Don't Short These Stocks

I was examining a list of the decade's greatest performers yesterday. Considering the market over the past 10 years has been relatively flat and plagued with recessions, I figured I would find some interesting characteristics in the companies on the list -- metrics I could use to find the next decade's big winners.

What makes winners
The three best-performing stocks from 1999 through 2009 were Medifast (NYSE: MED), Green Mountain Coffee Roasters (Nasdaq: GMCR), and Hansen Natural (Nasdaq: HANS). Their performances, respectively, were 16,209%, 9,210%, and 7,023%.

To decipher what special traits these decade-smashing stocks had, I analyzed their performance over the past 10 years. I expected to find that they had either been deep value plays or possibly random small caps trading at dirt cheap prices.

What I found, however, was a bit surprising:

Source: Capital IQ, a division of Standard & Poor's.
P/E = price-to-equity ratio. P/B = price-to-book ratio.

These three companies have been trading at high valuations over the past decade -- not just from an earnings perspective, but from a price-to-book standpoint as well.

Which made me wonder: Isn't high valuation supposed to be a good indicator for shorting a stock?

Where the trouble begins
It's true that many investors searching for shorting opportunities look to companies with high valuations, because this often marks companies whose stocks have been over-purchased. And who doesn't want to cash in on Mr. Market's mispricing?

But, as is usually true, it's not that simple. Had you shorted those three stocks over the past 10 years, you'd still be licking your wounds.

Here are four stocks with high valuations today that I'd recommend not shorting.

Source: Capital IQ, a division of Standard & Poor's.
P/E = price-to-equity ratio. P/B = price-to-book ratio.

After all, you don't see much better brand value or pricing power than at Whole Foods or Harley-Davidson. Intuitive has the robotic surgical equipment market in an all-out headlock, and Titanium Metals is pumping out higher profits and higher margins with expected future demand from Boeing.

Surprise!
But despite all of the advantages these four companies have, investors are seeing massive short opportunities.

Short interest as a percentage of float, which is a great yardstick for how heavily shorted a stock actually is, typically remains below 5% -- anything above that usually indicates a red flag. Take a look at these numbers.

Source: Yahoo! Finance.

Maybe it's because of their high P/Es (I'm guessing yes), but investors are shorting these companies in droves.

Remember the three companies I started with? Today, all three of those companies still trade for extreme premiums, and not surprisingly, two out of the three have insanely high short interest.

Now, I'm not saying that any of these companies are going to be the decade's greatest-performing stocks. Medifast, Green Mountain, and Hansen have likely already had their big runs, and most of the others are too big to grow at the kind of pace we saw from them.

However, if you simply ran a screen for expensive stocks with lots of short interest, you'd definitely run across these names. And I don't know about you, but these certainly aren't the types of companies I want to short. Whole Foods? Harley-Davidson? No way!

So what do you short?
Being confident in the fact that a company will drop in value requires more than a screen. It requires a detective's obsession -- rummaging through annual reports to find earnings irregularities, operational difficulties, overly aggressive accounting, or a possible disruption of management.

So don't set yourself up to short what could end up being the decade's next big stock. Instead, examine companies with troubling financials. If you're interested, enter your email address in the box below to get a free copy of "5 Red Flags -- How to Find the Big Short," a new report from John Del Vecchio, CFA, a leading forensic accountant. The report is free. Simply enter your email address in the box below.