Should You Avoid These Companies?

On the heels of the Great Depression, famed investor Benjamin Graham developed a strategy that served both him and subsequent generations well. Known as "value investing," Graham's approach rests on the belief that you can often get a good handle on what a company is worth, and make your buy and sell decisions accordingly.

Traditionally speaking, value investors look to buy low first and sell high later, relying on the market's penchant to eventually get pricing right to earn their profits. It's a great strategy, and when you consider that it's what made Warren Buffett and others like him rich, it's certainly worth pursuing.

Value also works in reverse
Perhaps the best-kept secret regarding the value strategy, though, is that you can also use it as a framework to short stocks. After all, the same market that serves cheap stocks to value investors also offers significantly overpriced shares as well. And the same valuation methods that tell you when a stock is cheap enough to buy can also tell you when they're expensive enough to sell.

Shorting can be riskier than going long, however, in that your losses can be unlimited if the market moves against you. Fortunately, Graham's value strategy has a secret weapon that you can use to protect yourself from the largest part of that risk: a roulette wheel.

But it's not just any roulette wheel. You get to operate this wheel as if you owned the casino.

Be the house
As a casino owner, you may occasionally have to pay out when a gambler's lucky number comes up on your roulette wheel. But because you've got a built-in advantage thanks to the payout odds, over enough time and enough spins, you'll do just fine. As an investor looking to short overpriced securities, your equivalent protection against the occasional large payout is known as diversification.

It's absolutely true that the market can move against you, and stay against you for a prolonged period of time. But if you spread your short positions around several overvalued companies in different industries, the odds are in your favor that the market won't simultaneously move against you in all of them.

And because your risk is spread across multiple different companies, when (rather than if) one of them moves against you, it doesn't hurt nearly as much as it would if you had only shorted that one.

Put it to practice
Say, for instance, you decide to go looking for companies that reported accounting profits while simultaneously turning in negative cash from operations.

It's a classic framework for finding short opportunities -- cash, after all, speaks louder than accounting does, and that discrepancy suggests there may be something hiding behind a too-rosy earnings report. A search like that would come up with companies like these:

Data from Capital IQ, a division of Standard & Poor's.

While the profits look nice, the negative operating cash flows make it clear that there's real risk involved in those businesses.

Ariad admits that it requires massive amounts of cash to fund its research -- research that may not always or ultimately pay off. Terex is heavily involved in the long-suffering construction industry. It owes its earnings due to selling parts of itself off, rather than to operating strength.

Avnet saw more than a $1 billion uptick in receivables largely drive its negative operating cash flow. While the revenue growth that drove that looks nice on the surface, the rapid rise in receivables suggests deeper research is warranted to see whether the company may have "bought" its growth. After all, one of the oldest tricks in the book is to extend overly favorable financing terms to customers to book earnings ahead of actual demand.

Similarly, Allegheny is claiming that its negative operating cash flow is due to its improving business. Sure enough, the company's resource-intensive operations require it to spend a ton of cash up front, prior to receiving full payment for its products. But that heavy cash investment also means that misjudging demand or a subsequent slowdown can be quite painful indeed.

DreamWorks certainly makes fabulous movies. Nevertheless, the lumpiness and hit-or-miss nature of its revenue, as well as the money it has to continually spend on the next big thing, mean it, too, can get in the position of shelling out net cash. Likewise, Universal always makes a large investment at the start of tobacco-growing season. That investment usually pays out in the end, but there's always the chance it won't.

Meanwhile, New York Community Bank has seen a massive increase in its loan originations, which could be a sign of strong future earnings if those loans perform well. Not that long ago, however, the entire banking system nearly collapsed in large part because of aggressive lending to people who couldn't pay back their debts.

So what?
The numbers certainly suggest risk, but they only tell part of the story. Universal, DreamWorks, and Allegheny, for instance, are fairly well established businesses for which periods like this can be expected. But tearing yourself apart, as Terex is doing, is rarely the mark of a strong company, and cash-hungry research-intensive pharmaceuticals companies like Ariad are often feast-or-famine-type businesses.

Ultimately, though, cash that runs out the door today can't be used to pay tomorrow's bills, whatever the profit statement may say. No matter how good the story, if the cash isn't there, the business won't be for long, either. If you're looking to short a company, consider starting with ones that aren't generating net cash. And if you're looking to make shorting a regular part of your strategy, you need to put Graham's diversification roulette wheel to work for you.

For more ideas on where to look to short, enter your email address in the box below. We'll send you our latest research the instant it's published -- plus, we'll also send you a brand-new, absolutely free report, "5 Red Flags -- How to Find the BIG Short," prepared for you by our resident forensic accountant, John Del Vecchio, CFA. Simply enter your email in the box below.