7 Short Ideas

If you own stock in the companies listed below, you're not going to like what I'm about to tell you. You and the management team will probably deny everything I'm about to share, and will even claim that this doesn't apply to you and your stock.

That's fine. But if the research is accurate, short-sellers could make killing on several of these stocks.

Research says ...
Stocks plummet when companies negatively restate past earnings, or when growth fails to materialize. Worse yet, stocks crater when reporting is fraudulent; just pull up a 2008-2009 stock chart on Satyam to see how bad the damage can be. Research shows that earnings manipulation takes only 19 months on average to become public after the fiscal year of the first violation.

The problem comes about because investors love growth stocks and their managers. This pressures management to maintain excellent reported results, even as the business eventually slows. At this critical juncture, some management teams decide to delay the inevitable earnings miss by getting aggressive with their accounting. Ultimately, investors punish the stock when the truth comes out.

How would you like to get out before the bad news hits? Or better yet, profit by shorting the stock before earnings manipulation becomes common knowledge?

How to find potential manipulators
Dr. Messod Beneish, the Sam Frumer professor of accounting at the Kelley School of Business, is an expert at predicting and understanding the consequences of earnings management. With surprising accuracy, his model can detect  the companies that are most likely to manipulate their financial reports to mislead investors.

In testing, his model identified about half of the companies that misstated their earnings, using eight criteria weighted to maximize success. Most importantly, it found these companies before their poor earnings quality became public knowledge. This provides investors an opportunity to avoid losing money, or even earn outsized returns, by shorting.

Let's look at these factors -- all easily calculated from financial statements -- to better understand just how robust this model is. If accounting isn't your thing, or you just want to get the dirt first, skip to the next section on the M-score.

1. Days sales in receivables index: This ratio compares year-over-year changes in how soon a company collects its receivables relative to sales. A large increase can signal a tighter competitive environment that's forcing the company to loosen its credit policy. Even worse, management could be accelerating revenue recognition and inflating earnings. Both are situations worth avoiding.

2. Gross margin index: This ratio compares this year's gross margin with last year's. If margins are decreasing, it may mean that the business is facing tougher competition, or that costs are going up. When faced with a poorer future, companies are more likely to stretch -- sometimes with creative inventory accounting-- to hit earnings targets.

3. Asset quality index: This measures the ratio of non-current assets other than plant, property, and equipment to total assets. An increase can indicate that management is deferring costs to increase profits. The ratio can also increase because the company made acquisitions that added a significant amount of goodwill to the books over this period.

4. Sales growth index: Fast-growing companies are under tremendous pressure to maintain growth targets, because one miss can spell disaster for their shares. Therefore, management may also feel the need to manage earnings. This measure means nothing nefarious on its own, but in combination with the other factors, it may highlight teams with great incentives to deceive investors.

5. Depreciation index: If the rate of depreciation slows down between two years, it may indicate that management has increased the useful life of key assets, or even changed its depreciation methodology. Without proper justification, this points to lower earnings quality.

6. Sales, general, and administrative expenses index: If SG&A expenses increase disproportionately faster than sales, the business may be facing poorer prospects, and therefore be more likely to manipulate earnings.

7. Leverage index: Increasing leverage year over year can increase a company's financial risk and may put a strain on existing debt covenants.

8. Total accruals to total assets: This measures the change in working capital (excluding cash) less depreciation versus total assets. A higher percentage of accruals points to lower earnings quality. This is a primary way that managers have discretion over reported earnings.

M-score
The above data points are collectively weighted and summed to produce an "M-score." When a company scores higher than -2.22, it is labeled a "likely manipulator," signaling a short opportunity. Of course, as with any statistical measure, you need to do your due diligence prior to shorting. But if you're not inclined to do your homework, I would at least stay away from these companies.

Short these offenders?
I've calculated the M-score for all the companies in the S&P 500, and included a few companies that the model identified as likely earnings manipulators. Before you breathe a sigh of relief that a company isn't on my short list, you should know that this list isn't exhaustive. In fact, I'm sure there are even worse offenders -- and even outright fraudsters -- who've trained themselves to pass this test.

Company

Price

P/E

M-Score*

Verizon (NYSE: VZ  )

$30.84

119.2

-2.17

Qualcomm (Nasdaq: QCOM  )

$40.90

21.50

-1.13

CVS Caremark (NYSE: CVS  )

$28.75

11

-1.98

Halliburton (NYSE: HAL  )

$30.22

22.9

-1.95

The New York Times (NYSE: NYT  )

$8.23

15.3

-2.05

Intuit (Nasdaq: INTU  )

$43.98

26.5

-2.01

Akamai Technologies (Nasdaq: AKAM  )

$50.12

61.7

-2.01

*Calculated using data from Capital IQ, a division of Standard & Poor's, as of Aug. 9, 2010.
P/E = price-to-earnings ratio.

This list should give investors pause. Many M-score criteria measure qualities correlated with manipulation, instead of directly measuring accounting trickery. However, the test has a high success rate. Great products or not, if you own any of the stocks in the table, you may want to revisit your analysis in light of these results.

If you're interested in protecting your portfolio from ticking time bombs or in 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.

Nick Crow is an analyst with Motley Fool Pro and Motley Fool Options. Thankfully, he doesn't own shares in any of the companies mentioned, but he isn't short them either. Akamai Technologies is a Motley Fool Rule Breakers recommendation. The Fool owns shares of Qualcomm. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Motley Fool has a disclosure policy.


Read/Post Comments (6) | Recommend This Article (5)

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 September 10, 2010, at 4:23 PM, kramsigenak wrote:

    So now instead of investing, the Fool is pushing yet another new "service," teaching us how to short stocks. Short Short Short, it's all we're gonna hear from the Fool so they can make a buck. First options, now shorting. Next it'll be trading on inside information. F you Fool. What happened to buying quality stocks to hold them... remember your preaching about Buffett? Screw the new Fool, time to think about canceling subscriptions... Short Short Short the Fool.

  • Report this Comment On September 10, 2010, at 7:37 PM, easyavenue wrote:

    Are you some kind of fool?! [Couldn't resist.] If you dislike the Fool that much, perhaps you would be better served, and would save us from your ignorant tirades, by going elsewhere. Please. It is obvious you're not capable of appreciating the lesson the article teaches. Of course they're going to hock their wares, so what? It's part of what they do. Get over it. Or get help. Seriously.

    I think the article provides me with more and better tools for examining companies and their value. I am grateful for this article because it could well save me some money. If a company I think is otherwise a good investment is manipulating their numbers to look good I sure would want to know that before I put my hard earned money behind them.

  • Report this Comment On September 11, 2010, at 7:11 PM, tcaffrey wrote:

    Shorting stock for the average investor is like throwing your money away , this is not a practice to be advised for the average investor

  • Report this Comment On September 12, 2010, at 7:09 AM, lcmesquita3206 wrote:

    This article is very informative. Very aggressive traders might consider shorting the stocks with a suspect M-score listed above. Not being an agressive trader myself, I am definitely selling one stock listed above that I currently own, and avod another stiock that is on my current screen of potential buys. Once agin I would like to commend the author for providing this very useful information.

  • Report this Comment On September 13, 2010, at 12:11 PM, rav55 wrote:

    oh yeah short Qualcomm. It seems that Apple is dropping Infineon for the next gen Iphone and qoing with Qualcomm. Intel is not to well appreciated.

  • Report this Comment On September 13, 2010, at 6:04 PM, BadCopNoDonuts wrote:

    The fool has never gotten any money out of me, and they never will. The increased number of daily headlines is a huge turn-off.

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