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Since I frequently write about how to identify the best stock candidates, I receive a lot of mail asking me to reverse the procedure to spot short-selling prospects.
As simple as that idea sounds … I can't make it work in practice. More on that in a minute, but first some background.
As you probably know, short selling is a strategy for profiting when stocks go down instead of up. Developing a viable shorting strategy is a worthwhile endeavor because it will give you a way to make money in a down market, an event many soothsayers are saying we will soon experience.
Going short
Short selling involves selling shares that you don't own. Typically, you borrow them from your broker. If all goes well and the share price drops, you buy shares at a lower price and return the borrowed shares.Here's an example using a fictional company.
Say you think Eagle Eggplant Farms, currently changing hands at $100 per share, will be lucky to fetch $50 after its next earnings report. So you sell 50 shares at $100, and your broker adds the $5,000 to your trading account. Since you didn't own the shares you sold, you owe your broker 50 Eagle shares.
Now, assume that you were right and Eagle's shares sink to $50. You could close the transaction by buying the 50 Eagle shares that you owe your broker for $2,500. So, in effect, you paid $50 each to buy the shares and you sold them for $100. The only unusual aspect is that you did the sale first.
One note: If Eagle paid a dividend while you were short, you'd have to pay the dividend to your broker.
The major problem with short selling, as with any other stock market strategy, happens when the market moves against you. Say that instead of dropping, Eagle goes up to $200 per share. If that happened, you'd have to shell out $10,000 (50 shares at $200) to buy the shares you owe your broker. If you closed out then, you would lose $100 per share.
In theory, since you know you were correct in your analysis of Eagle's prospects, you could simply wait until the market figures out what you already knew and Eagle trades down to $50. But there's a catch.
To sell short, you must first establish a margin account with your broker. A margin account allows you to buy stocks on credit. When you buy, you need only put up 50% of the purchase price. Your broker loans you the balance.
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Therein lies the risk of shorting. You could be right with your analysis but wrong on your timing and be forced to prematurely close out the transaction.
Another risk of short selling is that your shares could be "called away." When you sell short, your broker typically lends you the shares from another customer's account. If that customer sells its shares, your broker simply borrows the shares from yet another account. But what if everybody is on to Eagle's problems and shorting its shares? Eagle shares could become scarce, and you could be forced to close your position early simply because your broker can't find any shares to borrow.
Looking for candidates
Now back to the strategy of shorting stocks with weak fundamental prospects. Recently, I checked on the results of my latest attempt at implementing that process."Red flags" is a term I use to identify factors found in a firm's most recent quarterly report that signal the likelihood of future problems, namely negative earnings surprises or guidance reductions. Three red flags that I've found most reliable are: lower profit margins, rising accounts receivables and reduced cash flows, all compared to the year-ago quarter. You can read about them here.
In early June 2006, I put together a watch-list portfolio of nine stocks that showed all three of these "red flags" in their most recent quarterly report, which in most cases was the March 2006 quarter.
Instead of becoming basket-case stocks, those in my portfolio actually beat the market, averaging an 11% return from June 6 through Nov. 3 compared to 9% for both the S&P 500 Index ($INX) and Nasdaq Composite Index ($COMPX). What's more, seven of my nine picks gained versus only two that dropped.
That failure was the latest in a series of misadventures in my quest for an effective shorting strategy. I've tried more variations on that theme than I can count. I've built portfolios filled with stocks with faltering sales growth, debt-laden balance sheets, you name it.
Much research shows that stocks with accelerating sales and earnings growth, combined with strong price charts, are good bets to beat the market. So I've built portfolios filled with stocks with decelerating growth and weak price charts.
In all cases, I found that while some stocks did drop, as a whole my portfolios performed more or less in line with the overall market.
I haven't given up. I've tried one new approach that has shown some initial promise. It's not ready for prime time yet, but I'll tell you about it in case you want to experiment on your own.
When Wall Street gets it wrong
The buy and sell ratings that retail investors have access to come from analysts working for major brokerage firms. These analysts, experience shows, can be wrong as often as they are right.Institutional buyers, such as mutual funds, employ their own analysts to evaluate stocks. If institutions aren't buying a stock, it probably means that they've found something that they don't like. This screen looks for stocks that analysts are rating "strong buy," but ones the institutions aren't buying. The theory is that, eventually, whatever caused the big players to avoid the stock will become evident to the overall market and the stock will drop.
Here's how my screen works.
Institutional ownership is the percentage of a firm's outstanding shares owned by the big players. For most stocks, institutional ownership runs from 35% to 95%.
Screening parameter: Mean Recommendation = Strong Buy
Screening parameter: % Institutional Ownership <= 35
When I first ran this screen, it turned up mostly foreign stocks listed on U.S. exchanges as ADRs (American depositary receipts). These have low institutional ownership because domestic mutual funds don't buy foreign stocks by policy, not because they don't like them. You can eliminate ADRs manually, but I found that requiring at least 8% institutional ownership eliminated most of them. I don't think it hurt the screen because most U.S. stocks, even the dogs, have at least 10% institutional ownership.
Screening parameter: % Institutional Ownership >= 8
If a stock is trading at a very low price, say below $15, it is not a good short candidate because it's likely already out of favor with many market players. Also, stocks with low daily trading volumes, say below 50,000 shares per day, are subject to price manipulation and other issues. The following two screening requirements eliminate cheap stocks and stocks with low trading volumes.
Screening parameter: Last Price > = 15
Screening parameter: Avg. Daily Vol. Last Month >= 50,000
My screen turned up 18 stocks, including six ADRs. Here's the list, excluding the ADRs. Here's a link to the screen so you can run it yourself.
| Company Name | Industry | Recent Price* |
|---|---|---|
Diversified machinery | 17.25 | |
Oil & gas drilling & exploration | 27 | |
Industrial equipment wholesale | 27.36 | |
REIT -- diversified | 20.34 | |
Wireless communications | 36.59 | |
Closed-end fund -- debt | 28.58 | |
Internet software & services | 16.15 | |
Asset management | 44.89 | |
Credit services | 17.38 | |
Business services | 28.56 | |
Oil & gas equipment & services | 23.99 | |
General entertainment | 16.2 |
*Closing prices Nov. 3, 2006
Given my track record for picking shorting candidates, don't even think about shorting these stocks with real money. I'm presenting it only as an idea to be explored. File it away and see how the list has performed in six months or so.
At the time of publication, Harry Domash did not own or control shares of companies mentioned in this column.
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