Why Stocks Go to Zero

Last column, I confessed to having once peddled high-priced research to institutions, including some notorious short-sellers. I say "confessed" because I've always found the notion of selling the U.S. markets short if not un-American, well, at least a bit unsavory.

Don't get me wrong. The companies the shorts were attacking had it coming, to say nothing of the money-grubbing, new economy executives who were essentially looting their own shareholders. Those were the halcyon days of Healtheon, after all -- and theglobe.com and Healthsouth and Enron.

Bad times for honest investors like us
So, yes, I understand that short-sellers play a role in well-functioning markets. Bad people at bad companies do bad things, and it benefits no one to prop up their shady regimes. Still, when I learned that a professional short-seller was setting up shop at The Motley Fool, I had a few questions.

The guy's name is John Del Vecchio. He's a chartered financial analyst and calls himself a forensic accountant. Shocker, he doesn't agree that shorting is un-American -- or un-anything for that matter.

"If you grew up in Detroit," Del Vecchio admits, "shorting General Motors in recent years might have seemed un-American. But GM had problems. Its business model was outdated. It faced new competition. And so on. GM had years to fix its problems but was complacent. Short-sellers didn't create GM's problems. They pushed them to a resolution. In the end, America will be the better for it."

The same fate awaits Microsoft (Nasdaq: MSFT  ) and Intel (Nasdaq: INTC  ) at some point, Del Vecchio guarantees. "The shorts will be the first to see the end coming."

What's that, now?
"Even God-like Google (Nasdaq: GOOG  ) isn't above the business lifecycle," he suggests.

Microsoft and Intel must transition from the PC to the Internet model. Quite simply, they must figure out a way to leverage their skills in computing software and semiconductors, respectively, to remain a world increasingly shifting to smaller connected devices and cloud computing. Otherwise, competition will make them irrelevant.

Google, meanwhile, is the kingpin of search. But five years from now, there is no way of knowing what new technology will be out there -- or how the companies will react.

(In fact, social networking sites like Facebook are already encroaching on Google's monopolized share of Internet traffic. If they attempt a foray into search, it could be disastrous for the technology Google already thinks it has in the bag.)

"If you're not convinced, think of Xerox or Kodak (NYSE: EK  ) or even General Motors. In 1970, all three were utterly dominant. If I'd said what I just said about those three companies, you'd have burned me at the stake. And when it comes to slam-dunk short candidates, once-dominant companies 'jumping the shark' are just for starters," Del Vecchio insists.

"Kodak is still struggling for relevancy, which is evident in their numbers. Revenue continues to trend downward. Accounts receivable as a percent of revenue rose from 51% to 65%. I could go on and on."

Fair enough, but I was actually interested in the bit about the shorts being the first to see it.

Del Vecchio catches up: "Technically, the folks on the front line see it first, then the regional managers. When it bubbles up the management chain, the shenanigans begin. That's when I pounce. But even if management plays it straight, a top-notch short can sniff out the trouble. Longs never see it coming."

Here's where it gets interesting (finally, right?)
Shenanigans should be easy to spot, according to Del Vecchio, yet even professional investors miss the clues.

Say a company starts offering generous payment terms -- maybe 25% off and 360 days rather than 90 days to pay. Here's where the pros get it 100% wrong. They focus on the customer behind those receivables. If that customer is a reliable, heavy hitter like Cisco which has almost $25 billion net cash on its balance sheet, they assume the receivable isn't at risk and go on their merry way.

They're probably right, of course. But I couldn't care less about the receivable. A company that pulls revenue forward from a future quarter creates a revenue gap that will have to be filled. That alone can cause an earnings miss. More important, when management resorts to such tactics, it tells me everything I need to know about end demand.

"My earnings quality model will be the first to pick this up," insists Del Vecchio, "CEOs lie. The numbers don't."

