Time to Short SandRidge Energy?

At Fool.com, we believe in buying great companies for the long term. However, not every company commands a fair price, and many trade for far more than they're actually worth.

In these situations, investors actually have a chance to benefit from a stock's plunge. When shorting a stock, an investor bets that price of a stock will go down, and profits from any downward movement. The practice is risky, inviting unlimited losses while only providing limited upside. However, shorting wildly overvalued companies can also help balance your portfolio against the wild market swings we've seen in previous years.

To find shorting candidates, we screened for stocks with a high percentage of their publicly traded shares sold short. One such stock is SandRidge Energy (NYSE: SD  ) , with a current short interest of 7.23%. That's pretty high, but let's see how it compares to other companies in its industry:

Source: Capital IQ, a division of Standard & Poor's.

Source: Capital IQ, a division of Standard & Poor's.

We consider short interest greater than 5% to be a warning sign. While plenty of great companies can carry high short interest, that red flag is your invitation to dig for troubling information that the company's buyers might be missing.

When evaluating short candidates, start by assessing their near-term financial health. To check on SandRidge Energy's immediate health, we looked at its current ratio, which simply divides its current assets by its current liabilities. The more assets a company has -- cash, inventory, and accounts receivable, among others -- the more easily it should be able to pay off its obligations in times of financial distress.

SandRidge Energy's ratio in this category is a bit shaky, currently standing at 0.67. We look for current ratios greater than 1, meaning that a company could use its current assets to immediately fund liabilities, if it had to. Just remember that such situations are rare, and that companies can also raise money with other assets if need be. It's best to dig into SandRidge Energy's filings to see whether the company faces any short-term liquidity challenges.

Source: Capital IQ, a division of Standard & Poor's.

Source: Capital IQ, a division of Standard & Poor's.

Once we've assessed a company's short-term financial health, next we determine whether it's overstating its earnings. Earnings are meant to show a smoothed-out picture of a company's profit potential over time. However, they're prone to various assumptions and manipulations. Companies can aggressively recognize revenue, or show high earnings even while they pour excessive amounts of cash into capital expenditures that are slowly accounted for over time.

For this reason, it's best to compare free cash flow to earnings. Free cash flow accounts for the actual cash flowing out of or into a business, and then subtracts out actual capital expenditure costs over a given period of time. In the last twelve months, SandRidge Energy's cash flow has been -$192 million while their earnings were -$449 million.

SandRidge Energy's free cash flow has outperformed its earnings on average. That's generally a good sign that shows the company has been more conservative with its accounting and isn't using sleight-of-hand tricks to overstate its earnings potential.

Source: Capital IQ, a division of Standard & Poor's.

Source: Capital IQ, a division of Standard & Poor's.

One last consideration for shorting a company is valuation. Excellent companies often trade for prices that aren't justified by their business's long-term outlook. Think back to the dot-com bubble: While technology companies like Amazon.com would eventually produce large profits, at the time, they lacked business models and future earnings streams to justify their mammoth market capitalizations.

The PEG ratio is a simple measure of whether a company is excessively valued. It compares a company's P/E ratio to its estimated growth rate. We compared SandRidge Energy's expected P/E ratio of the next 12 months relative to its 5-year estimated growth rate. As an investor, you'd look for companies trading at P/Es less than their growth rate. As seen in the table below, SandRidge Energy currently trades at PEG ratio of 2.08.

Company

Forward P/E

5-Year Growth Estimate %

5-Year PEG Ratio

SandRidge Energy

20.84

10

2.08

Continental Resources (NYSE: CLR  )

23.35

11

2.12

Ultra Petroleum (NYSE: UPL  )

14.56

22

0.66

Range Resources (NYSE: RRC  )

42.93

10

4.29

Forest Oil (NYSE: FST  )

12.87

6.25

2.06

Source: Capital IQ, a division of Standard & Poor's.

With a PEG ratio greater than 1.5, short interest is likely targeting SandRidge Energy on account of its significant P/E premium relative to its growth potential.

The long road to superior shorting
Identifying good short candidates requires diligent research. More importantly, you've got to know where to dig into a company's financial statements. While the measures we showed above are a great start in searching for shorting candidates, red flags like accelerating revenue recognition, aggressive acquisitions to hide underlying financial weakness, and changes in reporting methods can only be spotted by carefully analyzing the notes companies bury deep in their filings.

Finding these opportunities requires skill, but you can do it. That's why John Del Vecchio, CFA, a leading forensic accountant and The Motley Fool's shorting specialist, put together a detailed report that shows you how to spot five serious red flags that can help you detect time bombs in your portfolio and lead you to the next big short. You can get the entire report free by clicking here or by entering your email address in the box below.

