Short sellers have made millions throughout the years by identifying precarious companies trading for rich premiums, then riding those investments down to the ground. As you probably know, shorting can be quite lucrative -- assuming you do your homework first.

The most successful short sellers will also stick to their guns when they've found their target, rather than questioning their thesis halfway in. They put in the effort on the front end, then patiently execute on the back end. Hard work and unwavering discipline? Sounds Foolishly familiar.

We're constantly dealing with a target-rich environment for shorts. At any point in time, there are companies trading for exorbitant premiums relative to their core fundamentals. Numerous companies seem inclined to fudge earnings, and plenty of sectors have skyrocketed way beyond their sustainable levels. Opportunities abound.

I'm not a short seller. I don't have the guts to ride a company into the dirt. But I do know a bad company when I see it, and I certainly know when it's time to stay away.

These signs say "stay away"
For those who want to know when to steer clear, or for adventurous short sellers looking for a few tips, I'll clue you in on a screen that I've developed to help me identify companies in my no-fly zone.

It starts with the Motley Fool's own CAPS screening tool, which I use to discover which one- and two- star stocks our 115,000-member CAPS investment community loathes most. Picking from this statistically advantageous group is like taking a 20-foot lead off first base; on average, these low-rated stocks have underperfomed the market by 11.3% and 4.9%, respectively. It's like drawing from a stacked deck.

Once I've compiled that list of potential losers, I move onto a few key metrics, which I believe portend companies that don't deserve my investment dollars:

  1. I shy away from companies trading for a significant earnings premium to the larger market. For the purposes of this screen, a P/E greater than 20 sounds about right.
  2. Companies that are not generating solid returns on equity are troublesome. Under 10% ROE is not good enough.
  3. Because high ROE's can be fudged with lots of debt, I'm steering clear of companies with that particular red flag. A debt-to-equity ratio greater than 70% grabs my attention.

Given those criteria, here are a few offenders I found:


CAPS Rating




Credit Suisse (NYSE:CS)










New York Times (NYSE:NYT)










Xerox (NYSE:XRX)





American Tower (NYSE:AMT)





Choicepoint (NYSE:CPS)





Source: Motley Fool CAPS as of Aug. 19, 2008.

Before the hate mail begins to flood in, let me say that these aren't my recommendations for short-selling. I'm just giving you my own fair warning that I wouldn't consider buying these stocks right now. Furthermore, these selections come pre-vetted by a community of more than 115,000 knowledgeable individual investors and professionals, and those savvy Fools found them decidedly unattractive. You make the call.

Curious about what else our Foolish community has picked or panned? Come join us on Motley Fool CAPS to dig into these companies further. Let our CAPS brain trust help you avoid the next landmine -- or take advantage of its imminent destruction.

Fool Nick Kapur has no positions in any of the companies mentioned above. Check out his long-only portfolio, if you're curious. The Motley Fool has an ironclad disclosure policy.