Are These Stocks a Short-Seller's Dream?

Apple (Nasdaq: AAPL) appears to be every short-seller's worst nightmare. In the early part of this decade the stock was left for dead. Its Mac computers appealed primarily to a niche audience of designers, a diehard group that supported the company, seeing themselves as the ragtag rebels fighting against the Death Star and Emperor Bill Gates ... er, Palpatine.

But then Apple developed the iPod. And the iPhone. And the iPad. And the iMousetrap.

And less than a decade later, the house that Jobs built has become the second-largest in the world, and everyone has beaten a path to his door. Despite these successes, Apple is still a short candidate.

But I wouldn't short it just yet.

Do I contradict myself? Very well then.
Now, the classic argument against short-selling is that you risk completely blowing up your portfolio because a shorted stock can rise to infinity. In contrast, when you go long, you can never lose more than you put in. Pop quiz, hotshot! How many stocks have you seen climb to infinity?

(I haven't seen one either.)

That truism about stocks going to infinity amounts to little more than a scare tactic. And scare tactics are always aimed at preventing rational decision-making. In fact, properly allocated and hedged, short positions can provide you a way to make money in all market environments. Yes, even in rising markets.  And yes, even with otherwise winning companies such as Apple.

There have been plenty of fantastic companies whose stocks have been chopped in half along their journey to further greatness.

Source: Yahoo! Finance and Capital IQ.

In fact, it's almost a rule that great companies get whacked like this. Some have seen Mr. Market ax them multiple times, but their indomitable franchises mean these market beaters keep setting new highs.

Google has a stranglehold on search such that superinvestor Charlie Munger has said that he's never seen a competitive moat like it. Amazon too is in an enviable position, as the e-retailer becomes a platform for other retailers to hawk their wares, taking a slice of everything that moves through its site. Chipotle has shown remarkable profitability on its megaburruitos, and same-store sales have exploded as has its store count. Bank of America's size gives it a huge scale advantage and opportunities to cross-sell financial products to millions of Americans.

Still, as shown by their whopping declines, the opportunity exists to make money on even great companies by going short.

But the thing you must never, never do is short on valuation alone. Shorting just on valuation is the same as guesswork. If the market goes irrational and decides to value Apple at a nosebleed multiple of 50 times earnings, what's to stop the insanity? Why can't the market value Apple at 60 or 70 times earnings? Or 100 or 200? Look at Amazon's P/E ratio, and even Chipotle's, right now. If you've invested during the dot-com era, you know exactly what I mean. You can't talk sense to an irrational Mr. Market.

Or can you?
One of the best ways to begin is to look for a divergence between a growing stock price and operational performance. Such was the case for Sirius XM Radio (Nasdaq: SIRI), a story stock if there ever were one.

Shares rose 10-fold from early 2003 until late 2005 despite the fact that the company's bottom line worsened each year. From a $226 million loss in 2003, the company lost progressively more until 2006, when it posted a loss of $1.1 billion. Amazingly, near the end of 2005 the market valued the company at over $9 billion -- for a company with just $242 million in revenue and generating losses over four times that amount!

Today, Sirius is generating free cash flow and hardly looks like a short candidate. Yet in the meantime, shares have fallen more than 80%.

But how else can you find short candidates? Search for the following characteristics:

• A sales slowdown. Since profit is ultimately derived from sales, a slowdown in sales growth can hit a company's bottom line hard, especially if a company has high fixed costs.
• Increasing days sales outstanding (DSO). Companies in difficult times often stretch their payment terms in order to gain more sales, and this is reflected in higher DSOs, the number of days it takes a company to collect revenue after a sale. Such a trend could also reveal that the company is having trouble collecting from customers, which could lead to further writedowns on receivables.
• Increasing inventory. Inventory levels growing much more rapidly than sales can signal that a company is having difficulty moving its products. Ultimately, this may lead to a writedown of inventory or falling gross margins as the company accepts lower prices in order to clear its shelves. If increasing inventory is mixed with a sales slowdown, it can drastically affect profit.

Let's look at Gamestop (NYSE: GME), which looks like a potential short candidate. Sales growth in the last six quarters has slowed markedly. DSOs don't appear to be a problem; customers pay with cash or credit, so the company collects promptly.

In contrast, for the last few years, inventory per day has been increasing in the quarter before Christmas … and then stayed higher year-over-year in the following quarter.

But does the company have high expectations? With a P/E ratio of about 8, maybe not. But over the last year or so management has consistently guided expectations much higher than it has been able to achieve.

And there are other warning signs: difficulty generating same-store sales growth even as the company builds out its store base, a management that overpromises, and a recent share buyback to help boost earnings per share. Add in the fact that Gamestop is a brick-and-mortar business in a world moving to Internet distribution, and it starts to look like the Blockbuster of video games.

So what about that short of Apple that I mentioned before? Well, according to one series of tests based on data from a noted accounting researcher, the company is raising some red flags that could be worth researching further. And given the expectations built into the company, a stumble in operations could really throw the market for a loop. But I'm waiting for even more expectations to be priced into the company: The bigger they are, the harder they fall.

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.