5 Stocks I'd Be Scared to Short

I've recently been turned onto the idea of selectively shorting stocks. This isn't because I'm particularly bearish. Nor is it because I plan to give up investing long in the solid, high-quality companies that make up the bulk of my portfolio. Shorting stocks is simply another tool for investors to add to their toolbox, and setting aside part of your portfolio for shorts gives you another way to profit from all of the research you're doing anyway.

But before you get too excited about running out and shorting that stock you know is headed south, here's a cautionary tale.

Seller beware
In Crocs' (Nasdaq: CROX) heyday, I was no fan. As a fashion statement, I didn't like the shoes. As a business, I didn't like the company. It all stunk of "fad" to me, and the stock was trading at what I thought were ridiculous multiples. I wasn't alone in thinking this, either -- heavy short interest suggested that many other investors were actively betting against the stock. In late 2006, I even wrote a piece for Fool.com suggesting that 2007 would be a bloodbath for Crocs.

As it turns out, 2007 was a great year for Crocs. With each piece of positive news, buyers rushed in, and short sellers ran scared. By October of 2007, the stock had more than tripled since my foot-in-mouth episode. By the time the 2007 closed, Crocs' revenue had more than doubled, and margins had reached impressive levels. Everything seemed to be clicking.

But in 2008, the specialty-resin wheels started coming off Crocs' train. Revenue growth faltered in the second quarter, and the company reported a loss in the third. By the time all was said and done that year, the company's revenue had fallen 15%, and the bottom line registered a $185 million loss.

After topping $70 per share in 2007, Crocs' stock closed 2008 at $1.24.

I'm a lucky dog
Fortunately, I did not fancy myself a savvy short seller back in 2006, so I didn't back up my eye-rolling about the company with a short position.

Even though I can technically say that I was right about Crocs' eventual fate, my timing was worse than awful. Had I actually shorted the stock, there's almost no chance that I would have held onto that position through the torrid run in 2007.

Avoiding a short-seller smackdown
Where did I go wrong with Crocs? Looking back, one thing stands out in particular -- short interest.

While having a lot of company on a short might seem like confirmation that your analysis was correct, shorting an already heavily shorted stock is sort of like plopping yourself down on a barrel of gunpowder. With heavy shorting already going on, there is a constant coiled spring under the stock, catapulting it higher on each good report as short sellers get cold feet and cover their positions.

Though Crocs isn't quite the highflier today that it was in 2007, nearly 15% of its float is still shorted. But Crocs is hardly the only stock that shorts have piled in on. Here are five other stocks whose short interest should worry potential short sellers.

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

I can picture the case that shorts are likely making for each of these stocks. Fuel Systems manufactures systems for using alternative fuels for cars, buses, and industrial vehicles -- not exactly a well-proven business model. And while profit growth has been scorching over the past couple of years, analysts see both 2010 and 2011 ending with lower earnings per share than the prior year.

I highlighted Ebix in a previous article as a potential short. Though its income statement has looked darn good, cash flow has lagged net income, which can sometimes be a sign of trouble. In addition, the company has been very acquisitive -- another possible cautionary signal.

Most investors probably know Advanced Micro Devices well. The shorts most likely see the company as an also-ran to archrival Intel, saddled with questionably consistent profitability and a boatload of debt.

By many measures, A-Power appears quite successful. But at the same time, it's a small Chinese company that carries a pretty healthy valuation multiple. Those two factors alone often seem like a sure recipe for investor skepticism.

Many investors have been wary of Las Vegas Sands for a while. Competitor MGM (NYSE: MGM) found itself quite close to bankruptcy, and some expected Sands to lurch in that direction as well. Though Las Vegas Sands' financial performance has been improving as new properties open for business, the company still shoulders a massive $10 billion debt load.

Whatever specific details short sellers focus on, all of these stocks are dangerous short targets, thanks to the high short interest alone. Even if the bearish thesis is correct, a big short-covering rally could be painful enough to push out short sellers before they ever take the first step of their victory dance.

A better way to go
So what should you be looking for in order to find a successful short opportunity? Obviously, a prime consideration should be avoiding stocks that already have high short interest, like those above.

Along with that, it's ideal to find specific red flags that suggest accounting shenanigans may be afoot, or that growth is set to come to a screeching halt. For instance, a sudden jump in a company's profit margins can sometimes be a sign that management is manipulating income or costs. While this may look good in the short run, it usually sets up the company for pain down the road.

Forensic accounting expert and fellow Fool John Del Vecchio, CFA, recently put together a report covering what he believes are five of the biggest red flags that can lead to successful shorts. If you'd like to check out those red flags, as well as learn more about shorting in general, enter your email in the box below and we'll send you a copy of John's report for free.