We've had some good results shorting The Donald, the leading gene chipmaker, and the No. 2 satellite radio hopeful. But there are no guarantees in investing, long or short. Shorting is a generally short-term and risky strategy and need not be employed in your long investing life. But judicious shorting -- careful analysis of a business to determine it's deteriorating -- can juice your returns quite nicely.  

When we look at Guitar Center (Nasdaq: GTRC), we see a business in trouble. And lick our lips.   

Why Guitar Center?
You may have read two columns by Fool analyst Matt Richey (TMF Matt) on Guitar Center: Profit From the Downturn and Broken Strings at Guitar Center. Matt's analysis shows that, contrary to the company's rosy press releases, its financials reveal trouble, with shares priced like a business in clover. We like that opportunity. We like to short stock -- not when it's a good business highly prized by investors, such as eBay (Nasdaq: EBAY), but when it's a bad business highly prized by investors, ripe for a fall.

Why is Guitar Center in trouble?
In June, Matt identified 10 big, bad, blindingly bright red flags. Here's a summary: 

1. Increasing inventories. Inventory growth outstrips sales growth, leading to markdowns and contracting margins. Not good for retailers -- especially when facing the key holiday selling season.

2. Reported earnings overstate economic earnings. By trumpeting its earnings, the company overstates the cash economics of its business. It has reported positive free cash flow only once -- in 2000.

3. Mounting debt. The company uses debt, not cash flow from operations, to fund growth. Compare that to debt-free Abercrombie & Fitch (NYSE: ANF) or Hot Topic (Nasdaq: HOTT).

4. Declining ROIC over the last five years. Declining same-store sales growth means each new store is less productive than the last.

5. Major insider selling. They've sold 8.8% of holdings in the last six months.

And this just in...
Last week, after latest quarter's results, Matt fingered more culprits:

6. Massively leveraged balance sheet. A large 1.27 times equity.

7. Flow Ratio in the danger zone. The Foolish Flow Ratio helps track management of working capital and shows potential trouble in inventory and accounts receivable. We don't like anything over 1.25, and a number topping 2.0 is "Danger, Will Robinson!" Guitar Center's most recent quarter shows a lousy 2.72, up for two consecutive years.

8. Deteriorating margins. Guitar Center increased sales 18% year-over-year, but its net income was flat. If interest expenses hadn't declined, Guitar Center's income would've fallen. But all of this points to lousy net margins -- 1.6%, down from last year's 1.9%.

9. Full-year earnings guidance at risk. With the economy uncertain, and because almost all retailers depend on Q4 sales to fuel their entire year results, how solid is management's guidance? Matt explains that for Guitar Center to meet its forecast, it would have to produce a 3.5% to 3.8% net margin in Q4 -- more than double its Q2 net margin. Even if its new distribution center or a sudden updraft in the demand for guitars, amplifiers, electronic musical gizmos, and instrument rentals were to have dramatic effects, we wouldn't expect near that kind of margin increase.

10. Continued insider selling. Insider selling increased to 10.2% of insider shares. 

The RB shorting criteria
We call some of the Rule Breaker Portfolio's shorting criteria "buzzard bait." We want enough liquidity (one reason we decided not to short Research Frontiers (Nasdaq: REFR)), a share price above $7.00, and more current liabilities plus long-term debt than current assets, and relative strength below 10.

Guitar Center meets the first three criteria. The average daily share (200,000) and dollar (~$340 million) volume is about the company's current market capitalization. There's a smallish float -- 4.7 million shares -- but as of July, only 13% of that float was shorted. Days-to-cover stood at four, comfortably within our seven-or-fewer days preferred range. On balance, we believe there's enough liquidity to buy back shares at a favorable price when we want to cover our short position. Guitar Center also meets the second and third criteria. Its shares sell above $7.00 and has current liabilities plus long-term debt about 1.25 times that of current assets. Worse, its long-term debt plus revolving line of credit (a.k.a. short-term debt) balance relative to cash is a massive 35.6 to 1!  

The criterion it doesn't meet? Shares do not have a relative strength below 10. In fact, Guitar Center's relative strength is a whopping 85. It's a popular stock. This means any new interest could drive up demand for its small float and spur the price. But our thesis is that even though Guitar Center's shares have been lifted by the same gusts that have made consumer stocks favorites, its business fundamentals are so lousy that it will soon be seen as floating on air. Therefore, we'll bypass the relative strength criterion, but be prepared for the possibility of upward movement.

Closed -- not open -- situation
We have explored other criteria for shorting in this portfolio as well. We want businesses in a "closed" situation, not an "open" one in which growth could shatter its earnings estimates. Verdict here? Shut tight. Guitar Center operates in a highly fragmented market that even it estimates to be growing, at most, in the single digits. And what upside do you see for Q4 holiday buying at anywhere but, say, deep discounters? We agree with Matt's case that the year's earnings guidance is seriously at risk. It's fair to say that the business' best days -- fueled by debt-driven growth -- are over. It will likely have to retrench or hit a wall.

