3 Short Success Stories

Given all of the distressed companies we came across last year, shorting stocks is a strategy our research team at Motley Fool Global Gains started experimenting with. We published all of our research for free online and ended up having a number of massive successes as well as one or two blowups along the way.

Here's a brief recap of three successes and one blowup, along with relevant lessons that you can apply to make money shorting stocks going forward.

Aug. 6, 2009: Short Fuqi International (Nasdaq: FUQI  )
The thesis here was simple: For every $1 of earnings growth Fuqi was generating, it was consuming at least $0.50 in cash to support working capital for expansion. This was a result of investment in inventory and slow collections of accounts receivable.

In fact, when we looked at the stock last year, its cash conversion cycle had almost doubled to 110 days, and we noticed a very low quality of earnings given how consistently free cash flow dramatically trailed net income. We considered the stock overvalued and likely to continue to dilute shareholders, and therefore recommended shorting it at $24.

Today, Fuqi trades for just $8.50. Revelations of accounting errors at the company were a catalyst for the drop earlier this year, and Fuqi has yet to file its 2009 report. That just adds to the risk profile of a business that was unattractive from an investment standpoint in the first place.

Sept. 17, 2009: Short China Fire & Security (Nasdaq: CFSG  )
China Fire was a stock we had previously recommended buying at Global Gains, but a number of compelling reasons caused us to reverse course and recommend shorting it.

First, the stock was up almost 170% -- to near $20 per share -- through the first nine months of 2009. Second, the company had somehow managed extraordinary margin improvement in the first and second quarters of the year to meet analyst expectations -- improvement that didn't look to us to be sustainable. Third, the company had lost a key contact at China's Fire Security Bureau. Fourth, the company's main customers (Chinese iron and steel companies) were coming under duress because of overcapacity issues, and China Fire was stockpiling receivables as a result, making for low earnings quality for the company.

Fast-forward and China Fire just released second-quarter results that showed revenues flat year over year, a gross margin decline from 64% to 54%, and the continued accumulation of receivables alongside a rising provision for doubtful accounts.

If China's iron and steel industry continues to struggle, expect a continued deteriorating in China Fire's business. While the stock is no longer an obvious short given today's valuation (it's fallen to $8 per share), we certainly don't expect to be buying shares anytime soon.

Sept. 17, 2009: Short AgFeed Industries (Nasdaq: FEED  )
Although I tend to be bullish on rural China, AgFeed industries was never a stock I could get excited about. That's because while the company did operate a promising feed supply business, it was also engaged in the very capital-intensive and potentially risky business of acquiring and modernizing hog farms in China.

What made the company a promising short at more than $5 per share, however, was the fact that I expected corn prices to rise (a significant cost for the company) and for the company to be unable to pass those rising costs along to consumers given the Chinese government's preference for keeping consumer food costs low.

Since last year, the company's profit margins have declined, and cash from operations and free cash flow have differed dramatically on the downside from stated earnings. The stock has also dropped to less than $3.

Aug. 27, 2009: Short lululemon athletica (Nasdaq: LULU  )
Citing a deteriorating consumer environment, we recommended shorting yoga apparel retailer lululemon at $20 per share. With the stock now at $40, that was clearly a bad move. What did we get wrong?

While Fuqi International, China Fire, and AgFeed Industries all showed poor earnings quality in addition to premium valuations, the short story for lululemon was based solely on valuation.

At nearly 40 times earnings and 20 times EBITDA, the stock looked ridiculously expensive, and if consumer spending retrenched as we thought it would, there was no way the company could meet the growth expectations priced into the stock. Further, the company was operating in an industry with extremely competent, well-capitalized, and much more reasonably valued competitors such as Nike (NYSE: NKE  ) and Under Armour (NYSE: UA  ) .

Yet as we all know, the consumer environment has recovered in 2010. lululemon's products continue to be extraordinarily popular, and the company has gone right on growing free cash flow.

The lessons
When it comes to shorting, one mistake can wipe out any number of successes. Although we got three out of four calls right in the above examples, the mistake with lululemon was so significant that it wiped out more than half of our overall gains. So be careful and remember that shorting stocks is not for everyone.

Further, note that while we believed all four stocks were overvalued, Fuqi, China Fire, and AgFeed all had clear earnings quality issues related to long cash conversion cycles and capital-intensive business models. Ultimately it was the weaknesses in these businesses that caused the stocks to drop -- and not just the simple fact they looked expensive relative to a peer group.

There's nothing more painful than shorting a stock like lululemon that just keeps growing and growing, so if you choose to short on your own, make sure you don't just look for expensive stocks.

