Look, I got no beef with you, short stuff. If you want to short the market to oblivion, I say good riddance. Heck, some of my best friends are shorties -- including both my newest drinking buddy and the guy who brought me into this business.
Now that was a time to be a skeptic. The market was on fire, corporate insiders were orchestrating the greatest transfer of wealth in history, and just down the street in Rockville, Md., a professor named Howard Schilit was making bean-counting sexy with a whacky notion he called "forensic accounting."
Financial Shenanigans was required reading
Reading Financial Shenanigans was mandatory everywhere professionals were looking at stocks. For years, old-school investors had scoffed at the machine-like growth U.S. corporations were reporting to Wall Street. By 1995, the doubters were dangling by a thread. Then Schilit's Financial Shenanigans gave them one last hope to cling to.
Years passed. On Oct. 27, 1997, the Dow cracked and then raced to new highs. In August, it cracked again. I picture this clearly because I spent both mornings in some random buy-side guy's office, trying to peddle my company's research and literally shouting over the clamor on CNBC.
I confess: I may have lit a Matchbox car on fire on a desk. I mean, we closed the deals all right. But not because we were good salesman (I assure you, coffee was not for us). No, we were moving obscenely expensive earnings quality "short" research in the greatest bull market in history for two reasons. First, as I said, the market was showing signs of cracking. There wasn't blood in the streets exactly ...
But you could smell the fear in the air
Second, we had a twist on Howard Schilit's Financial Shenanigans message -- one with a much broader appeal in 1997. Remember, by then, and certainly a year later, the shorts were getting toasted. But we weren't selling to hedge funds looking for the big short. We were selling to longs. Here's why they were buying.
You may recall that the final stage of the bull market was fueled by a small number of market leaders. This made for some goofy behavior. Among other things, professionals, no matter how dubious about the earnings game, pretty much had to crowd into the same high-growth stocks. Just as surely, when one of these darlings missed, even by a few pennies, the punishment was swift and brutal.
Don't forget, sitting on the sidelines was out of the question. If you wanted to keep your job, the trick was to avoid being the last guy out the door when the next darling blew up. In other words, the real value of Howard Schilit-style earnings quality research wasn't identifying short candidates for quick gains, but rather detecting time bombs in increasingly concentrated long portfolios. Good times.
So why the nostalgia?
It's been years since I've thought about those days. After all, we're long and strong investors here at The Motley Fool. Folks spend a lot of time eyeballing valuations and competitive advantages and forecasting future cash flows. There are exceptions, but we don't talk a lot about shorting the market, or individual stocks, for that matter.
Then, last week, I see this new guy stomping around Fool HQ, apparently beside himself over the pitiful quality of corporate earnings coming off the March 2009 bottom. He's not predicting a crash or even looking to short the market, but like my old boss in 1999, he's concerned about individual investors -- mostly because some dubious results are coming out of the very companies you and I own.
His name is John Del Vecchio, and he's got my attention. For one thing, he's an experienced forensic accountant who had the pleasure of working with Howard Schilit in his heyday. He's spent the past 10 years digging behind the reported numbers, both identifying short candidates for some of the nation's top-performing short funds and reviewing portfolio positions for successful long-only mutual funds. Now he's back at The Motley Fool.
So what's the "vulture" circling now?
The day I met him, Del Vecchio was banging the table (OK, bar, actually) on AsiaInfo-Linkage (Nasdaq: ASIA ) -- a Chinese information technology outfit I'd never heard of, but with heavy institutional interest. The timing was probably a fluke, but the company blew up before I could finish this column. Among the more familiar names, Del Vecchio is sniffing around Monsanto (NYSE: MON ) , Bally Technologies (NYSE: BYI ) , and General Electric (NYSE: GE ) .
Monsanto, according to Del Vecchio, is an inveterate "channel stuffer" that's a train wreck even at less than half its 2008 highs. Bally's has a nasty habit of accelerating revenue recognition and, according to Del Vecchcio, "is a joke." While "GE is essentially bankrupt." One man's humble opinion, but you can see that he doesn't mince words.
And what's his No. 1 piece of advice to investors like us? Don't mess around shorting great companies based on valuation. Companies like Apple (Nasdaq: AAPL ) and Google (Nasdaq: GOOG ) , his model confirms, aren't aggressively pulling sales forward and otherwise managing earnings -- at least not yet. "Why fight something as subjective as valuation," Del Vecchio asks, "when you can bet against a company like Monsanto that was clearly stuffing the channel?"
Is your portfolio ticking?
In the spirit of full disclosure, I don't own Monsanto, but it is a Motley Fool Inside Value pick. And that's why I like Del Vecchio's focus-on-the-numbers approach: No matter how experienced, I'm not convinced that analysts can accurately forecast future earnings or cash flows. As a result, I don't have much use for price targets or so-called margins of safety, either.
I also don't short stocks. At least not yet. That being said, I'm impressed with Del Vecchio's methodology and the brute-force screening power of his earnings quality model (it's amazing how technology has progressed in a few years). And if a proven "forensic accountant" with a track record of beating the market on the short side has evidence that a company I own is cooking the books or finessing earnings, I want to hear about it.
If you feel the same way, do this. Drop me an email. I'll be interviewing Del Vecchio over the next couple of weeks to hear more about his EQ model and what he likes on the short side. I'll publish as much as I can here on Fool.com. If you like, I can notify you when I've got something new. I'll also pass along any new research John works up over the next couple of weeks and is comfortable with me sending out.
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