Two Fads You Should Avoid

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

I like to short companies that don’t have a strong a business motto built around them, and are priced by (in Buffett Words) Mr. Market as if they were the Coca-Cola's of this world – which is the most powerful business franchise I can imagine and is priced at a forward P/E under x 19.

Below you may find two very different businesses that cannot justify their current market valuation, even if short term results had been better than what was expected. That said, when shorting a stock timing is more important than ever. A wrong bet on the short side grows as a percentage of your portfolio, which is the opposite of what happens when you make a wrong decision going long. 

Abercrombie & Fitch (NYSE: ANF), which reported 3Q 2012 earnings ahead of consensus expectations and rose nearly 30% in one day, cant justify current market valuation of $3.5 billion with a x5.5 EV/EBITDA and x14 P/E, even if management’s efforts to make the turnaround happens to work for a while.

Even with positive surprises and with 3Q EBITDA jumping to $167 million from $137 million last year, and with operating margins increasing to 9.6% from 7.2%, same store sales still declined 3% (compared to -10% in 2Q 2012), proving that weaknesses are still in place. 

Lets review some numbers where I see weaknesses:

1) A&F same store sales fell 4% and total revenues rose just 0.9% year over year, even after opening flagships in Hong Kong and Munich

2) Hollister same store sales fell 1% and total revenues rose 16.3% year over year by opening 9 international stores

3) Abercrombie kids same store sales fell 3% and total revenue fell 4.2% year over year after opening one flagship in Munich

4) US sales were flat year over year (70% of total) as 78 stores closed

5) International sales rose 37.2% year over year by opening 53 new stores

Of course, a lot of work is being done by management, and there are results, but sometimes business results depend more on the boat you row than on the sailors in it. Gap (NYSE: GPS), which has been through its transformation phase for longer, trades under x15 P/E generating positive free cash flow and reporting same store sales growth for 2012. The GPS yardstick tells us that ANF is expensive, and I would start shorting it at a market cap of $4 billion. 

The St. Joe Company (NYSE: JOE) is Northwest Florida's largest private landowner, with approximately 567,000 acres of land, and the biggest fad I have seen in many years (after Green Mountain Coffee Roasters - which fell from $71 per share to just over $21).

Joe is a piece of land located in a region of northern Florida with no oil (David Einhorn said that Joe's management unsuccessfully looked for oil there), no civilization around, and no way to compete with the more compelling Southern Florida companies where land is still cheap thanks to the real estate bust. The company manages some timber operations on the land and develops residential communities and resorts on Northern Florida's shores.

How much are Joe's acres worth? Its difficult to tell since there are almost no revenues, EPS is always negative (at least for now), and its trading at x3.5 price to book value. I don’t know whats the fair value for Joe, but it's definitely not the current market cap of $1.96 billion.

Again, timing is essential when shorting stocks, and it should be carefully done. When I do it I also go long on the ETF that represents the index of the industry where the company I am shorting operates. When lacking such an ETF, I just go long on the S&P 500 index in order to hedge myself from general market upturns. You need to remember that short positions become larger in your portfolio as the market goes against you, so hedge yourself & choose the correct time to jump in - patience is essential!

martinzaldua has no positions in the stocks mentioned above. The Motley Fool owns shares of Green Mountain Coffee Roasters and has the following options: short DEC 2012 $21.00 calls on Green Mountain Coffee Roasters, short DEC 2012 $21.00 calls on Green Mountain Coffee Roasters, long DEC 2012 $16.00 puts on Green Mountain Coffee Roasters, and long DEC 2012 $16.00 puts on Green Mountain Coffee Roasters. Motley Fool newsletter services recommend Green Mountain Coffee Roasters, Gap, and The Coca-Cola Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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