Bad News Bears
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Being a broker is tough enough without having to worry that one of the companies on your firm's recommended list is going to blow up a la Enron or Kmart. Even worse, is when a client points out that you could have known. In fact, before nearly every catastrophe, there are investors who are aware of the danger — and betting on disaster. They are, of course, the hated short sellers.
Shorts have been derided as thieves, liars and even traitors. (Peter Lynch once called shorting “borrowing with criminal intent.”) But the fact is, it is wrong to write-off short sellers as perma-bears and cranks. If you own stocks, you should also know what could go wrong. Get the bear story.
Needless to say, you're unlikely to find it in your firm's research reports. How many sell-side analysts downgraded Enron to a sell, even after it began imploding? Still, brokers can call their research analysts and their associates and ask them what the bears have been saying. Another good place to find the short story is the trading desk, where information (even outright rumor) spreads like the flu.
The best place to get an early hint that a stock is in trouble is in the short interest tables, which are published monthly by the exchanges. Brokers should be on the lookout for stocks with a high short-interest ratio (the amount of shares shorted compared to shares outstanding). “If it [short interest] is growing quickly, you have to ask yourself why are there all these smart people willing to bet against the stock,” says Aaron Edelheit, the president of Atlanta-based hedge fund Sabre Value Management.
Shorting alone does not indicate that a stock is ready to fall. Many widely held stocks are shorted for hedging or tax purposes, not because of any weakness. In addition to a high short interest, Edelheit looks for insider selling, deteriorating balance sheet items (such as a jump in accounts receivables or a surge in inventories), positive earnings but negative cash flow and complicated financial statements. A high price-to-earnings multiple is in itself not enough, shorts say, because a stock can stay overpriced longer than you can remain solvent, as Keynes used to say (who himself was an excellent short seller).
While some shorts use anecdotal information as the basis for their bets, close scrutiny of the financials is what counts. One short, who asks to remain anonymous, is looking at Calpine, a power company that has lots of debt and many intangible assets on its books. “The industry was receiving lots of press, which suggested to me that the sector was over-hyped,” he says, “and, oh, it had all this and it sells a commodity product.”
Jeff Middleswart, vice president of research at David Tice & Associates, a Dallas short seller, looks for companies that are meeting quarterly earnings estimates by jamming sales at the end of the quarter. “They're essentially borrowing from future sales,” he says. Another tip: When a company's 10-Q or 10-K reports have pages of footnotes, the company bears scrutiny. “A good rule of thumb is that if the 10-K is more than 400 pages, it's a short,” quips another short.
Also, beware of companies that take “special one-time charges” every quarter, or companies that blame a poor quarter on questionable factors such as the weather.
Shorts also look askance at corporations that set up separate holding and operating companies. “Why not just keep them as the same company?” Middleswart asks, citing AES, the power producer and a favorite short of his.
Beyond the numbers, look for high turnover of key managers, and especially for vague reasons. Another sign is an extreme over-reaction to short sellers and any critical coverage in the press. That happened at Enron.
Finally, trust your instincts. Charlie Mayer, senior vice president and director of value and fixed income at Invesco Funds Group, says if he doesn't understand it, he sells it. “If I own it and they start doing something I don't understand, I sell it,” says Mayer. “Enron was a case in point. I bought if for one reason, which was for E&P (exploration and production) and the pipeline and cash flow, and when they moved further into energy trading and broadband, I couldn't get my arms around it.”