There are some risks. Stocks tend to move in the same direction. If most stocks are moving up, that threatens a short position, and a declining market pulls down long positions. All else being equal, and provided you bought the stock at a reasonable valuation, the longer you hold, the more likely the stock price is to follow value creation in the business -- up or down.  

That leads to the second risk. You need a margin account to short, because when you establish a short position, your broker is, in effect, lending you money. And there are Federal Reserve and stock exchange requirements about how much you can short versus how much equity you have in your account, explained well by Chris Lott and John Marucco. Make sure you understand how this works, and that if your short stock goes up in price enough so that the value of the equity in your account is below a certain level (it's a little complicated, so it's best to read the article and consult your discount broker's website), you may get a margin call from your broker and have to sell securities or deposit additional cash or securities to your account.

Also remember, shorting presents a risk-reward ratio the opposite of buying long: unlimited downside, but no more than 100% upside. You need to watch a short position more closely, and that's not something everyone wants to do.

We're shorting Guitar Center
We will short Guitar Center to the tune of 5% of the portfolio's value, today about $15,000, within the next five business days, in accordance with The Motley Fool's online portfolio trading policy.

Two caveats: Our broker must be able to borrow shares. It took all morning for our discount broker to obtain shares of Sirius Satellite Radio, but the stock had much higher short interest than Guitar Center.

Also, if Guitar Center's shares should slide before we short -- say, below $15.00 -- we are likely to reconsider. This is because, unlike Sirius and more like Affymetrix, we see a business in trouble but aren't convinced it's going belly up. The company could retrench before it hits the wall. This difference is important because if we think a stock is going to zero, it matters less at what price we short it: We earn 100% if it goes to zero, whether we short at $100 or $10. But if, as here, we think there are poor signs for business, and that the stock could be sliced in half if investors realized this, we're looking at a 50% return. So if the stock declines 30% tomorrow, the risk-reward ratio is much less favorable than it is today.

Finally, we won't set a target for covering our short, but will keep an eye on the business and the stock market's overall direction.

We might be wrong, but we're having fun. We use David Gardner's real money, make actual choices in the light of day, give you those decisions online for free, and then take our kudos and lumps (which you can contribute on our Guitar Center and RB Strategies boards!). No brag, just fact. Okay, maybe just a little brag. 

This quarter's deposit
Some final housekeeping. When we first announced we would add cash quarterly to the Rule Breaker Portfolio, we had two reasons. First, we didn't want to have to sell profitable positions and incur capital gains taxes to buy more stock. Second, we wanted to operate and encourage you to be like most individual stock investors, who save from paychecks and make regular investing decisions as available cash increases. Our latest quarterly deposit of $12,500 was due in July.

But our reasons for adding cash are not valid this quarter. To buy any new shares, we have about $27,000 in S&P 500 Depositary Receipts (AMEX: SPY). We also have several losing positions we could sell without incurring capital gains tax liability, and a profitable short position for which we will have to pay short-term capital gains whenever we cover -- whether today or years from now. So we'll add no new cash this quarter, and we'll review the situation in October and each succeeding quarter.  

Have a most Foolish week! Updated portfolio returns are below.

For advanced investors only: There's a way to turn shorting around -- to give you, at most, a 100% loss and more upside than 100%, but it's strongly suggested for advanced investors only. TMF analyst Zeke Ashton explains in the July issue of The Motley Fool Select.

Tom Jacobs (TMFTom9) shorts stocks but is neither short nor long. He's five feet ten and one-half inches. Yes, he still clings to that "half." He has no positions in stocks mentioned in this article. To see his stock holdings, view his profile. The Motley Fool has a disclosure policy.

Rule Breaker Portfolio Returns as of 8/19/02 Market Close:

            RB        S&P     S&P 500
            Port      500      DA*    Nasdaq
Week      +6.61%**   +5.19%   --      +6.63%
Month     +8.64%**   +4.29%   --      +4.91%
Year     -22.86%**  -17.19%   --     -28.55%
 8/4/94  +22.01%     +9.49%  +11.36%  +8.55%

*Dividends added.

**Please keep in mind that these figures will be distorted for the RB Port once a quarter when we deposit $12,500 in new cash. See next note! 

***Compound Annual Growth Rate using Internal Rate of Return. This performance measure accounts for the periodic deposits. Total return wouldn't be meaningful, because we started adding cash to the portfolio in July 2001. In a total return calculation, or (Current Value - All Cash Deposited)/All Cash Deposited, cash added shows up as returns.