Will You Profit From the Next Subprime Meltdown?

Readers of Michael Lewis' The Big Short will undoubtedly remember Steve Eisman. Brash, acerbic, and completely uninterested in beating around the bush, Eisman was described as a man that said exactly what was on his mind.

Eisman's wife boiled it down simply for Lewis:

Even on Wall Street people think he's rude and obnoxious and aggressive. ... He has no interest in manners. Believe me, I've tried and I've tried and I've tried.

But whatever else Eisman is, he was also -- as Mona Lisa Vito would put it – dead-on balls accurate when it came to the subprime mortgage meltdown. Eisman and his partners at FrontPoint Partners bet against the subprime mortgage market to the tune of hundreds of millions of dollars, and when Armageddon struck, they smiled all the way to the bank.

And now he has a new target
A BusinessWeek article from earlier this year quoted Eisman as saying:

Until recently, I thought that there would never again be an opportunity to be involved with an industry as socially destructive and morally bankrupt as the subprime mortgage industry. ... I was wrong. The for-profit education industry has proven equal to the task.

For-profit education companies such as Apollo Group (Nasdaq: APOL  ) (parent company of the University of Phoenix), ITT Educational Services (NYSE: ESI  ) , Strayer Education (Nasdaq: STRA  ) , and Corinthian Colleges (Nasdaq: COCO  ) have been Wall Street darlings in recent years thanks to heady growth and healthy profit margins.

But Eisman's views on these for-profit educators have landed him smack in the middle of a very public, very heated debate about how much the U.S. government should crack down on the industry. In a variety of venues -- including testimony in front of a Senate committee -- Eisman has slammed the industry, comparing it to the subprime mortgage industry that he so gleefully shorted into oblivion.

His critics, meanwhile, paint him as a greedy Wall Streeter doing what's right for his own bottom line while potentially imperiling the educational opportunities of the less fortunate.

Are you ready for your public showdown?
No you say? Well that's A-OK.

From what I've read about Steve Eisman, he strikes me as a very sharp guy. When it comes to his investing, though, Eisman seems just as concerned -- if not more concerned -- with demoralizing those he sees as doing wrong as much as he does with scoring a big financial windfall.

In The Big Short, Lewis writes that Eisman "was emotional, and he acted on his emotions. His bets against subprime mortgage bonds were to him more than just bets; he intended them almost as insults."

But throwing emotionally charged thunderbolts isn't everyone's style. And, in fact, my fellow Fool John Del Vecchio -- a forensic accountant and a successful short-seller in his own right -- believes short-sellers are better off away from the heat of the spotlight. In a recent report, he wrote:

Like all investing, the purpose of short-selling is to make money. Petty conflicts with management and rooting against a particular stock in the media aren't just distracting, they can cost you money. The best short sellers are the ones you never hear about until AFTER the fact.

A better way forward
But just because we're not about to launch into an impassioned conquest to vanquish financial-market evildoers doesn't mean that we should forget about shorting stocks. As my fellow Fool Matt Argersinger points out, there are so many underperforming stocks out there that it almost doesn't make sense to not have some portion of your portfolio in shorts.

So what should we be on the lookout for? Well, we're going to want to avoid stocks that short-sellers are already flocking to, because it can get dangerous if they all begin to cover their positions at once. That means looking for stocks with low short interest.

Past that, there are a variety of financial red flags that can help lead us to companies that might be short-worthy. One of those red flags is when a company's cash flow lags its accounting net income. A gap between net income and cash flow is often seen with young, growing companies that are trying to grow as quickly as possible and are plowing a lot of money into inventory and allowing favorable credit terms to new customers.

It's important to note, though, that it's not necessary for a company to plow tons of money into working capital in order to grow. Over the past decade, Urban Outfitters (Nasdaq: URBN  ) has grown its revenue more than 600% and net income has expanded some 15-fold. Every year during this growth spurt, the company delivered cash flow in excess of its net income.

The company's effective management of its working capital has helped it continue to fuel growth while maintaining a stellar balance sheet. Today, Urban Outfitters has nearly $600 million in cash against zero debt.

For a lesson on how growth can go wrong, we can turn to pretty much any of the homebuilders. Take Standard Pacific (NYSE: SPF  ) , for instance. Like many of its competitors, it surrendered its cash flow to sink billions into inventory during the housing boom. You can probably guess how that movie ended -- the company marked down billions in assets and recorded hefty losses as the housing market reversed course.

That was then
Eisman's subprime victory and the demise of the homebuilders may be in the history books, but there are still many places for investors to look today for short opportunities.

One stock I've just recently added to my short watch list is AutoChina (Nasdaq: AUTC  ) . The company runs a lease-to-own business in China, allowing rural Chinese customers to get their foot into the trucking business.

Now there's no established credit-rating system in China, so we can't technically say that the company is a subprime truck leaser. But it doesn't take a Spidey sense to smell the risk in lease-to-own trucks in rural China.

But it was the recent yawning gap between net income and cash flow that put the company on my radar. Digging in a bit more to figure out exactly what was driving the difference, I found out that the company is brimming over with related-party transactions.

Related-party transactions arise when the company in question does business with a separate company that an executive officer or board member has a financial interest in. To me, these are always a red flag because there's just too much opportunity for funny business when insiders have conflicts of interest.

In the case of AutoChina, the related-party transactions include tens of millions in financing agreements and the purchase of trucks from and the sale of trucks to companies partially owned by AutoChina insiders.

I'm continuing to dig further into AutoChina to figure out whether its inside dealings constitute shortable shenanigans or not. You can certainly take a crack at figuring out the rest of that puzzle on your own, or you can get started finding short opportunities of your own.

If you need a hand to get you going, John Del Vecchio has put together a report -- "5 Red Flags -- How to Find the BIG Short" -- that covers five of his favorite short-selling red flags. If you'd like a free copy of John's report, just enter your email address in the box below.

Fool contributor Matt Koppenheffer does not own shares of any of the companies mentioned. Apollo Group is a Motley Fool Inside Value choice. 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 Fool's disclosure policy assures you no Wookies were harmed in the making of this article.


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