Back in the day, identifying a deteriorating business was like finding a needle in a haystack. We literally had to comb through the quarterly and annual filings, focusing on the footnotes.

Now, models like Del Vecchio's constantly "pull massive amounts of data from increasingly reliable sources, analyzing trends in four or five dozen financial metrics that point to red flags in real time."

Lots of guys can pull the data. The secret sauce -- and what sets a great short-seller apart -- is defining the metrics to monitor and grade.

So, how do you learn this stuff?
Like everything, there's an easy way and a hard way. After leaving The Motley Fool in 1999, Del Vecchio had the good fortune of working directly under Howard Schilit, author of Financial Shenanigans and a pioneer in the field of forensic accounting. He also worked alongside notorious short-seller David Tice on his now-famous Prudent Bear Fund.

"I'm a skeptic by nature," he admits. "I know that there are always companies that are going to outperform. I even made money during the bull market of 2003-2007 -- shorting stocks. But I understand people are optimistic. That's OK. Even long-term buy-and-hold investors can add shorts to their overall portfolio and benefit from it, especially in this market."

Not calling for a market crash
Del Vecchio argues:

There's a common misconception that short-sellers are un-American or evil, or that we're always hoping for a market crash. In fact, in a well-functioning market -- even in the strongest economic period -- most companies will always be losers (remember, I made a great deal of money shorting stocks in the last bull market). The best investors I've met make money on both sides of this inescapable equation.

Say, for instance, Motley Fool Stock Advisor has a conviction long idea. Let's say it's Microsoft. And my proprietary EQ-Scan model -- which looks for aggressive accounting and financial shenanigans -- shows me that Citrix Systems (Nasdaq: CTXS  ) is heading for a miss. In fact, my model unabashedly gives Citrix an "F."

Days sales outstanding are steadily rising, indicating the company might be accelerating revenue recognition. Not to mention, accounts receivable as a percent of revenue spiked in the most recent quarter, from 59% to 70%, indicating the company might be getting more lenient in permitting customers to order on credit -- which can (and often will) work out for the worst. "Pulling revenue forward" is an aggressive tactic that always merits further investigation.

We can short Citrix and go long Microsoft. If we're right on both companies, we can make a ton of money. Even if Citrix goes up, so long as it lags Microsoft, we're still ahead and have dramatically reduced our risk. That's just one quick example.

Listen: We love the occasional blowup. But let's face it, massive stock market corrections and catastrophes like Citigroup (NYSE: C  ) and AIG (NYSE: AIG  ) in 2008 come around just so often. It's the low-risk trades that what we're all about. Over time, they allow us to consistently generate a few extra percent per year with much lower risk -- and that's critical in a low-return environment like this.

AIG still owes the U.S. government a whopping $102 billion for its massive bailout. Any cash it might squeeze from asset sales and its insurance operations probably won't be enough to cover this. Citigroup's above-average exposure to consumer banking makes it extremely vulnerable to more pain in the housing market and new restrictions on consumer credit thanks to the financial reform act.

What to do now ...
As a rule, I don't short stocks -- yet. But I have to admit I'm impressed with Del Vecchio's methodology and the brute-force screening power of his earnings quality model. And if a proven "forensic accountant" with a track record of beating the marketing on the short side has evidence that a company I own is cooking the books or finessing earnings, I want to hear about it.

If you feel the same way, do this. Put your email address in the box below, and I'll send you his latest report -- as well as an invitation to his latest service, The BIG Short.

Fool writer Paul Elliott does not owns shares of any of the companies mentioned in this article. Google, Intel, and Microsoft are Motley Fool Inside Value picks. Google is a Rule Breakers recommendation. Motley Fool Options has recommended buying calls on Intel and a diagonal call position on Microsoft. The Fool owns shares of Google, Intel, and Microsoft. If you're interested in shorting stocks or want to hear more about John Del Vecchio's research, send me an email by clicking here. 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 has a disclosure policy.


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