You Won't Make Friends by Shorting Stocks

Recently, I've been exploring the idea of adding short-selling to my investing toolbox. I've always had a bit of a bias against shorting, but an article from my fellow Fool Matt Argersinger piqued my interest and had me looking into it a bit more.

As I kicked the tires of some of the methods for finding short candidates, I happened to mention both Yongye International (Nasdaq: YONG  ) and Melco Crown Entertainment (Nasdaq: MPEL  ) as stocks that I believed were flying red flags.

Inviting ire
In an article late last week, fellow Fool Tim Hanson made it very clear that he disagreed that either of these stocks should be on anybody's short list (pun intended). In fact, Tim has recommended both of the stocks as buys for the Motley Fool Global Gains newsletter.

Don't worry: As far as I know, Tim hasn't taken a contract out on my life yet. At the Fool, there are no sacred cows and we encourage differences in opinion.

A great point
In his article, Tim emphasized an important point -- that numerical red flags are nothing more than good starting points. If you're going to be a savvy short-seller, you need to go beyond those numbers.

However, the fact that Tim and I see things a bit differently highlights another important point about shorting -- that you'd better be ready to be one lonely hombre (or hombrette).

Long investors may feel like they're going against the grain sometimes by buying a stock that's out of favor. But in reality, those investors are always going to have a lot of company. Not only are their interests aligned with many other long investors, but undoubtedly management will also be playing up all of the positive aspects of the company.

It's a very different story for short-sellers. Having company on a short is actually a troublesome development for a short-seller because high short interest can lead to crippling short-covering rallies. Meanwhile, management will typically trip over itself to come up with explanations for why apparent red flags aren't actually worrisome.

In other words, while you need to be objective in your analysis, you also need to be ready to face vehement disagreement.

A breed apart
Infamous short-seller David Einhorn has had more than his share of successful, and highly publicized, shorts. His hotly contested campaign against Allied Capital led to the book Fooling Some People All of the Time, which pretty much epitomized how a short-seller can run up against a wall of disagreement and apathy from management, Wall Street, other investors, and even government agencies.

Einhorn only called off the dogs after Allied Capital had lost around 85% of its value and was acquired by Ares Capital (Nasdaq: ARCC  ) . Ares is managed by Ares Management -- a firm run by former Apollo Management executives that has $37 billion under management -- and it doesn't appear that Einhorn has any beef with the combined company.

Einhorn also clashed with Lehman Brothers, which fought his assertions tooth and nail right up until it slunk into bankruptcy.

Jim Chanos, who famously shorted Enron before its demise, was crowing about a short position in Ford (NYSE: F  ) in recent months. His take is that the company is going to struggle with United Auto Workers negotiations now that the group has an ownership stake in GM and Chrysler.

Do you think Ford management is going to agree with his analysis? How about the long investors who are watching the company return to profitability and churn out cash flow?

In short (there's that pun again), I don't expect that shorting stocks is ever going to end up as a chapter in Dale Carnegie's How to Win Friends and Influence People.

What of Yongye and Melco?
But we started with two very specific stocks here.

In his article, Tim notes that Yongye's cash flow has trailed net income primarily because the company has been aggressively investing in inventory. Which is very true. But that doesn't necessarily close the book on our concerns.

While it's good to see a company that's confident in its future, big investments in inventory do not always play out well. Holey-shoe specialist Crocs (Nasdaq: CROX  ) spent years pumping its cash flow back into inventory. Unfortunately, the future wasn't as bright as expected, and when sales tripped up, the company fell flat on its face and found itself writing down tens of millions in inventory.

As for Melco, Tim points out that the casino industry that Melco calls home is teeming with companies whose financial metrics suggest financial distress, so Melco's precarious-looking numbers aren't as out of order as it might seem. Of course, to that I'd say that Gary Busey wouldn't look all that out of place in the locked-door ward of an asylum. But that doesn't mean he isn't a wacky dude.

The fact is that most of the major casino companies operate very risky business models. They're highly levered businesses, and when it comes to their seemingly unending construction projects, they are -- as the gamblers would put it -- constantly betting on the come.

As Tim points out, Wynn Resorts (Nasdaq: WYNN  ) has navigated itself into a more secure financial position, but it's also one of the more conservative operators and is run by a casino industry legend. MGM Mirage (NYSE: MGM  ) , on the other hand, was pretty darn close to having to succumb to filing for bankruptcy -- and had to do some less-than-advantageous maneuvering to keep afloat.

That said, I haven't settled on either Yongye or Melco as a prime-time short candidate. And frankly, Tim and the team at Global Gains have come up with enough rocket-shot stock picks that it gives me major pause to bet against them. But whether or not I come to the conclusion that these are short-able stocks, I have no illusions that a lot of people will be nodding in unison with me.

Don't forget the payoff
What makes Einhorn, Chanos, and other great short-sellers so good at what they do? Among other things, they're independent thinkers willing to dig deep in their research and go against the grain. And while they may find themselves at odds with other investors along the way, their hard work and willingness to zig when others zag has paid off with tremendous results.

Think you have what it takes to find the red flags that other investors have missed or dismissed and profit from it? If so, you may benefit by going short with a portion of your portfolio.

