Wrap yourselves a bit tighter in your securities blanket, Fools, and gather a bit closer to the fire. Tonight we've got a tale of woe to tell, a grisly story of investors courting a metaphorical bloodbath. Anyone betting against Motley Fool Hidden Gems recommendation Select Comfort (NASDAQ:SCSS) is setting themselves up for a ghastly fall.
Can 4.6 million short-sellers be wrong?
According to the ultra-accurate and constantly updated data miners at Capital IQ, 4.6 million shares of Select Comfort -- 13.2% of the stock's float -- are currently sold short. While that could, in theory, mean that 4.6 million people feel bearish on the stock, it's more likely that a much smaller circle of investors is taking on a proportionately larger pile of risk in betting against this company's success.
With close to $94 million in stock value at risk here, the stakes are high. Now, it's accepted wisdom that "shorts" -- investors who hope to profit by borrowing shares of a company they do not own, selling those shares, and then buying them back at a lower price -- are smarter than your average bear (so to speak). But I fear that the short sharks circling Select Comfort seriously underestimate the company.
Facts are stubborn things
That quote's apropos here, because the facts suggest that Select Comfort's anything but easy pickings. Let's review once more the major elements of a valid short thesis, as laid out in Hidden Gems co-analyst Bill Mann's seminal piece, Betting Against the House: Shorting for Profit (yours free for trying a subscription). To recite just a few of Bill's suggestions, you probably do not want to short a company unless it has:
- Minimal profits
- Massive stock option issuances
- Massive debt
- Excessive valuation
The problem with Select Comfort, as a shorting candidate, is that it strikes out (in a good way) on each of those elements. In fact, Select Comfort:
- Has booked $35 million in profits over the past year.
- Has held its share count fairly constant since the beginning of 2004.
- Has no debt whatsoever. On the contrary, and in fine contrast to its comfy bedding, Select Comfort boasts the proverbially "rock solid" balance sheet, replete with nearly $60 million in cash and equivalents.
- Is valued pretty reasonably at 22 times net earnings and 23x free cash flow (FCF). What's more, if you net out the company's sizeable pile of cash to arrive at its enterprise value (EV), the company sports a most attractive EV/FCF ratio of 21. Far from suggesting overvaluation, each of those valuations actually offers a discount to both the company's return on equity and its projected long-term growth rate.
In summation, stock-shorting ghouls would be better off feasting on the walking dead of the equities world. Companies like Select Comfort, with sound balance sheets, sizable profits, fair valuations, and minimal stock dilution, won't make the tastiest snack for salivating short-sellers.
Incidentally, this isn't the first time we've warned against the folly (small "f") of betting against Select Comfort. Had the shorts been listening even as recently as last month, perhaps they would have avoided yesterday's bear-baiting carnage.
Don't be scared! Pour yourself a mug of hot cocoa and curl up with the latest comforting issue of The Motley Fool's premier small-cap newsletter, Motley Fool Hidden Gems . You can try it out free for one full month . And there's no need to fret -- if you don't absolutely love it, you'll be free to cancel any time within that month. No tricks, we promise.
Fool contributor Rich Smith owns no shares in any company mentioned in this article.
