Buy or Short These Retail Stocks?

If you want to find winning -- or losing -- stock ideas, you'll need to understand what lies beneath a company's reported revenue. Many investors screen on metrics like net income or related measurements such as EBIT, EBITDA, or operating cash flow. But companies know that Wall Street is closely monitoring these factors, and they can sometimes attempt to massage their numbers in hopes of providing a "good story" for investors.

Investors can get a much better picture of a company's true revenue or cash flow story by looking into the quality of earnings instead. Diligent Fools will play the role of forensic accountant, reading all of a company's SEC filings and financial statements in search of accounting tricks that might be masking deteriorating company performance. To help your investigation, I've uncovered a powerful shortcut: subtracting net income from operating cash flow.

Let's test how well this shortcut works by rounding up a clutch of companies with five-year annualized growth rates greater than 10%. Then we'll rank these contenders with my quality-of-earnings metric, divided by each company's market cap to normalize the candidates' different sizes.

Here are the top two and bottom two Internet and catalog retail companies in my quality-of-earnings screen:

Top quality of earnings

Source: Capital IQ, a division of Standard and Poor's, and author calculations. Figures are the average of five one-year growth rates since 2005.

Bottom quality of earnings

All of these Internet and catalog retail companies are in the Consumer Discretionary sector. Let's look at how companies in this sector have performed over the last decade when ranked by my simple quality of earnings metric:

The graphs tell the story
Higher quality of earnings companies significantly outperform lower quality of earnings companies. Quantile 1 stocks (with the highest earnings quality) generated nearly 18% annualized returns while Quantile 5 stocks (lowest earnings quality) returned about 7.5%.

Clearly the revenue growth story for the Internet catalog and retail companies above is an inadequate measure to evaluate these companies.  Our earnings quality screen (and decade of corroborating evidence!) suggests that PetMed and NutriSystem are buy candidates, while Overstock.com and Gaiam might potentially even be shorting opportunities. Of course, before pulling the trigger, investors should do their homework to get an even better and more comprehensive picture of quality of earnings and earnings growth.

Finding companies to short using a quality of earnings screen will take more than my simple quality of earnings short cut. That's why John Del Vecchio, CFA, a leading forensic accountant and The Motley Fool's shorting specialist, put together a detailed report that shows you how to spot five serious red flags that can help you detect time bombs in your portfolio and lead you to the next big short. You can get the entire report free by clicking here or by entering your email address in the box below.