Short Selling

The best shorts should be "Terminal Shorts" not just stocks following a down trend. 

Terminal shorts have the following characteristics:
1. Management lies or uses shady accounting to obscure actual business trends (this shows up in filings)
2. Bubble valuation (not just overvaluation, bubble valuation)
3. External events will affect the company or invalidate the business model

Clues that a stock could be a good short:
a. Frequent accounting changes or obscurity in reporting. (Modern example I've seen: when RIMM decided it would no longer report handset activations or ASPs)
b. Insider sleaze. This is usually found in the proxy statements, which no one reads anymore.
c. Fads/bubbles. Cabbage patch dolls, weird soft drinks, LA Gear shoes.
d. Overvalued assets on balance sheet. Again, need to read filings closely.
e. Weak balance sheet.

Four elements of a good short:
1. Overvalued stock
2. Fundamental problem
3. Weak financial condition
4. Weak or crooked management

Other tips:
a. "50% Rule:" Need potential for at least a 50% drop in stock price, or it is not a good short because the risks of being wrong are so high.
b. Don't even waste time talking to management because they will give you the same rosy picture they tell everyone.
c. Timing is key on shorts- some bubble stocks can rally for a very long time
d. LBOs/acquisitions/M&A make good short targets
e. Excessive margins and no R&D spending are big red flags. (Recent example is some of the Chinese stocks that imploded.)
f. Shorts take a LOT of work! Start with the IPO prospectus (S1) because it will lay out the risk factors in front.
g. "More than 2 with the same name rule" - good red flag for shorts when there is a lot of family on the board, etc.
h. Shady management background- if someone was a crook before, they'll be one again.
i. Pipeline fill- a great red flag- when the company stuffs the channel to make earnings. (Again, RIMM a good example recently, won't say how many handsets sell-through, only sell-in)
j. Read the proxy statements! Tells you compensation, insider dealing, a lot about management.
k. Accounts receivable up big is a red flag. Financing sales to customers is not good.
l. Reality checks on sustainable growth rate- need to compare it with overall industry- does it make sense?
m. "Always looking for money" -constantly doing debt offerings, secondary stock offerings, PIPEs- this is a red flag that the company has something wrong
n. Obsolescence. Great area for shorts. Tech obsolescence, real estate busts, oil busts, banks in areas hit in a specific industry.

Mistakes short-sellers make.

The three big sins
1. Sloth. You must do your work! A short position takes much more detailed knowledge than a long position because you don't have the entire Wall Street sausage factory working in your favor.
2. Pride. Shorting a good company is a major error! Don't short good companies!
3. Timing. Don't underestimate the insanity of the public to pay a high price for faddish stocks.

Small errors
1. Shorting companies influenced by commodity cycles without tracking the commodity trend
2. Tech stocks- hard to short because traditional metrics on inventory, margin, etc. don't apply
3. Short squeezes- highly shorted stocks are vulnerable
4. Buy-outs! These can rescue even the worst stocks
5. Fear. It's very hard to stay short sometimes when everyone is against you
6. Shorting mediocre companies is a mistake. They can muddle along for a long time.

A checklist for shorting stocks
1. Analyze the Financial Statements
a. Fuzzy assets, inventories, receivables
b. Proxy statements
c. Cash flow is king!
2. Greed and sleaze
a. Management pay scheme
b. Proxy statements!
c. Options awarded to management
3. The big puzzle
a. Store checks
b. "grass-roots" research
c. Non-Sell-Side research
d. What do competitors say about the company? 
4. Who owns the stock? 
a. High institutional ownership is great for a fast collapse
b. Management ownership level
5. Wall Street reports 
a. See what the bulls are saying
b. Taking the temperature- are they "defending?"
6. Pay attention!
a. Listen to earnings calls
b. Every short is different and no two follow exactly the same pattern
c. Watch timing- stalk the company before shorting

Source: The Art of Short Selling by Kathryn Staley, via DavianLetter.com

I have been asked whether our difficulty finding acceptable longs means we should adapt and focus more on shorting. We have shorted just a couple handfuls of times in the history of the funds. As I have described previously, I do not like the math of shorting stocks, nor the risks. It is simply a better use of time, over the long run, to focus on finding great longs. Certainly during the last year there is an industry or two that we could have profitably shorted. Moreover, we were right on top of the fundamentals, and we perhaps should have shorted but for some stubbornness on my part. At this point, nearly all of the situations where our insight may have led to a successful short have passed us by. Few such situations are on the radar today, unless I assume significant disruptions of the consumer and residential real estate. The credit default swap portfolio has that covered in spades. [Emphasis added; Source: 2006 3Q Letter to Investors]