SHORT-SELLERS ARE THE PERENNIAL UN-AMERICANS, vampires intent on driving down the prices of shares, destroying companies and greedily sucking the blood out of innocent investors.
That’s the mistaken image that many people have of shorts. In reality, there’s nothing unfair or devious about betting against a stock that you think will decline, just as there’s nothing wrong about betting against the NFL team that you believe will lose the Super Bowl. And over the past decade, investors who shorted some stocks probably would have done much better than the vast majority of individuals, who go only long — buying shares in the hope of eventually selling them at a higher price. Shorts reverse the process. They borrow stocks and then sell them, hoping that their prices tumble, which would let them replace the borrowed shares for less than what they paid for them.
Why don’t more individuals short stocks? Short sellers’ unwarranted slimy image repulses some of them. In addition, many people consider bull markets to be the long-term norm — a belief that recent events have sorely tested. Lastly, shorting is considered to be very risky, even though it needn’t be more volatile than using a long strategy. There is, however, one big danger. Whereas the most a long can lose is the price he paid for a stock, the price of a shorted stock theoretically can rise infinitely, making it immensely expensive to buy shares to cover a short position and creating losses far in excess of the original investment.
But, done intelligently, shorting can be enormously lucrative. Just consider the trading record of Short Alert, a small North Carolina-based research firm that has been producing reports recommending stocks to short since 1998. In the 10½ years ended June 30 of this year, about 75% of the 86 recommendations it made would have turned a profit, even if they were judged based on the conservative criteria used by Barron’s in examining Short Alert’s record. In other words, the firm offers an excellent window on how to pick stocks to sell short.
Barron’s found that the firm, led by managing partners Nat Guild and the ironically named Michael Long, produced annual returns averaging 18.3% from 1999 through 2008. If the period studied is stretched through the end of June, the annual returns jump to 20.3%. But beware: Short selling isn’t always a route to easy money: 2004 would have produced a terrible loss of 37%, followed by three years in a row of 13% losses.
In judging Short Alert, Barron’s tracked the short positions for a year after they were implemented. Thus, the most recent of the 86 reports we reviewed is dated June 19, 2008.
Currently, Short Alert has five short recommendations. Two of them — j2 Global Communications (JCOM) and Middleby (MIDD) — are companies that it successfully recommended shorting last year but that it contends still have room to fall. The others are Compass Minerals (CMP), K12 (LRN), and Pactiv (PTV).
Specifics on these stocks are given later, but obviously, these aren’t household names. In fact, the companies targeted by Short Alert tend to be small, with stock-market values around $1 billion. Small stocks are especially prone to becoming overpriced, says Baruch Lev, a New York University finance professor. “There is a great deal of information on large companies,” he observes, “which makes it very difficult to hide protracted overvaluation. In comparison, very few people watch the prices of the billion-dollar companies, so most of the earnings manipulation takes place on that level.”
THE “MANIPULATION” HE REFERS to can simply mean taking unwise steps to boost earnings to justify a lofty stock price. Adds Lev: “The main reason for firing managers is bad stock-market performance, so the greater the overpricing, the greater the risk to managers. The managers know this, but unfortunately their typical response is to try desperate things to justify the price — ultimately a self-defeating strategy. The short sellers can make a positive contribution by trading against these subterfuges.”
An unpublished study co-authored by Southern Methodist University business professor Hemang Desai argues that Short Alert does make such a contribution. Desai and two collaborators examined the research firm’s recommendations from 1998 through 2005, to discover traits common to them. One was unsustainable financials, produced by, say, increasingly booking sales that haven’t yet been paid in cash, or by taking lower depreciation to pad reported earnings. Others include huge growth in overhead, low book-to-market ratios and big price increases over 12 months.
APPLYING THESE MEASURES, the researchers sifted through the stock-market histories of a broad list of companies from 1990 through 1996. Their key finding: The traits drawn from Short Alert’s picks reliably identify underperformers. But that’s only a start. While such stocks generally will fall during bear or sideways markets, that’s not necessarily true in a bull market, which tends to push up even unworthy companies. What Short Alert brings to the party is an ability to find those with a particularly “leaky business model,” as managing partner Guild puts it, and the leakier the better.
Indeed, Short Alert’s returns were quite healthy in the bull market of the late ’90s. For positions initiated in 1998, returns in 1999 averaged 58%; for those initiated in 1999, returns in 2000 averaged 43%. And its 46% return in the bear year of 2008 meant that its picks fell by more than the overall market.
The four losing years from 2004 through 2007 were due partly to the fact that, under Barron’s assumptions, losses and gains were allowed to run without being capped by stop orders. (Such orders mandate that a position be covered at a certain price.) Instead, we imposed a trading protocol based strictly on time. For each short-sale recommendation, a profit was allowed after one year if one existed. If it didn’t, the position was held another year before being covered at a profit or loss. (A full explanation of our methodology is available here.)
The lack of stop orders might be unrealistic; a professional short seller would probably use them, or options, to stem losses. But because Short Alert leaves it up to its readers to determine if, and at what levels, any stops should be put in, we felt it would be misleading and arbitrary for us to assume that they had been used. This removes the possibility of using 20-20 hindsight to improve results.
In any case, the absence of stop orders occasionally resulted in a short seller’s worst nightmare — open positions held, and at times closed out, at more than a 100% loss. What made all the difference was diversification, with other positions often showing a profit. And patience at times proved to be a valuable virtue. For example, Terayon Communications Systems, a short recommendation initiated on Aug. 3, 1999, had more than tripled in price a year later, which would have resulted in more than a 200% loss. The method dictated by Barron’s required that the stock be held another year — by which point it was 63% below the initial sale price.
