7 Short Ideas

If you own stock in the companies listed below you're not going to like what I'm about to tell you. You and the management team will probably deny everything I'm about to share and will even claim that this doesn't apply to you and your stock.

That's fine, but if the research is accurate, short-sellers could make killing on several of these stocks.

Research says ...
Stocks plummet when companies negatively restate past earnings or when growth fails to materialize. Worse yet, stocks crater when reporting is fraudulent; just pull up a 2008-2009 stock chart on Satyam to see how bad the damage can be. Research shows that earnings manipulation takes only 19 months on average to become public after the fiscal year of the first violation.

The problem comes about because investors love growth stocks and their managers. This pressures management to maintain excellent reported results even as the business eventually slows. It is at this critical juncture that some management teams decide to delay the inevitable earnings miss by getting aggressive with their accounting. Ultimately, investors punish the stock when the truth comes out.

How would you like to get out before the bad news hits? Or better yet, profit by shorting the stock before earnings manipulation becomes common knowledge?

How to find potential manipulators
Dr. Messod Beneish, the Sam Frumer professor of accounting at the Kelley School of Business, is an expert at predicting and understanding the consequences of earnings management. His model can detect -- with surprising accuracy -- the companies that are most likely to manipulate their financial reports to mislead investors.

Using eight criteria weighted to maximize success, in testing, his model identified about half of the companies that misstated their earnings. Most importantly, it found these companies before their poor earnings quality became public knowledge. This provides investors an opportunity to avoid losing money, or even earn outsized returns, by shorting.

Let's look at these factors -- all easily calculated from financial statements -- to better understand just how robust this model is. If accounting isn't your thing, or you just want to get the dirt first, skip to the next section on the M-score.

1. Days sales in receivables index: This ratio compares year-over-year changes in how soon a company collects its receivables relative to sales. A large increase can signal a tighter competitive environment that's forcing the company to loosen its credit policy. Even worse, management could be accelerating revenue recognition and inflating earnings. Both are situations worth avoiding.

2. Gross margin index: This ratio compares this year's gross margin with last year's. If margins are decreasing, it may mean that the business is facing tougher competition, or that costs are going up. When faced with a poorer future, companies are more likely to stretch -- sometimes with creative inventory accounting-- to hit earnings targets.

3. Asset quality index: This measures the ratio of non-current assets other than plant, property, and equipment to total assets. An increase can indicate that management is deferring costs to increase profits. The ratio can also increase because the company made acquisitions that added a significant amount of goodwill to the books over this period.

4. Sales growth index: Fast-growing companies are under tremendous pressure to maintain growth targets, because one miss can spell disaster for their shares. Therefore, management may also feel the need to manage earnings. This measure means nothing nefarious on its own, but in combination with the other factors, it may highlight teams with great incentives to deceive investors.

5. Depreciation index: If the rate of depreciation slows down between two years, it may indicate that management has increased the useful life of key assets, or even changed its depreciation methodology. Without proper justification, this points to lower earnings quality.

6. Sales, general, and administrative expenses index: If SG&A expenses increase disproportionately faster than sales, the business may be facing poorer prospects and therefore be more likely to manipulate earnings.

7. Leverage index: Increasing leverage year over year can increase a company's financial risk and may put a strain on existing debt covenants.

8. Total accruals to total assets: This measures the change in working capital (excluding cash) less depreciation versus total assets. A higher percentage of accruals points to lower earnings quality. This is a primary way that managers have discretion over reported earnings.

M-score
The above data points are collectively weighted and summed to produce an "M-score." When a company scores higher than -2.22, it is labeled a "likely manipulator," signaling a short opportunity. Of course, as with any statistical measure, you need to do your due diligence prior to shorting. But if you're not inclined to do your homework, I would at least stay away from these companies.

Short these offenders?
I've calculated the M-score for all the companies in the S&P 500, and included a few companies that the model identified as likely earning manipulators. Before you breathe a sigh of relief that a company isn't on my short list, you should know that this list isn't exhaustive. In fact, I'm sure there are even worse offenders -- and even outright fraudsters -- who've trained themselves to pass this test.

*Calculated using data from Capital IQ, a division of Standard & Poor's, as of Aug. 9, 2010.
P/E = price-to-earnings ratio.

This list should give investors pause. Many M-score criteria measure qualities correlated with manipulation, instead of directly measuring accounting trickery. However, the test has a high success rate. Great products or not, if you own any of the stocks in the table, you may want to revisit your analysis in light of these results.

If you're interested in protecting your portfolio from ticking time bombs or in 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.