John Del Vecchio, a forensic accounting expert, professional money manager, CFA, and all-around Foolish investor, has recently put together a report, "5 Red Flags -- How to Find the BIG Short." Whether you're new to shorting or are looking for an extra edge, John's report features some great ways to track down short-worthy opportunities. Just enter your email address in the box below, and we'll send you a copy of John's report for free.

And if you hear anything about a contract on my head signed by Tim Hanson, please do me a favor and drop me a line.

Fool contributor Matt Koppenheffer does not own (or have short positions in) shares of any of the companies mentioned. Ford Motor is a Motley Fool Stock Advisor pick. Melco Crown Entertainment and Yongye International are Global Gainsrecommendations. The Fool owns shares of Yongye International. 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.


Read/Post Comments (8) | Recommend This Article (15)

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 15, 2010, at 3:05 PM, pondee619 wrote:

    will any fool who has not written about short selling within the past 30 days, please sign in below. these fools claim to be indivduals with their own ideas, yet they sure pile on when a new service is coming.

    On September 14, 2010, at 9:19 PM, TMFKopp wrote:

    "yes, you're correct that we're launching a new service around short selling... Matt"

  • Report this Comment On September 15, 2010, at 3:57 PM, TMFKopp wrote:

    @pondee619

    Hey pondee, I'm a bit confused, do you have an issue with the article? With short selling in general? Or are you just trying to be disagreeable?

    Matt

  • Report this Comment On September 15, 2010, at 7:51 PM, anopenmind wrote:

    Comparing Crocs inventory of goods to Yong's?

    Is not that a bit of a broad spectrum? Crocs has unique product vs many many shoe competitors with their own unique, even more diversified line of styles of products. Drill into Yong's product base, distribution channel, and market base of customers.

    An expert even comparing these two makes me wonder....he be an "expert"?

  • Report this Comment On September 15, 2010, at 8:07 PM, TMFKopp wrote:

    @anopenmind

    Are Crocs and Yongye's products different? Absolutely. But we're talking about a more general concept here -- inventory management. Stack yourself up with more inventory than you can actually sell and you can run into trouble.

    You were a bit coy about the distinction you're making between Crocs situation and Yongye's, so I'm not exactly sure what in particular you're getting at.

    What I will say though is that it can have a great distribution channel and customer base, but if it stocks up too much inventory it still won't be able to sell it. Now, to be clear, I'm not saying that this has happened for sure, but the company has been investing a lot in that direction which makes the likelihood of that happening higher.

    Of course you're certainly free to disagree with me. This article was sparked by fellow Fool Tim Hanson suggesting that I was nuts for even hinting that Yongye and Melco should be on a short watchlist. (http://www.fool.com/investing/general/2010/09/03/should-you-....

    Matt

  • Report this Comment On September 17, 2010, at 10:12 AM, GorillaGorilla wrote:

    YONG had to keep it's inventory up because it couldn't make it fast enough during the summer! So, they had to make extra batches in the quiet season.

    Now that it has a new plant online they should not need the extra buffer. I'm expecting Q3's and Q4's inventory to be much lower than last year and hence more cash in the balance sheet.

    YONG is heavily shorted - most Chinese firms with liquidity are crowded with shorts.

    rich

  • Report this Comment On September 17, 2010, at 10:14 AM, GorillaGorilla wrote:

    Here's the short list 6 days to cover and climbing....

    http://www.nasdaq.com/aspxcontent/shortinterests.aspx?symbol...

    rich

  • Report this Comment On September 17, 2010, at 5:07 PM, TMFKopp wrote:

    @GorillaGorilla

    "Now that it has a new plant online they should not need the extra buffer. I'm expecting Q3's and Q4's inventory to be much lower than last year and hence more cash in the balance sheet."

    I'll keep an eye out for that. That would make a big difference.

    "YONG is heavily shorted - most Chinese firms with liquidity are crowded with shorts."

    Yeah, this is actually one of the things that would worry me the most about shorting a stock like this. I talked about this more generally here: http://www.fool.com/investing/general/2010/09/10/5-stocks-id...

    Matt

  • Report this Comment On September 20, 2010, at 10:48 AM, pondee619 wrote:

    Matt:

    I have a problem with the fool hyping shorting like it is the investors best friend only because you have a new "service" coming out. Shorting has never been one of the fools' tools and has, in the past, been shunned, (where, in your 13 steps, does shorting fit?) it's dangers carefully outlined. I find it disturbing that all fool "indivdual thingers" come out in favor of shorting once the fool has a new "service" coming out, with little more that lip serice to its dangers.

    Says you:

    " I've always had a bit of a bias against shorting," but now the fool has a new shorting "service" and I gotta sell you on it.

    Sell a "service", Matt. fool writers may not agree on a stock ( whether to buy it or short it) but they sure fall in line when there is a "service" to sell.

    My problem is not with the article, it really does not say anything. I don't have a proplem with shorting in general, other than its inherent dangers, nor do I just feel like being disagreeable. The sudden rush of "stories" extoling shorting on the advent of your new "service" without fully explaining the dangers is troubling, contrary to the Fool's prior statements regarding investing and a dis-service to your readers. Since fool writers fail to point this out, I will.

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