The Perfect Short

I'm a long-term, buy-and-hold investor.

That doesn't preclude me, though, from having fun with some thought experiments, like what the perfect short would be. I've done it twice before, once with Morgans Hotel Group, and once with DryShips. The short on Morgans would have beaten the market by 25% when I closed it out on my CAPS portfolio, and DryShips is down 7.6% since I wrote about it, versus a 2.5% gain for the S&P.

My inspiration
Recently, I was rereading one of Tom and David Gardner's very first books: The Motley Fool Investment Guide.

I noticed something I must have missed on my first read-though: a section on shorting stocks. Though the references in the book may be dated (they explain how to use ... the Internet), the guidance on shorting stocks hasn't changed.

Today's contenders
To start things out, I went looking for seven contenders for this month's "perfect short." Below are the companies I selected, along with what each one does.

In their book, the Gardner brothers hash out four signs that one should look for when shorting a stock; let's run these seven companies through their metrics.

1. High ratio of debt to cash
For the purposes of this experiment, I'm specifically looking for companies that have more than twice as much debt as cash. Though in some industries going into heavy debt is just part of doing business, such heavy loads can strain a company's balance sheet if tough times hit. Here's how today's companies stacked up.

Source: S&P Capital IQ. Cash and debt in millions.

After examining our first criterion, we see that Boeing probably isn't the best shorting candidate. We'll throw it out and move on to the second criterion.

2. Low levels of cash flow
This is where things get tricky. Because earnings are reported using the accrual method, companies may not yet have collected all of the money that they say they've earned. Things like accounts receivable and payable, depreciation, and goodwill are included in earnings -- and they don't immediately affect the amount of money a company has in the bank.

The good news is that there is a way to see how much money a company has put in the bank: free cash flow. This number is very important -- some Fools would say more important -- in evaluating a company's value.

For this metric, I looked to see if these companies had a considerably higher price-to-free-cash-flow ratio than their price-to-earnings ratio. Such a discrepancy could signal that investors are paying more than they think they are for a stock.

Source: S&P Capital IQ; author's calculations. As of Oct. 13.

Using our criteria, we see that Deere, Las Vegas Sands, Huntsman, and UPS all have significantly higher ratios in free cash flow than they do in earnings. Again, this could represent a weakness that investors are overlooking.

We'll stop considering the rest of the companies, as they either have fairly similar ratios (RPM), or they actually have lower free cash flow ratios than earnings ratios (NZ Telecom).

3. A closed situation
When the Brothers Gardner wrote their book, they meant that it would be unwise to short a company that had an open-ended future. Think of Amazon, Apple, or Google; they don't fit nicely into any one industry or field. Whether moving into cloud computing (Amazon), all things movies and music (Apple), or even alternative energy investments (Google), all three of these companies could have their hands in a dozen different fields 10 years from now. It's not very Foolish (big F) to short a stock with such potential.

Since the potential for Las Vegas Sands in Macau is vast, and Huntsman is aggressively expanding its global reach, I'm throwing these two stocks out as well. There's no reason to place bets when you don't have a clear vision into a company's future.

4. Low short interest
When a stock is heavily shorted, it poses a serious threat to those hoping to profit from its downfall. An earnings surprise -- or a herd mentality to cashing in profits -- can lead to a ballooning stock price. That's a shorter's worst nightmare.

Neither UPS (1.8%) nor Deere (2.6%) has particularly high short interest as a percentage of their float, meaning they pass this test as well.

Draw your own conclusions
I'll be the first to admit that I was surprised to see these two stalwarts pop up as potential shorting candidates. Their fates are tied fairly closely to that of the overall economy. If you think we're headed for a recession, they're probably a good short bet. If not, you might have to keep looking.

And speaking of the possibility of recession, The Motley Fool has developed a special free video report to help prepare you for that very possibility: "Watch This Before The Market Crashes." You'll see how to protect your portfolio, and find out about a company that could be this generation's Intel. The video report is yours today, absolutely free!