These Stocks Will Bite You

Shorting stocks is dangerous business if you don't know the types of stocks Mr. Market thinks are worth shorting. I mean that literally. Mr. Market can't tell the difference between a good and bad business, and he's liable to buy or sell for the pure joy of causing us common investors pain.

But don't take my word for it. A quick check of Capital IQ finds that just 23 stocks have a beta rating of 3 or better over the past year, meaning they've been at least three times as volatile as the broader market. Notable names from this list include Allied Irish Banks (NYSE: AIB), with a beta of 3.76, and Liz Claiborne (NYSE: LIZ), with a beta of 3.21.

These scores should scare the beejeezus out of you. Why? Of the 23 stocks whose betas were 3 or better over the past year, 11 lost money. Allied was the biggest loser, down 72%, but eight of the 11 fell at least 20%.

Data like this explains why I think frequent traders are crazy. End up on the wrong end of a short-term guessing game with a volatile stock, and your portfolio will bleed red. But you know what? Short sellers have exactly the same problem.

Not exactly like trading, but close
Below, you'll find the 10 worst performers among stocks worth at least $150 million in market cap as of Sept. 10, 2009. (Not including bankruptcies and delistings.)

While the middle column -- the return -- may have the most shock value, pay more attention to the first and third columns. There, you'll notice that none of these stocks went down in a straight line. And in the case of the worst performer, YRC Worldwide, the stock doubled before it nosedived.

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

Scared yet? Honestly, you should be. Shorting is for neither the weak-stomached nor the ill-prepared. Yet for all my warnings, there's good news to be found in this table. There are patterns we can follow in seeking new stocks to short.

Searching for patterns
Let's take a closer look at each of the three worst performers.

Trucking and transportation specialist YRC had suffered two consecutive quarters of capital destruction by July 2009. Gross margin had also gone negative, yet the stock was trading for more than four times tangible book value. It's enough to make me wonder whether visitors to company HQ had to pass through a set of flashing red warning lights. Today, bankruptcy remains a major concern for many investors.

Gleacher & Company followed a similar pattern of capital destruction. After a big gain in the quarter ended June 30, 2009, the small investment banker began a series of consistent declines in return on capital (ROC) that has yet to stop.

Wind energy supplier Broadwind Energy had been growing revenue massively in the quarters leading up to last year's Q3, when revenue declined. It's been down ever since, sliding like an out-of-control skier on a five-diamond slope.

Other stocks have suffered for reasons not having to do with management inefficiency. For example, Cell Therapeutics suffered when the Food and Drug Administration (FDA) declined to approve its lymphoma treatment, pixantrone.

Bond insurer Ambac Financial has paid dearly for insuring clients that weren't investment-grade. (Harrisburg, Penn. may soon make that list.) Bankruptcy may be in the cards for the company. Still, huge earnings losses were a feature of their declines.

What to do? Short the capital destroyers
If you're going to insist on shorting, the lesson I draw from the table above and the year's worst performers is that rapidly declining returns on capital presage poor stock returns, just as increasing ROC foreshadows stock outperformance.

Both of these stocks has a recent history of revenue declines and poor ROC, and as a result could be worth shorting:

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

Flamel Technologies makes drug delivery platforms, but its partnerships and prospects have at times been shrouded in byzantine language. That's not a good sign when both revenue and returns on capital are declining.

Retailer Pacific Sunwear also looks vulnerable. Not only are revenue and ROC down, but comparable-store sales also fell 10% in the latest quarter.

Neither company impresses me right now. Think I'm wrong? Leave a comment to share your perspective. And if you're looking to short individual stocks for big, real-money gains, enter your email address in the box below and we'll send you "5 Red Flags -- How to Find the Big Short," a report by John Del Vecchio, CFA, a leading forensic accountant, that shows you how to spot the next big short opportunity – for free.