Down With the Shorts?

" The test of a first-rate intelligence is the ability to hold two opposed ideas in the mind at the same time and still retain the ability to function." -- F. Scott Fitzgerald

Your average short sellers are not evil, and they certainly aren't stupid. They just take the opposite view of longs.

I'm not comfortable shorting stocks. When I think about it, just because I believe a company is overvalued doesn't mean it can't become more overvalued. And if I'm on the short side of that case, even if I'm right, I'm going to lose lots of money.

So if I'm a long-only type investor, should I disregard what the shorts have to say? Absolutely not. In fact, that would be arrogantly stupid. Instead, I prefer to take a page from Richard Pzena's playbook and carefully examine the bear argument. Mr. Pzena manages about $11 billion of capital at Pzena Investment Management, and his track record is excellent. He goes through his research process, makes a decision, and gets ready to buy. But before he makes a purchase, he invites a known bear into the office to present the opposite viewpoint. Imagine that: a very smart guy like Mr. Pzena inviting someone to his office to essentially say "you're full of it."

That's the beauty of Pzena's strategy: He knows that he doesn't know everything. By knowing he doesn't know everything, he's aware of the risks. Risk is by definition uncertainty, and the only way to alleviate uncertainty is through information. So instead of simply accepting the uncertainty or, even worse, sloughing it off, Mr. Pzena confronts it head on. I'd like to shake his hand and say "thanks" for being a stellar example to individual investors everywhere.

Extra large shorts
Heavy short interest implies a binary set of outcomes. That is, one large group thinks the price will go up while another large group thinks the price will go down. So let's go to the most heavily shorted list and try to boil down the bull and bear arguments to one simple question.

I screened for companies with more than 20% of their float shorted. Below are the results.

These are simple shorts
The first one I'll look at is independent power producer Calpine. Back in the go-go years, Calpine was a shining star. It had access to an almost unlimited supply of capital and used that power to build out its power-generation base ... until demand for new power plants dried up. Access to capital then dwindled, leaving the company to struggle with its debt obligations, even though not all of its power plants were up, running, and generating revenue.

If you're a bull, you most likely believe that the demand for power will always exist and is not very likely to decline. Electricity is as essential as water, food, and housing. Also, Calpine has some of the finest power-generation assets in terms of reliability, availability, efficiency, and emissions. Finally, Calpine has so far been able to sell assets and renegotiate credit terms in order to meet its financing obligations.

If you're a bear, you most likely believe that selling assets and renegotiating credit terms is not the best way to succeed in business. Furthermore, it's difficult to know when the demand for new power is going to increase at a significant rate. Finally, there's always the possibility that Calpine will have to convert debt to equity at some point. And this extra supply of equity is likely to cause the stock price to go down.

So the question becomes: Will Calpine be crushed by its debt burden before it can monetize its assets enough to generate returns for shareholders?

Cable company Charter Communications mirrors Calpine in many ways. Charter has a huge debt load and stagnant growth, which has left nothing for equity holders. And to make matters worse, its network requires huge maintenance capital expenditures and heavy investment to keep its offerings up to date. Also, despite its local monopolies, I think it will be difficult to maintain its current pricing power because of all the competition from satellite and telecom companies.

So the question now is: Will Charter be able to increase sales via its new product offerings before it has to make an equity infusion into the business to pay down its debt burden and fund its future capital requirements?

And what can I say about Krispy Kreme? I'll sum it up in a quote from one of my finance professors: "They're doughnuts!" And then I'll point out that Krispy Kreme is a Motley Fool Stock Advisor recommendation, even though Fool senior analyst Bill Mann is on record saying he believes its equity has no value. Seems pretty binary to me.

Are these nice shorts?
Netflix is the bomb! As loyal new customers, Netflix is a fantastic service for my family. Frankly, we think there's so much garbage on TV that we've done away with cable. So getting a special red envelope in the mail from Netflix is a big deal in our house.