The safer play is to identify an overpriced company with earnings quality issues. If you're interested in protecting your portfolio from ticking time bombs or shorting stocks for big gains, enter your email in the box below. I'll send you a new report, "5 Red Flags -- How to Find the Big Short," by John Del Vecchio, CFA, a leading forensic accountant who has made a good deal of money identifying companies with low-quality earnings. Simply enter your email in the box below.

Tim Hanson is co-advisor of Motley Fool Global Gains. He does not own shares of any company mentioned. Under Armour is a Motley Fool Hidden Gems selection. Under Armour is a Rule Breakers pick. The Fool owns shares of Under Armour. The Motley Fool has a disclosure policy.


Read/Post Comments (11) | Recommend This Article (53)

Comments from our Foolish Readers

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  • Report this Comment On August 10, 2010, at 3:32 PM, blaueskobalt wrote:

    Tim,

    I like this article, and I've enjoyed seeing some attention paid to potential shorting opportunities. I'm not sure that I'm quite ready to short an individual stock with real money, but CAPS presents a good opportunity to learn (though I notice that you didn't discuss HMIN here, which I red-thumbed alongside you, and it is now the worst performer in both of our CAPS portfolios...).

    I also think articles discussing short theses is helpful in critically evaluating stocks, even for an all-long portfolio. IMO, if one is investing the time to read the SEC filings, there is inherently a bias towards wanting to take a position on a stock. If going long is the only option, that creates a bullish bias. However, if shorting is an option, that makes one more open towards seeing the other side. Even if this doesn't lead to a short, it can prevent one from taking a long position on an overvalued stock.

    Sean

  • Report this Comment On August 10, 2010, at 3:58 PM, TMFMmbop wrote:

    Thanks, Sean. HMIN is another example of a growth stock that looked dramatically overvalued, but didn't necessarily have red flags in the financials (though I continue to dislike management there). It has, as you noted, delivered a punishing loss to anyone who shorted it. Perhaps fodder for another shorting recap!

    Tim

  • Report this Comment On August 10, 2010, at 4:13 PM, jts187 wrote:

    Any one else find the situation with FEED ironic? The profitable part of that business is feed. Yet the part of thier business that isnt profitable is not so in part due to high feed costs.

  • Report this Comment On August 10, 2010, at 6:31 PM, ragtopbull wrote:

    Hmmm.... me thinks the short gains have more to do with the exposure of China's accounting practices and uncertainties cast on valuations than competitive forces cited impacting these stocks. The lesson on shorting is not lost - there is little brilliance to it and vs long positions you are constrained on upside return (theoretically 100%) and take on much greater downside return risk (theoretically infinite losses if you hang on).

    Fool on!

  • Report this Comment On August 10, 2010, at 8:39 PM, wwmcn wrote:

    Tim,

    Below is pasted what happens when I put my email address in, requesting the DelVecchio report - this address is correct, and what Fool reports are sent to.

    'bmcneary@ldd.net' is not a valid email address. Please enter a valid email address.

    Thanks,

    Bill

  • Report this Comment On August 10, 2010, at 10:40 PM, Pr0metheus wrote:

    Bill,

    As a programmer by trade, I'm guessing the Fool's form validation doesn't like "ldd.net". I can toss you a gmail invite if you'd like.

    -Bob

  • Report this Comment On August 11, 2010, at 9:01 AM, Gonzhouse wrote:

    Rather than outright shorting a stock (where losses are in theory unlimited) a less risky play is to buy Put options. For stocks that have cash conversion/earnings quality issues, shorting makes sense. For growth-premise issues, puts are the better play.

  • Report this Comment On August 11, 2010, at 4:05 PM, prospectorgadget wrote:

    I'm a Global Gains member and I must have missed the short recommendations. Maybe I wasn't paying attention, but they're not in the scorecard, I don't see them in the updates from those days. Where are they?

  • Report this Comment On August 12, 2010, at 12:23 AM, JonBarleycorn wrote:

    One small point. One must approach a short sale like any speculator, with stop loss orders and exit strategy in hand (not a philosophy often endorsed by the Fool).

    JB

  • Report this Comment On August 12, 2010, at 4:51 PM, grizthedog wrote:

    Concerning the recommendation below to limit your exposure by buying Put options.....

    Good idea but make sure you don't end up with a thinly traded Put that you can't unload because there's no market.

  • Report this Comment On August 13, 2010, at 10:16 PM, weihou258 wrote:

    Good timing.

    When ShangHai market topped from the bottom of 2008?

    Aug, 2009.

    No "Guan Xi", no money, especially doing business with government. If you have a senator, your business should not be bad.

    For most of the Chinese stocks, if it has not dropped 30%+ from its high, it could be a target to shot.

    If S&P 500 can not bounce back above 1090, everything can be the shorting target.

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