Short sellers get ideas from many sources. Some of the best ideas come from the most obvious of places - Barron's, WSJ, Forbes, etc. Short interest and stock float are important. A short seller should make sure the short interest is not so high that a short squeeze can increase the risk relative to return.
Franchises have extensive potential for financial stumbles; and once one franchise is analyzed, a group of them can be easily perused. A short seller should look for types of business that eat money - financial services and real estate - or companies with complex financial statements and blind pools of investments - the financial sector is another solid choice in this category. Once a company is targeted it should be analyzed with skepticism and curiosity every time a new financial document is published.
(1) The Pessimist's Guide to Financial Statements
The financial statements are always the first step for any serious student of stocks. Short sellers attempt to discover what is behind the numbers, what drives the company, what the business prognosis is.
Quality control - The first look at the financials is with the intent of breaking teh company into tiny pieces and checking to see if all those pieces are real. The most useful part of the financials will be the footnotes. The other consistent keys are what is not there and what cannot be understood. Start by looking for bogus assets. Then test accounts receivable and inventories looking at growth versus previous years and comparing growth to growth in sales and CGS. If the receivables growth is substantially greater than the growth in revenue, problems with earnings are likely. Growth in inventory vs growth in CGS is the single most reliable indicator that a manufacturer or retailer will stumble. A frequent area of abuse is deferred charges. Examples of deferred charges are prepaid advertising and deferred commissions or sales charges. Another category worthy of jaundice is goodwill and other intangible costs. Capitalizing routine expenses is another clue that a company is manipulating earnings. Accumulated depreciation is a sleeper balance sheet line that nobody watches much. If accumulated depreciation drops when gross PPE rises, the company might have changed the average life assumption and run the reversal through the income statement or might have simply reduced the depreciation expense in subsequent quarters. Look for off balance sheet liabilities, debt guarantees or recourse factored receivables. Make a subjective decision on what percentage of the business is stable and repeatable. Give it the buzz word test. Watch for auditor turnover - it is the one signal that is truly indicative of trouble.
(2) In Search of Greed and Sleaze
Form 4 - insiders purchases or sales.
Proxies - one of the best data sources for inurement and greed.
WRT salaries - compare salaries + bonuses to net income. Look at cash compensation relative to company earnings. Does the company pay a % of pretax profits to the primary officers in the form of a bonus? Are they paid a % of revenues? Does the company pay a bonus for taxes on options? Terms of retirement contracts? Unusual severance pay contracts? Arms length transactions??? Is the board a bunch of rubber stamps?
(3) The Bigger Puzzle
The research segment starts in the library, whereas the store check segment ends up watching the marketplace.
(4) Who Owns It?
High institutional ownership and high Wall St coverage can make for a quick collapse if something unexpected happens.
(5) Check The Water Temperature
Accumulate brokerage reports to provide the company think and Wall St attitude. Use analysts for indications of Street-think and as conduits of management information.
(6) Pay Attention
Keep paying attention. The date of the earnings release is also statistically relevant. The later they are, the worse the numbers. Keep watching - once a potential target, always a potential target. Do not cover just because of price movements; wait until resolution of the scenario. Short selling can be much like a cat waiting outside a mouse hole - the level of persistence, patience, and attentiveness is not for everyone, especially over sustained periods of time.
Recap
Wall St ices the inefficient cake with compulsive conformity. Everyone gets on the bandwagon and stays until the evidence is too compelling, then they all fall off with a jolt.
Do not genuflect in front of a business, an executive or an analyst. Keep your distance and your objectivity. The stock market is about people disagreeing over stock prices.
A short seller is a skeptic with a constructive, optimistic bent.
The rule of thumb when you study a proxy is that if you have to read it three times, you have struck pay dirt.
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