3 Risk Factors Identified by Successful Short Sellers

Kyle is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

To generate investing profits regardless of market direction, investors must be able to short effectively. Shorting successfully is challenging for many reasons. The best short sellers identify profitable short candidates by delineating one or more of three main risk factors: (1) Balance Sheet Risk (2) Valuation Risk and (3) Earnings Risk.

 Balance Sheet Risk

Balance sheet risk can manifest itself in two ways. (1) A company’s assets could be overvalued or (2) a company’s competitive position & future earnings may be in peril due to excess financial leverage such as debt, long-term contracts, or underfunded liabilities. A company with significant financial obligations may have difficulty reinvesting in their business to support operations and/or missing the flexibility to pivot in response to market changes. A company’s financial leverage magnifies the effect of revenue or margin changes both positively and negatively.

Balance sheet risk is idiosyncratic for each company given different sets of future financial obligations. The specificity is important to short sellers as current market sentiment is less important than company factors. As such, balance sheet risk shorts can be successful across both bull and bear markets.

Historical Balance Sheet Risk Examples:

A recent classic example of a balance sheet which misrepresents a business’s economic worth is the Saint Joe Company (NYSE: JOE). A battleground stock between David Einhorn (short) and Bruce Berkowitz (long) in 2010, the valuation question with Saint Joe was simple: what were the real estate holdings worth? As seen in the stock price, Einhorn and the short sellers were correct: the land was worth much less than suggested by the balance sheet.

 

The perils of overleveraged balance sheets were seen during 2008 when many “old media” companies found their business models drastically changing. Media companies historically produced significant free cash flow regardless of market environment. As a result, many of these companies were significantly leveraged. Many old media companies found operating strategy dictated by maintaining compliance with debt covenants at the expense of investing in new media segments such as online or mobile content. Some examples of overleveraged old media companies which made excellent shorts in 2008 were New York Times, Gannett, Media General, and yellow pages publishers Supermedia and Dex One.

Current Potential Balance Sheet Risk Examples:

One business in the competitive financial services products industry with balance sheet risk is NCR (NYSE: NCR). Per the Sept. 30 10-Q, NCR has $1,194 million of underfunded pension liabilities even after contributing $489 million in cash to the pension plan last summer. This payment represents ~ 2 years of free cash flow thus leaving the firm little optionality to re-invest in operations or return cash to shareholders NCR shares rallied significantly during 2012 so this risk factor has not yet been a catalyst for short sellers. 2013 will shed new light on how detrimental NCR’s balance sheet woes are for continued financial performance.

Valuation Risk

Valuation risk applies to high flying growth stocks valued on future prospects as the market has ceased to care about traditional valuation, such as cash flow or earnings, instead focusing on alternative valuation methods. A couple examples would be companies based on “eyeballs” during the late 1990’s or users during the 2010 / 2011 social media frenzy.

Shorting into a rising market tends to be counter-productive regardless of over valuation. As John Maynard Keynes advises: “The market can remain irrational longer than you can remain solvent.” For this reason, knowing the market environment is paramount for valuation risk shorts. A bull market tends to perpetuate increasing prices of these story stocks. A flagging bull market or an outright bear market causes investors to reassess their positions and story stocks are often marked down considerably in price.

Historical Valuation Risk Examples:

The technology bubble in 2000 and 2001 is a classic example of valuation risk shorts working extremely well at the right time. Companies such as Cisco and Level 3 Communications in 2000 were completely on market sentiment and estimates of future growth which ultimately fell flat.

Current Potential Valuation Risk Examples:

Salesforce.com (NYSE: CRM) has been growing revenue above 30% per year for the past few years and the stock has more than doubled. At 9.6x price to sales and 110x non-GAAP earnings (note negative GAAP earnings), the market is valuing Salesforce primarily on its revenue growth rate. If revenue growth remains strong, Salesforce.com will likely continue to appreciate in price. If the company misses Wall Street sales growth expectations, valuation risk may present itself as investors re-rate the stock downward.

Earnings Risk

Earnings risk is a catch-all category which crystallizes a myriad of risks which cause companies lower earnings. Earnings risk can capture if a company’s business model is broken, management is overly optimistic or disingenuous, or if competition is eroding market share or pricing power. Utilizing a company’s reported earnings as a catalyst for shorting is a powerful way to capture deterioration in a business. The classic case here is any stock that misses earnings due to competition or an evolving economic landscape.

Historical Earnings Risk Examples:

Many successful short positions are due to missed earnings. A few high profile shorts which worked well in 2012 due to earnings risk were Zynga (NASDAQ: ZNGA) and Facebook.

Current Potential Earnings Risk Examples:

Many stocks will undoubtedly make excellent earnings risk shorts in 2013 so there are many current examples.

Green Mountain Coffee Roasters (NASDAQ: GMCR) remains a name which could again miss earnings due to competition for single serve coffee makers and pods and/or margin compression from production contracts for other coffee firms.

Conclusion

By considering each potential short opportunity in light of these three risk factors, short sellers structure their thinking about potential positions. By recognizing a paramount risk factor for each short, investors force themselves to focus on why a stock ought to decline in price.

Short selling is one way to increase your portfolio’s robustness during 2013. When you sell securities short, consider one of these risk factors to realize the overvaluation your investment is predicated upon. Best of luck shorting in 2013!


GrizzlyRock has no positions in the stocks mentioned above. The Motley Fool owns shares of Facebook and has the following options: long JAN 2013 $50.00 puts on Salesforce.com and long JAN 2014 $20.00 calls on Facebook. Motley Fool newsletter services recommend Salesforce.com, Cisco Systems, Facebook, and Green Mountain Coffee Roasters.

blog comments powered by Disqus

Compare Brokers

Fool Disclosure