Selling Short And Sweet? It Can Be Done

Some good plays exist amid sky-high valuations

With stocks climbing to what often appear to be crazy valuations, it seems there are plenty of great short-selling opportunities out there. Take Internet stocks, which by every measure are fantastic shorts: limited revenues, little earnings, sky-high valuations. Yep, they're a no-brainer, but only in the sense that if you short Net stocks--as well as a whole range of other high-flying tech stocks--you truly have no brains.

The amount of money pouring into Net stocks--from institutions and small investors alike--means shorting such stocks on the basis of valuations is a good way to lose money. Still, despite the relentless bullishness, opportunities do exist for short-sellers.

Shorts sell borrowed stock in the hope of buying back the shares at a lower price. Anyone with a margin account can do it. The only requirement is an appetite for risk. Short-selling is always risky, even in bearish times, because losses are theoretically unlimited.

One way to reduce the risks of short-selling is to not short the biggest names in the Internet and high-tech world. Sure, they may collapse--if a 200-foot tidal wave sweeps Silicon Valley. Otherwise, the Intels and Amazon.coms are too risky to short, because those kinds of stocks are on everybody's buy list. A better idea is to pick a company with a fundamental problem not recognized by the market.

Such stocks can be gems. When BUSINESS WEEK reviewed short-stock picks last summer, one of the most popular was Iridium World Communications Ltd., which was having trouble paying off bank loans. The company has since sought bankruptcy court protection.

Another popular short-seller approach is to zero in on secondary names that are less popular with institutions. Money manager Bob Bandera, who runs the Westlake Investing money management boutique, was short at midyear the shares of Navarre Corp., which runs an Internet radio network that had investors excited (BW--June 14). Bandera felt that the market had vastly overestimated the company's prospects, and so far he's right. The stock, 12 in late May, is now down to about 7.

SQUEEZE PLAYS. Nowadays Bandera is shorting ZixIt Corp., another Internet stock he believes has gone crazy. The company is developing an Internet messaging system. Its stock has climbed almost 600% over the past year, and it has a $930 million market capitalization. But Bandera believes the company's product is simply not superior enough to warrant such a huge valuation.

The "less impressive than it sounds" theme runs through many of the better short picks nowadays. One is Perle Systems Ltd., a standout performer over the past year--up 500%--that sells data-communications products such as remote-access devices for local-area networks. One short, a hedge fund manager who requested anonymity, is betting against Perle in the view that its technology is not all that new or unique. Another remote-access provider, Ariel Corp., is being targeted by shorts for similar reasons, as is Rhode Island-based Log On America Inc., which has gained quite an investor following (BW-- Sept. 13). But shorts believe the company, though still below the high of $37 a share that it reached in April, will eventually slump further. "It's a small Internet service provider trading at 100 times revenues," says one short.

Stocks such as Log On are good shorts for a technical reason: As of mid-November, when the last short interest numbers were released, there weren't a massive number of people shorting the stocks. In the case of Log On, it was about 600,000, vs. a float of 7.7 million shares. A large short position in the stock can be dangerous because such stocks are vulnerable to "short squeezes," in which shorts are required to replace the shares they've borrowed and sold. Squeezes are a major reason for losses, because shorts can often be forced to replace their borrowed shares at much higher prices. Short squeezes, fed by a raging bull market, have contributed to crummy performance by short-selling hedge funds.

NUTCASES. Like it or not, high short ratios are a feature of some of the most eminently short-able stocks. However, there are still shorts that remain relatively virgin territory. One prominent short has been taking a position in MicroStrategy Inc., which has gone bonkers since it went public at 12 in June, 1998. The stock is up 700% over the past year; it now boasts a market capitalization of $7 billion and a price-earnings ratio of over 600. Another "gone nuts" stock that is not too heavily shorted is Commerce One Inc., an Internet e-biz company that went public last July at 21 and is now selling at over 400. That's a market value of $10 billion.

Shorts in Commerce One are betting that this is not the next, which has creamed them. Sometimes there isn't a heck of a lot of difference between a high-flying and a not-so-high-flying, except in the vagaries of investor sentiment. To be safe, shorts prefer stocks that have a negative book value and stubbornly negative earnings. Among the "no earnings but healthy valuation" stocks are a host of tempting targets. One, Source Media Inc., has not crashed through the ceiling like some of the other new-media stocks--its market capitalization is a "mere" $216 million. The company provides new-media content and interactive cable-television programming, and is being shorted widely in the view that its prospects are hazy at best. Another short in that mold is C3D Inc., which is developing digital-storage technology products. Shorts view C3D's $600 million market cap as overblown, even after a recent sharp decline.

The Y2K disaster play is one short-investing theme that hasn't gone very far. The possibility of calamity at the millennium's end is generally viewed as being reflected in share prices, at least among the few companies viewed as vulnerable. One Y2K play of sorts is Royal Caribbean Cruises Ltd., the world's second-largest cruise operator. The stock is under pressure because of concern about weak demand for cruises; shorts believe the company's millennium celebration business will also not meet expectations.

Sick of the Pokemon craze? One eminent New York-based short is betting against 4Kids Entertainment, a diverse toy design and development company that, among other things, has the license to market Pokemon products. That has helped send 4Kids shares zooming 986% over the past year. The short is wagering it's a "fad stock." And it may be. The problem is that the the Street elevates glorious, mediocre, and crummy stocks alike. That used to look like a fad, too--back in 1982, when the bull market first began to make short sellers miserable.