No one can argue with Netflix's subscriber growth. More and more people continue to try the service, and I believe more and more people will continue to try the service. It's easy to use and gives consumers the freedom to choose exactly what they want to see. In fact, Netflix recently upgraded its expectations for subscriber growth.

But for a customer-based business model, growing the customer base is not enough. Customers must create value over time, and the company must be able to capture that value. In financial terms, customer revenue minus customer service costs (gross profits) must be greater than the cost of brand-building and customer acquisition. And investors have to understand the breakpoints within the model.

This is where the bear argument is extremely helpful -- it's very easy to be blinded by the fact that Netflix is a great growth company and that growth conquers all.

What do I mean by breakpoints? Well, I'm going to borrow some data from Wedbush analyst Michael Pachter, a known perma-bear on Netflix. Pachter estimates that it costs Netflix $1.80 to store, mail, and receive DVDs. So at the $17.95 price point and a gross margin percentage of 34% (data provided by Capital IQ), customers can rent 6.6 disks per month. At the $9.95 price point, to maintain the gross margin percentage, customers can rent 3.7 disks per month.

At $9.95, Netflix is generating less money per customer. So to maintain the absolute gross margin dollars, customers can only rent 1.5 disks per month. Since this value proposition is more expensive than going to a local video store, it seems unlikely that customers will rent fewer than two DVDs per month. The more customers that choose the $9.95 price point, the more difficult it is for the company to grow its bottom line without supercharged subscriber growth, a reduction in customer churn, a reduction in cost of goods sold, and/or a reduction in customer acquisition costs.

So, then, the question for Netflix is: Will the value created by growing the customer base outpace the value lost by customers migrating to lower price points?

That's a tough question, and it's why stocks like Netflix give me trouble. I can see both arguments pretty clearly, but I think the more likely scenario is that more customers will move to the $9.95 price point over time. Regardless, though, the stock has a passionate following. What's more, it's difficult to precisely calculate when the inflection point will occur. While I'm certainly not buying at this price, I'd be even more scared to go short. That's why -- despite being a very happy new customer -- I'll pass.

I need to be careful
Why I am going through this exercise? Because DeckersOutdoor, my Motley Fool Hidden Gems recommendation, recently appeared on the Reg SHO list. The heavy short interest has been well known for some time. But why would such a straightforward, easy-to-understand company be so heavily shorted as to end up on the Reg SHO list? The default position is that the shorts are wrong. Down with the shorts! But that position is shortsighted, dangerous, and flat-out stupid.

I spelled out the risks during my recommendation write-up and have monitored them since. So when the company recently went on the Reg SHO list, I decided the best thing to do is to act exactly like Pzena and revisit the short argument again. I read all of the bearish information out there on Deckers (and there's not much) to ensure that I'm not missing a structural flaw or some pertinent piece of information that would change my thesis.

Is it overly dependent on Nordstrom (NYSE:JWN)? Are Uggs a fad with a slowing demand? Is the Ugg brand losing pricing power? Is the Teva brand fading because competition is too stiff? Is Deckers stuffing the channels? Are gross margins about to decline because Deckers is discounting prices to retailers? Is there a fundamental problem with sheepskin supply or sheepskin processing? Will costs go up because sheepskin suppliers will be able to hold out for higher prices? Or is it simply that the shorts believe things are going to get worse before they get better following the revised guidance earlier this year?

All of my analyses point against these arguments, but I'd be remiss if didn't revisit the bear case for a double check. Thanks, Mr. Pzena, for being a great example.

Deckers Outdoors is a Motley Fool Hidden Gems pick. Netflix and Krispy Kreme are Motley Fool Stock Advisor picks.

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David Meier owns shares of Deckers Outdoors but does not own shares in any of the other companies mentioned. Netflix is a Motley Fool Stock Advisor recommendation. The Fool has adisclosure policy.