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Read This Before You Go Short

It wasn’t too long ago that I documented four of our Motley Fool Global Gains team’s first experiences going short. Given the positive response to that column, here are a few more shorts we proposed last year, reports on how they’ve panned out, and what lessons we’ve learned that you can apply to your own short research process -- and why not have one in this sideways market? -- going forward.

June 11, 2009: Short China BAK Battery (Nasdaq: CBAK  )
One key we’ve found to shorting successfully is to not just identify a company with an untenable valuation, but also one whose financials reveal emerging operational red flags that will act as a near-term catalyst for the stock’s decline. That was the playbook when my colleague Nathan Parmelee identified China BAK Battery last year, noting not only that China BAK Battery was trading at a 24 EV/EBITDA multiple, but also that the company had never generated free cash flow over a fiscal year and was rapidly burning through the cash on its balance sheet trying to compete with larger battery industry competitors such as Sony (NYSE: SNE  ) . Nathan concluded that the company would either have to leverage up its balance sheet or dilute shareholders to stay in business -- both events that would cause the stock to drop from its lofty multiple.

As it’s turned out, the company announced a more than $20 million offering in October and remains free-cash-flow negative. This successful short has dropped from $3.50 to $1.50 per share.

June 25, 2009: Short (Nasdaq: CYOU  ) ; Buy (Nasdaq: SOHU  )
Given the lesson learned from our Naspers short (which you’ll read about below), I chose last June to couple a short of fast-growing and dramatically overvalued Chinese online gaming company with a long position in its parent company -- which was valued more reasonably and owned a near-70% stake in Changyou here. While I expected both stocks to fall, the idea here is that Changyou would fall more given its relatively higher valuation. The reason to pair them together is that if Changyou somehow managed to keep going up (as can happen when the market gets irrational with growth), Sohu would rise as well, given its ownership stake in Changyou, protecting us from losses.

This has played out as expected, with Changyou down 36% since last June and Sohu down 29%. Although nothing exceptional, the lower-risk return from this pairs trade is nothing to scoff at in the current market, and I expect it to continue to grow going forward given the valuation discrepancy that continues to exist between the two companies.

May 14, 2009: Short Naspers (NPSNY.PK)
I previously mentioned the lesson we learned from Naspers, and boy was it a doozy. The thesis here was that Naspers was a no-growth media business that the market was valuing like a high-growth Internet company because of its ownership stake in the popular Chinese instant messenger platform Tencent. Yet I’ve been skeptical of leading Chinese Internet companies such as Tencent and (Nasdaq: BIDU  ) because the government has worked to protect them from foreign competition, and because the market has been valuing at levels that look simply unsustainable given prospects for competition and a weakening Chinese economy.

As a result, I thought Tencent was due to drop and that Naspers would drop right along with it. Somehow, however, Tencent has managed to almost double since last May thanks to continued strong revenue and earnings growth. While I still think Tencent is overvalued, the market remains impressed and willing to pay a premium for its business -- taking Naspers along for a ride very painful for anyone short the company. As with Changyou and Sohu, the better move here would have been to pair Naspers and Tencent together in a simultaneously long-short position to limit downside exposure.

The lessons
When it comes to shorting, one mistake can wipe out any number of successes. Although two of three of the investment theses here were correct, the mistake with Naspers more than wiped out the gains in the other two. So be careful and remember that shorting stocks is not for everyone.

If shorting is something that interests you, however, note that the key finding of our experience is to find businesses showing increasing operating difficulties in their financials in addition to a premium valuation. Because while the market can remain irrational about growth stocks, troubled companies will eventually get their due.

Knowing that, if you’re interested in learning more about how to identify stocks with troubling financials, enter your email address in the box below to get a free copy of “5 Red Flags -- How to Find the Big Short,” a new report from John Del Vecchio, CFA, a leading forensic accountant. The report is free. Simply enter your email in the box below.

Tim Hanson does not own shares of any company mentioned. Baidu and Sohu are Rule Breakers picks. The Motley Fool has a disclosure policy.

Read/Post Comments (3) | Recommend This Article (37)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 16, 2010, at 8:49 PM, prginww wrote:

    I was pleased to read of a failed plan.

    The author gained my admiration for his honesty. It seems that few on this site will own up to their mistakes.

    Avoiding mistakes comes from experience, and experience comes from making mistakes.

  • Report this Comment On August 16, 2010, at 9:19 PM, prginww wrote:

    i agree with the above comment - i am much impressed with the authors account of a failed recommendation and the reason why - it gives him much credibility and i will certainly read anything he presents in the future

  • Report this Comment On August 18, 2010, at 10:07 AM, prginww wrote:

    Hmmmmm the message is right on the mark as far as shorting, I found that out all to well and too late to save my CAPS score. Talk about an experiment gone bad. Geees! Glad I did it with the game and stuck with my plan in my regular portfolio,

    I'm sticking with strong Dividend payers and Stock Advisor stuff. I may not crush the market but beating the S&P in returns and expenses

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