Jeremy Phillips does not own shares of the companies mentioned. Amazon.com is a Stock Advisor recommendation. Try any of our Foolish newsletter services, free for 30 days. The Motley Fool has a disclosure policy.


Read/Post Comments (4) | Recommend This Article (23)

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 17, 2010, at 11:32 AM, dougluvs wrote:

    NICE ANALYSIS, BUT YOU'RE ABOUT $65 A SHARE LATE ON SD--PICK ANOTHER STOCK.

  • Report this Comment On August 17, 2010, at 1:49 PM, jhc5478 wrote:

    I must respectfully inform you guys that this is a poorly laid out thesis and a somewhat irresponsible recommendation to make on a site frequented by non-professional investors.

    I can’t tell from your article if it’s a general tutorial on picking potential short candidates, or whether you have real conviction on a SandRidge-specific short thesis. It almost seems as if you have an ulterior motive for suggesting this name- but I digress.

    Using the criteria highlighted above why pick SD? It looks as if it has average Short Interest and sports an average PEG ratio among the group of peers you selected. All that means is that the energy space is out of favor right now. Anyone who follows the market on a more than casual basis already knows this. Why not short Mariner Energy or Range Resources which seem to have SI and PEG ratios (respectively) above their peers?

    Dougluvs is right… This stock, even if you don’t like it as a long position, is a poor short candidate for someone just getting involved. It’s down 70% from its 52-week high, and down 25% in just the last two weeks. It already has very high short interest (as you pointed out) and a low absolute dollar price. We got a PERFECT example of why this can be dangerous last Friday when Dynegy (DYN), down 78% from its 52-week high, and down 24% over the previous 2 weeks, received a bid from Blackstone Group at a 63% premium to the previous close.

    I think it is borderline unethical to recommend shorting ANY stock below $5.00 to a non-professional investor. You seem to approach your article from a “Shorting for Dummies” perspective, yet don’t mention that a major risk to shorting low-dollar, high short interest stocks is, in addition to the takeout highlighted above, a major short-squeeze. If you are fair-minded enough to post my feedback, let it be known to any ‘Ameritraders’ out there that the risks of shorting stocks like this far exceed the reward, historically speaking. I was told by an old-timer when I first entered the business to never short a stock below $5.00, especially if it has high short interest, unless you have a catalyst or good reason to believe that the company is GOING OUT OF BUSINESS in the very near term.

    SD is unlikely to go out of business anytime soon. While the price action in SD shares implies distress, the bonds do not. SD has about $2.6B in publicly traded Sr Notes outstanding, all of which trade at or near Par. Just this morning, $1mm face of the 8.625% Sr. Notes due 4/15 traded at 97½. The implied YTM at that price is 8.95%, which is essentially in-line with the average HY bond at 8.3%.

    Happy shorting…

  • Report this Comment On August 17, 2010, at 4:04 PM, Thaeger wrote:

    ( http://caps.fool.com/Ticker/SD/Stats.aspx?source=icasittab00... ):

    Short Interest

    Current Month (Mil) 25.98

    Previous Month (Mil) 50.53

    ---

    Back when the Arena merger was still giving them indigestion, this was peaking around 50 million shares shorted, which at the time was around a 35-40% short interest and, with the ~6mil daily volume, a pretty high short ratio.

    A month later, the merger is complete and behind us, and though there hasn't been a significant spike in price, the number of shorted shares has halved (with the remainder diluted by new shares issued as part of the merger)

    Between the rats abandoning a sinking short bus, and the positive, if tentatively so, news (merger, Q2, etc) surrounding a stock long shrouded with gray clouds, I would say that this is horrible time to short Sandridge. It's not that I believe the stock is going to rocket away in the near future, but all of what you've mentioned has long since been baked into the price. At the very _least_ the near-term future price of this stock is much more uncertain now, than it was when it had the 30%+ short interest.

    ----

    IMHO, that you would even advocate shorting at all on a site like this is borderline criminal (like anyone intelligent enough to take these articles seriously is going understand the risks, pay attention to disclaimers, or seriously do their 'due diligence'), and now days morbid curiosity is about the only thing keeping me clicking on TMF material.

    ---

    Other than that, this has probably been one of the better TMF articles I've seen in a while. You presented a lot of information and in an organized fashion, even if it was fairly superficial (no mention of merger, recent trends, etc, just a 'scratch the surface' snapshot of some numbers). This article has been a nice break from the usual "Hey, look at _this_ stock screen!" TMF articles that make me want to douse my head with brain bleach...

  • Report this Comment On August 19, 2010, at 2:49 PM, catoismymotor wrote:

    Book Value Per Share: -0.62

    Cash Per Share: 0.01

    Profit Margin: -64.92%

    Debt: $2.77B

    52 Week Change: -62.96%

    This company is a trainwreck.

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