Is Shorting Stocks Foolish?

There's been a fair amount of coverage on Fool.com recently regarding shorting stocks. Even true-blue, long-only investors like me have been talking up the idea of shorting. But loyal Fool readers may be wondering whether shorting is really Foolish.

The Fool has long been a cheerleader for individual investors doing their own investing and encouraging the long-term ownership of high-quality companies. That is, investing as if you were taking an ownership stake in the business.

When a stock is shorted, an investor borrows shares of stock and sells them. That investor is then hoping that the stock will decline in value so that he can buy it back cheaper than he sold it and pocket the difference.

The two don't seem to compute, do they?

But what is Foolish?
The name "The Motley Fool" and the jester logo weren't just pulled out of a hat labeled "confusing things to name your financial community" -- there's a very specific meaning behind them. As told in Foolish lore:

Our name comes from Act II, Scene vii, of Shakespeare's As You Like It. In Elizabethan drama, only Fools could speak the truth to the king without losing their heads. David and Tom Gardner founded The Motley Fool, Inc. in 1993 to help people make better financial decisions by exposing the shams behind the conventional Wall Street "kings."

In Roger von Oech's classic on creativity "A Whack on the Side of the Head," he has an entire chapter dedicated to the art of being foolish (though we capital "F" Fools would recognize it as also being Foolish). Speaking in particular about the medieval fool, von Oech writes:

 

The king's advisors were often "yes-men" who told him exactly what he wanted to hear. The king realized that this wasn't a good way to make decisions. Therefore, he gave the fool a license to parody any proposal under discussion and to shatter the prevailing mind-set. ...

The fool operates in a world that runs counter to conventional patterns. Everyday ways of perceiving, understanding, and acting have little meaning for him. He'll extol the trivial, trifle the exalted, and parody the common perception of a situation.

This is beginning to get a little interesting, eh? It sounds like to be Foolish -- if I can be so bold -- is to constantly be questioning the status quo. In fact, it would seem that to say that there's a set-in-stone, single way to be Foolish would be practically the epitome of being un-Foolish!

A Fool and his shorts
Now that we've laid out what it means to be Foolish, part of me wonders what could be more Foolish than shorting a stock? OK, maybe we won't go there, but think about it for a moment.

Short-sellers dig deep into companies' Securities and Exchange Commission filings and listen to everything management has to say, questioning everything along the way. Why did the margins jump like that? Where did that top-line growth come from? Should inventory be growing like that? Why in the name of Christopher Walken is this CEO being paid that much?

If you can picture a motley-capped jester dancing around, peppering those questions, and really letting a company have it when something doesn't add up, then we're on the same page.

And let's not forget, The Motley Fool's mission is "to educate, amuse, and enrich." So if our detective work yields a profitable opportunity to bet against a company that has set itself up for a fall, well, why pass that up?

A Fool meets Holmes
Now you could start just questioning every company out there. And, in fact, even if you're looking at a stock as a potential long investment, asking a lot of questions is never a bad thing. However, if we're looking for good places to flex our shorting muscles, there are clues we can look for that can lead us to potential short opportunities.

One red flag that can lead to short opportunities is a big jump in profit margins. I know what you're thinking, "Aren't higher margins a good thing?" Yes, they are -- usually. But sometimes a jump in profit margins could be a signal that something unsustainable is going on behind the scenes.

For example, companies may take reserves against losses in one period and then reverse those reserves in future period. Big banks like Bank of America (NYSE: BAC) and JPMorgan Chase (NYSE: JPM) have taken huge provisions against credit losses stemming from the lending boom.

If, down the road, they decide that they're not going to experience losses as high as previously expected, they could reverse some of those provisions. That would boost profit in the future period, but not represent a continuing source of profit. If investors get too excited about such a jump in profitability, it would set up short-sellers to profit from the inevitable reversal when the banks ran out of excess reserves.

My, what big margins you have!
To kick-start our search for companies that may have something funny going on behind the numbers, I've dug up five companies that have seen a big jump in their operating margins over the past year.

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

As I noted above, these numbers are nothing more than starting points for further analysis. It's crucial for investors to pour a big cup of coffee and get intimate with SEC filings to determine where these profitability gains are coming from and whether they're sustainable.

In the case of insurer CNO Financial, for example, the company's investments took a big hit in the wake of the financial meltdown, and part of the recent improvement has had to do with fewer losses and more investment income. In addition, Coventry discontinued a line of business that it partnered with CNO on, and that happened to be one of CNO's less profitable business segments.

Potential short-sellers would want to watch the company's investment portfolio mix for signs that income might start moving in the wrong direction. In addition, if the company begins to chase less profitable business, it's possible investors may not appreciate the potential margin contraction.

Western Digital, meanwhile, benefitted from a big boost in gross margin that it attributed to volume, the mix of products it sold, and industry pricing. As the company competes in a cutthroat industry that's largely commoditized, it would seem like these gains would be tougher to hold on to. (Based on the stock's current valuation, it appears that investors are pretty skeptical.)

Similar to Western Digital, Corning's profitability jump came largely from higher volume -- in its case from sales of glass for LCD TVs, notebook computers, and desktop monitors. Unisys gained ground through cost-cutting and selling more of its ClearPath mainframes. Activision-Blizzard's gains came from a scattered array of favorable product mix changes, lower royalties and marking expenses due to fewer game releases, and some headcount reductions.

But as with CNO and Western Digital, investors need to be careful to pick apart these gains to figure out whether the higher margins are really sustainable.

Keep Foolin'
The companies and thoughts above give a good idea of how to approach shorting stocks Foolishly. In short, though, the formula all boils down to always asking questions. The more you question assertions, challenge numbers, and play detective, the more likely you are to find a prime-time short candidate.

If you'd like some help getting started, forensic accounting expert and fellow Fool John Del Vecchio has put together a special report, "5 Red Flags -- How to Find the BIG Short." If you'd like to check out a copy of this report for free, just put your email address in the box below.