Should You Really Short These Stocks?

Recently, a few of our Motley Fool Global Gains recommendations have been profiled on Fool.com as short candidates. Since we're a motley group of Fools, I didn't take exception to this, but how can it be that a stock can look like both a compelling buy as well as a short candidate?

The answer, like the devil, lies in the details, and I think it teaches an important lesson about how to be a smart short.

Show me the money
One of the red flags our shorting analysts are looking for is operating cash flow that lags accounting net income. It's a red flag because it could indicate that a company is being too aggressive about how it books its revenues.

When fellow Fool Matt Koppenheffer ran this screen, one of the stocks that popped up was Yongye International (Nasdaq: YONG), a small fertilizer maker based in rural China that our Global Gains team first visited last summer. Since we made it the top pick of our Chinese Rural Boom basket last year, the stock is up more than 110% -- and we expect it has even further to run.

But Matt's screen is right that Yongye has a problem generating operating cash flow -- an observation Fool contributor Rich Smith also made not too long ago. So what's the story?

Show me the money ... when you have it
Interestingly, three of the four companies Matt's screen tabbed as operating cash flow offenders are based in China. The reason that's interesting is because it's evidence of the fact that, for myriad reasons, days sales outstanding tend to be longer in China.

This is particularly true for Yongye, which sells fertilizer to generally poor farmers. Not only is this a seasonal business, but Yongye tends to have to wait until the end of the growing season to collect its money. This means that the company makes significant sales in the spring and summer, books those sales as receivables, and then endeavors to collect those accounts during the fourth (winter) quarter -- when there's not much else to do in frigid Inner Mongolia.

Here's how that cycle played out for Yongye during 2009:

Source: Company filings.

The seasonality and long cash conversion cycle of Yongye's business are obvious. But the question remains: Why didn't those receivables turn into cash at the end of the year?

The answer is that due to rapid sales growth, the company quickly plowed that money back into inventory to sell during 2010. Take a look:

Source: Company filings.

Clearly, the company has decided that the business opportunity here warrants an ongoing buildup of inventory -- a decision that's been rewarded through the first half of 2010 with sales up almost 95%. In other words, the reason there's been no operating cash flow is because the company is aggressively reinvesting in itself to successfully grow the business. And that's not a scenario that I suspect will be kind to shorts.

On the verge of bankruptcy
Matt's screen employed a metric called the Altman Z-score. He noted that this score is "used as a predictor of bankruptcy," that "scores below 1.8 are downright scary," and that Global Gains recommendation Melco Crown Entertainment (Nasdaq: MPEL) has an Altman Z-score of 0.8.

I was quickly asked by a curious investor why Global Gains would recommend a company likely to go bankrupt.

Although Melco is not without its warts, including recent management turnover and lower than average profitability within its peer group, the Altman Z-score probably isn't the most appropriate metric to measure the company by at this point in time.

The reason for this is that the company just completed two large construction projects, the Altira and City of Dreams casinos in Macau that, like most real estate projects, was financed with debt. Since these projects are relatively newly opened, they are still ramping to capacity, which is why the company's operating income seems so small relative to the company's debt load.

This fact is true of many casino companies that also recently completed debt-financed projects in Macau:

Source: Capital IQ, a division of Standard & Poor's.

While it's clear Melco has some work ahead of it, it's also worth noting that Wynn, one of the best casino operators, had an Altman Z-score of just 1.2 back in March 2009 -- and it seems to be doing just fine today.

All told, Melco's debt load is not onerous in the near-term, and the company recently closed a $600 million note offering that should enable it to pay off the construction loans coming due at the end of the year. Now, if Macau flops or if the new City of Dreams resort fails to gain market share, then Melco could be in trouble down the line. But the Altman Z-score today isn't in itself an indicator that Melco is in imminent dire straits.

The takeaway
When it comes to shorting, screening for red flags is a great place to start. But when it comes to actually shorting stocks successfully, the key is to be able to look into the numbers and see what they say about the health of the underlying business.

If you're interested in learning more about how to do that, 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. Not only will he tell you the metrics to use, but more importantly, he'll show you how to use them.