Where You'll Find the Next Killer Short

There are some stocks out there not worth holding. Ever.

These are companies with questionable management teams, eroding competitive advantages (assuming they had them to begin with), and business models so bad they'd make a 5-year-old's lemonade stand look like genius.

Execs at these companies desperately try to hit their numbers every quarter and sometimes, when they just can't make 'em ... well, they might just be inclined to fudge 'em.

The good news is that you have the power to spot these potential snakes in the grass -- you just need to know what to look for.

Taking out the garbage
Why should you be looking? Two reasons: You need to avoid long positions in companies that are likely to blow up, and you could choose to short those companies that, well, deserve to be shorted.

Though not a short-seller myself (I like to set my investing goggles to more optimistic settings), I respect the work that short-sellers do. After all, they attempt to keep the markets honest. And they're among the most dedicated and diligent fundamental researchers in the market. They have to be. It's a matter of survival.

Unlike pure longs, short-sellers can lose more than their shirt. So they'd better be right -- they can't afford not to be.

Many of these guys and gals are no-nonsense filings-gurus who are able to cut through the noise when it matters most. As well-regarded short-seller James Montier said, "Short-sellers tend to be the most fundamentally driven investors. Indeed, far from being rumor mongers, most short-sellers are closer to being the accounting police."

And that's worthy of imitation -- whether you're buying long or short -- because I think the practice will lead to superior returns.

Pulling back the curtains
Montier's greatest contribution is a screening tool called the C-Score -- and sadly, since this isn't Sesame Street, C stands for "corruption," not "cookie." He identified six red flags that, when combined, may reveal troubled companies with numbers that evidence deteriorating businesses: the kind of company perfect for a solid short position:

1. Divergences between net income and operating cash flow. Remember, cash is king. While net income is easily fudged, cash is not.
2. Increasing day sales outstanding (DSO). This is a key indicator of a company's ability to collect revenues after making a "sale" and whether it's a competent collector of credit sales. Increases are bad.
3. Increasing day sales inventory (DSI). Making product but can't move it? That's a problem.
4. Increasing other current assets to revenues. For the cunning CFO, playing with the "other current assets" line item is a way to obfuscate the truth.
5. Declines on depreciation relative to gross property plant and equipment. This sounds complex, but it's actually fairly straightforward. A company should be depreciating assets at a fairly consistent rate. When this changes in the direction Montier indicates, it may mean a company is padding the bottom line.
6. Increasing total asset growth. When a company makes acquisitions, it can artificially increase profits. Is this always a bad thing? Certainly not. But when you combine it with flags 1-5, it's not an ideal investment situation.

Owning a stock that scores a perfect 6 in this litmus test doesn't necessarily mean you're holding a company headed for the gutter. But management had better be able to rationalize this perfect storm of warning signs -- because evidence suggests that these companies are about to take a hit.

Voila: underperformance
Montier's analysis found that in the period between 1993 and 2007, stocks that scored highly on this test underperformed the market by an average of 8% per year -- a whopping figure when you consider the implications 8% per year would have over the course of an investor's career.

Montier went a step further though. Stocks that scored highly on the test and also had a price-to-sales multiple greater than 2 (for valuation purposes) performed even worse -- corresponding to a negative absolute return of 4% per year!

That's some powerful stuff.

So who's currently scoring a six out of six? There are currently about three dozen offenders; here's a sampling:

Does this mean these are fraudulent businesses? Not necessarily. In fact, in his study, Montier identified several companies that scored highly but don't appear to be cooking the books, including Amazon.com (NASDAQ:AMZN) and Apple (NASDAQ:AAPL).

So you can't just set this screen and forget it. The five stocks above may well not be good short candidates. But they live among a statistically disadvantageous group. As evidence, I'll mention that the last time I ran this screen, about two months ago, Bare Escentuals (NASDAQ:BARE) popped up to the top of the list -- and it's since returned (64%)!

In other words, don't blindly follow the C-Score, but use it to give yourself an excellent starting point to identify stocks you'd do well to avoid ... or possibly short-sell.

The Foolish bottom line
If you're like me and you don't have the guts to short individual companies, this is still a powerful tool for your toolbox. Management has the power to fudge their financial strength -- so keep tabs on them.

That's why we use tools like this one and insist on unquestionably great management in the Motley Fool Stock Advisor service before we invest -- and why Stock Advisor is beating the market by 30 percentage points since inception in 2002.

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Nick Kapur owns no companies mentioned above, but wished C did stand for Cookie. Amazon and Apple are Motley Fool Stock Advisor recommendations. Bare Escentuals is a Rule Breakers and a Motley Fool Hidden Gems pick. The Motley Fool has a disclosure policy.