Fuqi Looking Spooky: Why Are Investors Shorting This Stock?

Editors note on top: A previous version of this article encouraged investors look at the company's financial statements. However, Fuqi has yet to issue last year’s 10-K or subsequent quarterly filings. In addition, any reference to LTM in tables or charts below refers to the last 12 reported months from filing for the period ended Sept. 30, 2009.

At Fool.com, we believe in buying great companies for the long term. However, not every company commands a fair price, and many trade for far more than they're actually worth.

In these situations, investors actually have a chance to benefit from a stock's plunge. When shorting a stock, an investor bets that price of a stock will go down, and profits from any downward movement. The practice is risky, inviting unlimited losses while only providing limited upside. However, shorting wildly overvalued companies can also help balance your portfolio against the wild market swings we've seen in previous years.

To find shorting candidates, we screened for stocks with a high percentage of their publicly traded shares sold short. One such stock is Fuqi International (Nasdaq: FUQI), with a current short interest of 20.26%. That's pretty high, but let's see how it compares to other companies in its industry:

Source: Capital IQ, a division of Standard & Poor's.

We consider short interest greater than 5% to be a warning sign. While plenty of great companies can carry high short interest, that red flag is your invitation to dig for troubling information that the company's buyers might be missing.

When evaluating short candidates, start by assessing their near-term financial health. To check on Fuqi International's immediate health, we looked at its current ratio, which simply divides its current assets by its current liabilities. The more assets a company has -- cash, inventory, and accounts receivable, among others -- the more easily it should be able to pay off its obligations in times of financial distress.

Fuqi International's ratio in this category was last reported at a solid 4.32. We look for a current ratio greater than 1.0:

Source: Capital IQ, a division of Standard & Poor's.

Once we've assessed a company's short-term financial health, next we determine whether it's overstating its earnings. Earnings are meant to show a smoothed-out picture of a company's profit potential over time. However, they're prone to various assumptions and manipulations. Companies can aggressively recognize revenue, or show high earnings even while they pour excessive amounts of cash into capital expenditures that are slowly accounted for over time.

For this reason, it's best to compare free cash flow to earnings. Free cash flow accounts for the actual cash flowing out of or into a business, and then subtracts out actual capital expenditure costs over a given period of time. In the last 12 months it reported, Fuqi International has burned $21 million in cash, while booking $48 million in earnings.

Fuqi International's free cash flow has trailed earnings on average. We consider this a possible warning sign. If free cash flow is showing a consistent trend of underperforming earnings, it could mean that the company is overvalued according to its stated earnings. Alternately, it might be recognizing earnings too aggressively, which could lead to free cash flow declines in the future.

Source: Capital IQ, a division of Standard & Poor's.

One last consideration for shorting a company is valuation. Excellent companies often trade for prices that aren't justified by their business's long-term outlook. Think back to the dot-com bubble: While technology companies like Amazon.com would eventually produce large profits, at the time, they lacked business models and future earnings streams to justify their mammoth market capitalizations.

The PEG ratio is a simple measure of whether a company is excessively valued. It compares a company's P/E ratio to its estimated growth rate. We compared Fuqi International's expected P/E ratio of the next 12 months relative to its five-year estimated growth rate. As an investor, you'd look for companies trading at P/Es less than their growth rate. As seen in the table below, Fuqi International currently trades at PEG ratio of 0.34.

Source: Capital IQ, a division of Standard & Poor's.

With a PEG ratio of less than 1.0, based on the PEG ratio Fuqi International looks attractively valued relative to its expected growth. However, with micro caps analyst estimates are prone to large fudge factors. In the case of Fuqi, the biggest red flag leading to heavy shorting is almost certainly the company’s lack of recent filings with security agencies. The company hasn’t yet filed its 10-K for last year, and has yet to follow up with any 10-Q’s after the third quarter of last year.

The long road to superior shorting
Identifying good short candidates requires diligent research. More importantly, you've got to know where to dig into a company's financial statements. While the measures we showed above are a great start in searching for shorting candidates, red flags like accelerating revenue recognition, aggressive acquisitions to hide underlying financial weakness, and changes in reporting methods can only be spotted by carefully analyzing the notes companies bury deep in their filings.

Finding these opportunities requires skill, but you can do it. That's why John Del Vecchio, CFA, a leading forensic accountant and The Motley Fool's shorting specialist, put together a detailed report that shows you how to spot five serious red flags that can help you detect time bombs in your portfolio and lead you to the next big short. You can get the entire report free by clicking here or by entering your email address in the box below.