundo Braverman]More on DMD, and why it might be the short of the century:
http://www.observer.com/2011/tech/demand-media-ipo-how-desperate-are-in…]
Very compelling argument, almost enough to make me break my short philosophy, but I think I'm going to stick to my guns.
[quote=Edmundo Braverman]More on DMD, and why it might be the short of the century: http://www.observer.com/2011/tech/demand-media-ipo-how-desperate-are-in…] Totally agree with you Eddie - DMD is a steaming pile of shit and I will be shorting the hell out of it as soon as I am able. A ton of their content is garbage (basically search engine spam), and Google could torpedo them at any moment. The fact of the matter is that search engine spam like Demand Media is becoming a bigger and bigger problem, and Google is going to have to solve it or take a major hit to its user base. Who are you willing to bet on surviving - Google or Demand Media?
As far as shorting NFLX goes - good luck catching that falling knife. The valuation is absurd, but it's been absurd for months and keeps getting more ridiculous. People have been trying to short the hell out of it for nearly half a year now and keep getting murdered. When a stock isn't behaving rationally, I'm staying away. As the old saying goes - the market can remain irrational longer than you can remain solvent.
that's funny you brought up OPEN... I was talking to a buddy on monday about how we both thought it was a great short.
My personal choice is is RIMM
Personally really like these:
http://mirror.altrec.com/images/shop/detail/swatches/CLB/10.81587_d.jpg
CREE - soon to be vastly more commoditized business, ramping up Chinese competition (see tooling sales from VECO & other manufacturers), high valuations, earnings misses, guidance weakness
Maybe paired with a long on the LED tool manufacturers (VECO).
I would only play CREE as a pairs trade like you mentioned. If the business is commoditized (which it will be), then that spread will tighten. I wouldn't short CREE outright and I don't really have space for more pairs trades, so I'll hold off on it even though I do like your recommendation. If CREE spikes to like 70 and VECO languishes, then I might put it on because the discrepancy is greater, but at these levels I'm not gonna pull the trigger.
^^^Oh yeah NFLX is a scary short. It would have to go to like $4,000 a share before it did me in, though (and that's not happening, that'd be a $200B mkt cap for NFLX one year from now)
Very true, which is why I refuse to short it with real money. The opportunities for international growth are tremendous.
I think the smartest move would be to buy NFLX Jan 2013 225.000 call (NFLX130119C00225000), and NFLX Jan 2012 220.000 put (OPR: NFLX120121P00220000 ). I can make a reasonable argument to short the stock, but I can also make a reasonable argument that it's going up 10 times in value, over the next two years. Too bad I can't trade options in my personal account.
Actually I take part of that back, NFLX Jan 2013 310.000 call (OPR: NFLX130119C00310000 ) would be a more suitable call to buy for this situation.
Demand Media
Alex, are you on sumzero? If not I'll shoot an invite
Lululemon (LULU) is an interesting short.
The topic of shorts got me thinking about DRL (Doral Financial). If you want to see a chart that'll make you physically ill, check it out.
http://finance.yahoo.com/echarts?s=DRL+Interactive#symbol=DRL;range=5y
December 2004 Price: 985 Today's Price: 1.38
I'm sure there are others that are as bad or worse but I came across that one in particular today and its just...nauseating
AOL. Loosing money - declining add revenue - investors bailing - so what do they do? Not only do they pay $300 million cash to buy Huffington Post - they hire Ms. Huffington ($4million) a year and put her in charge of "content".
They are either assuming that Huffington is going to take a more level-headed approach to her stories, cut out the left-wing bias, I seriously doubt this is going to happen. Even if this is the case, who knows how she will do in charge of content that is not filled with political undertones - big gamble. Also, if she does move more toward the center, what good does she bring to the table? Its not main stream people who visit her site, it is those on the fringe. If she moves to the center - they have no interest in her POV.
Or they are assuming that she will stay left of center, all of her followers will accept that she now works for the "main-stream media" and that there is a big enough market out there of individuals who enjoy reading news through a liberal glass. MSNBC is barely hanging on - and this is their bread and butter.
I think the future of AOL has been sealed.
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