The truth is that it’s much easier to determine that a stock is overpriced than to accurately predict when it will fall. That can lead to stomach-churning uncertainty that can last for weeks, or even months. The shorting game is clearly not for everyone.
THE FIVE TO SHORT
The five stocks that Short Alert currently identifies as ripe for shorting are a varied lot.
COMPASS MINERALS, says Guild (pronounced “guyld”) is a “one-off [success] that Wall Street treats as a continuing story.” The company is North America’s largest producer of de-icing salt, which accounts for 55% of its operating profit. The rest comes from potash, used in fertilizers.
While the price of every other fertilizer component has collapsed by 70%, potash remains at bubble levels, Guild says, even through demand has collapsed and North American inventories are at record levels. Farmers don’t need to apply potash every year for a healthy crop and, even if they did, buying much now would be a problem, since credit is tough to obtain.
As for the salt business, long-term demand grows if new roads are built, and road-miles have been rising only 0.2% a year in the U.S. In the short run, demand is driven by winters, which were among the worst on record in the Midwest and parts of New England over the past two years. But unless the coming winter is especially severe, high prices and state and local budget woes could crimp demand.
A Compass spokesperson notes that, of the six analysts that cover the stock, one rates it a Strong Buy, another as a Buy and three as Hold. Only one of the six agrees with Short Alert that it’s a Sell. But Guild contends that, based on normal prices and sales volume for salt and potash, the stock is worth 12, far below its current level in the mid 50s.
J2 GLOBAL COMMUNICATIONS, the subject of a June 19, 2008, report by Short Alert, was down 14% a year later, but Guild sees far more downside.
About 80% of the company’s sales come from transmitting electronic faxes, a business that’s in decline. Its growth in subscribers has come from acquiring other companies, he says. And 50% of its paid subscriber list turns over every year. Its stock is now hovering above 20 but could easily plunge below 10, asserts Guild, if it were hit with the one-two punch of no significant acquisitions and fewer paid subscribers. J2 President Scott Turicchi counters that “our short position has fallen to 1.7 million shares, less than 4% of outstanding shares of j2 Global and near an all-time low.”
K12 is viewed by Guild as a “limited-market” story. “When Wall Street gets excited by a new product,” he remarks, “it overestimates the size of the market.” K12′s product is an online educational package for home-based students from kindergarten through high school. The company can also provide live teachers for students who really need help.
Guild cites research showing that on-line learning has clear benefits for a very limited number of students, and he adds that state and local budget cuts threaten to reduce per-student support. K12 Chief Financial Officer John Baule notes that the company’s market is now quite small and has lots of room to grow. The key question, however, is whether the stock deserves a price/earnings multiple of 50. If its earning growth slows and its P/E shrinks to, say, 25, the stock, recently in the low 20s, could fall sharply.
The fourth stock, Middleby, was the subject of a Jan. 18, 2008, report by Short Alert. A year later, it was off 58%, but it has since retraced two-thirds of its loss.
Guild calls Middleby, which makes commercial-kitchen equipment, a “classic roll-up,” with acquisitions hiding the slipping growth in the core business. The Short Alert analyst says “research shows that most acquisitions reduce shareholder value,” an assertion seconded by finance professor Lev. Middleby has been buying some of its rivals. But the recession has led to a decline in new restaurants and, by extension, in orders for equipment. Middleby CFO Tim Fitzgerald readily concedes that there’s “softness in the restaurant industry,” but adds that the company is “strategically well-positioned when the market returns.” But, Guild would argue, at a price much lower than the recent 44.68. The Barron’s protocol would have required that profits be taken on MIDD early this year, at 23.81 a share.
The fifth company, Pactiv, makes egg cartons, plastic cups, take-out containers and Hefty bags. The subject of a critical June 17 online feature by Barron’s Daily Stock Alert (“Pension Problems Could Put a Hefty Hurt on this Stock”), Pactiv is what Guild terms a “misleading earnings story,” stemming from certain accounting rules.
Although Pactiv has massive, unfunded pension liabilities, all of its earnings for 2008 came from a nonexistent return on pension assets. Similar legerdemain, says Guild, is bloating earnings in 2009. Pactiv CEO Richard Wambold and CFO Ed Walters counter that their handling of pension income is quite proper and merely applies generally accepted accounting standards. Guild agrees, but maintains that GAAP sometimes distorts a company’s financials. According to his calculations, Pactiv could be worth as little as $6.40 a share. It recently traded above 20.
IN ADDITION TO RECOMMENDING outright shorts, Short Alert also publishes a “Most Dangerous” list of stocks that rate further scrutiny. That list, available in greater detail on www.squareoneanalytics.com, now includes:
Imax (IMAX): Short Alert argues that Imax’s 3-D systems are at the end of their growth cycle and face new competition, and that the company is bleeding cash, with all of its debt due next year.
Hanesbrands (HBI): This is an apparel maker whose brands are in decline and that gets 40% of its earnings from pension “profits.”
Lancaster Colony (LANC): It sells caviar and candles — items that consumers can easily do without in a recession and that face growing competition.
Scholastic (SCHL): Short Alert views this famed outfit as a fading monopoly on elementary-school book clubs.
Pentair (PNR): This maker of pool pumps and equipment is overleveraged and faces a declining market.
Sally Beauty Holdings (SBH): This outfit, which has grown by acquiring beauty salons, could run into trouble if recession-plagued consumers cut back on buying high-priced salon grooming products.
Yes, there are dangers in shorting stocks. But there are dangers in going long, too. Vilify short sellers if you must. But remember, the smart shorts cried all the way to the bank last year and for much of 2009; other investors simply cried.
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BRAD DAVIS contributed to this article.
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