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.
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.