Given all of the distressed companies we came across last year, shorting stocks is a strategy our research team at Motley Fool Global Gains started experimenting with. We published all of our research for free online and ended up having a number of massive successes as well as one or two blowups along the way.
Here's a brief recap of three successes and one blowup, along with relevant lessons that you can apply to make money shorting stocks going forward.
Aug. 6, 2009: Short Fuqi International
The thesis here was simple: For every $1 of earnings growth Fuqi was generating, it was consuming at least $0.50 in cash to support working capital for expansion. This was a result of investment in inventory and slow collections of accounts receivable.
In fact, when we looked at the stock last year, its cash conversion cycle had almost doubled to 110 days, and we noticed a very low quality of earnings given how consistently free cash flow dramatically trailed net income. We considered the stock overvalued and likely to continue to dilute shareholders, and therefore recommended shorting it at $24.
Today, Fuqi trades for just $8.50. Revelations of accounting errors at the company were a catalyst for the drop earlier this year, and Fuqi has yet to file its 2009 report. That just adds to the risk profile of a business that was unattractive from an investment standpoint in the first place.
Sept. 17, 2009: Short China Fire & Security
China Fire was a stock we had previously recommended buying at Global Gains, but a number of compelling reasons caused us to reverse course and recommend shorting it.
First, the stock was up almost 170% -- to near $20 per share -- through the first nine months of 2009. Second, the company had somehow managed extraordinary margin improvement in the first and second quarters of the year to meet analyst expectations -- improvement that didn't look to us to be sustainable. Third, the company had lost a key contact at China's Fire Security Bureau. Fourth, the company's main customers (Chinese iron and steel companies) were coming under duress because of overcapacity issues, and China Fire was stockpiling receivables as a result, making for low earnings quality for the company.
Fast-forward and China Fire just released second-quarter results that showed revenues flat year over year, a gross margin decline from 64% to 54%, and the continued accumulation of receivables alongside a rising provision for doubtful accounts.
If China's iron and steel industry continues to struggle, expect a continued deteriorating in China Fire's business. While the stock is no longer an obvious short given today's valuation (it's fallen to $8 per share), we certainly don't expect to be buying shares anytime soon.
Sept. 17, 2009: Short AgFeed Industries
Although I tend to be bullish on rural China, AgFeed industries was never a stock I could get excited about. That's because while the company did operate a promising feed supply business, it was also engaged in the very capital-intensive and potentially risky business of acquiring and modernizing hog farms in China.
What made the company a promising short at more than $5 per share, however, was the fact that I expected corn prices to rise (a significant cost for the company) and for the company to be unable to pass those rising costs along to consumers given the Chinese government's preference for keeping consumer food costs low.
Since last year, the company's profit margins have declined, and cash from operations and free cash flow have differed dramatically on the downside from stated earnings. The stock has also dropped to less than $3.
Aug. 27, 2009: Short lululemon athletica
Citing a deteriorating consumer environment, we recommended shorting yoga apparel retailer lululemon at $20 per share. With the stock now at $40, that was clearly a bad move. What did we get wrong?
While Fuqi International, China Fire, and AgFeed Industries all showed poor earnings quality in addition to premium valuations, the short story for lululemon was based solely on valuation.
At nearly 40 times earnings and 20 times EBITDA, the stock looked ridiculously expensive, and if consumer spending retrenched as we thought it would, there was no way the company could meet the growth expectations priced into the stock. Further, the company was operating in an industry with extremely competent, well-capitalized, and much more reasonably valued competitors such as Nike
Yet as we all know, the consumer environment has recovered in 2010. lululemon's products continue to be extraordinarily popular, and the company has gone right on growing free cash flow.
When it comes to shorting, one mistake can wipe out any number of successes. Although we got three out of four calls right in the above examples, the mistake with lululemon was so significant that it wiped out more than half of our overall gains. So be careful and remember that shorting stocks is not for everyone.
Further, note that while we believed all four stocks were overvalued, Fuqi, China Fire, and AgFeed all had clear earnings quality issues related to long cash conversion cycles and capital-intensive business models. Ultimately it was the weaknesses in these businesses that caused the stocks to drop -- and not just the simple fact they looked expensive relative to a peer group.
There's nothing more painful than shorting a stock like lululemon that just keeps growing and growing, so if you choose to short on your own, make sure you don't just look for expensive stocks.
The safer play is to identify an overpriced company with earnings quality issues. If you're interested in protecting your portfolio from ticking time bombs or shorting stocks for big gains, enter your email in the box below. I'll send you a new report, "5 Red Flags -- How to Find the Big Short," by John Del Vecchio, CFA, a leading forensic accountant who has made a good deal of money identifying companies with low-quality earnings. Simply enter your email in the box below.