It's Boom Time For The Shorts

Short sellers are ahead for the first time since '94

More than a few people made a killing earlier this year by selling Internet stocks short. And with many other stocks heading south these days, the tactic of short-selling--borrowing shares, then selling them in the hopes of buying them back later at a lower price--is fast coming back into vogue after half a decade in the wilderness.

The year 2000 was certainly far kinder to short sellers than it was to bull-market riders. According to Harry Strunk, an investment consultant in Palm Beach, Fla., who tracks professional short-only money managers, this is the first year that shorts have reaped positive returns since 1994. They were ahead 6% in October, and Strunk expects that figure to be a lot higher when November results are toted up.

Making money by selling short isn't complicated--it's just reversing the sequence of buy low, sell high. Perfect for a bear market, right? Not necessarily. Shorting is an extremely risky business, with a potential for loss that is theoretically unlimited. And it can get even riskier as more players decide to bet on declines. If stock prices turn up, for example, people who have shorted stocks can sometimes panic and all try to buy back shares at the same time. That can make closing out a short position and limiting your losses extremely tough to do--and the higher the prices rise, the more money you lose. "Liquidity is one of the biggest risks of shorting," says Sean McDaniel, a portfolio manager at EMX Investments, a Dallas hedge fund. But if done properly, he adds, short-selling can provide opportunities in any market.

The technology sector has already taken a beating this year. But that doesn't mean there aren't still good ideas for short sellers. One way to find them: Look for companies that might be forced to lower prices on their products, which could clobber both revenues and earnings. One such prospect is SanDisk Corp. (SNDK), which makes "flash" data-storage cards for cameras and audio products. Because of overcapacity in semiconductors, says a hedge-fund manager who asked not to be named, the cost of flash memory could drop by 50% in the next few quarters. SanDisk, he believes, will be forced to sell its products for less as competitors cut their prices--and will thus fail to meet revenue projections.

Not surprisingly, SanDisk disagrees. "We don't expect a 50% decline in the next two quarters," says CEO Eli Harari. "We have very substantial cost reductions coming ahead, but we are able to reduce manufacturing costs at the same time, so we can maintain our earnings and grow the market." Still, the pessimistic fund manager is looking for SanDisk's share price, currently $68, to halve in the next six months. He figures the market will slash SanDisk's 50 price-earnings ratio if it senses that sales are stumbling.

Another way to evaluate short potential from p-e's is to judge whether a company's ratio is justified by how its products stack up against those of rivals. Steve Worthington, a portfolio manager at Barbary Coast Capital Management, a San Francisco hedge fund, thinks programs offered by Manugistics (MANU), a developer of software for supply-chain management, don't measure up to the competition's. "I2 Technologies is clearly the leader in this field," he says. Yet Manugistics' stock, now around 100, is trading at a price-earnings ratio of 478. By contrast, Wall Street expects I2's earnings to grow 30% faster than Manugistics'--yet its stock, at 57, has a p-e ratio of 249. His conclusion: Manugistics shares are in for a 50% correction.

Another outfit with a stratospheric valuation is Research in Motion Ltd. (RIMM), a Canadian company that makes the BlackBerry, a handheld wireless e-mail device that has been a hot seller. RIM's profits are forecast to grow 80% a year--but its p-e ratio is a staggering 13,600. With cell-phone makers such as Motorola now targeting RIM's market, Worthington thinks RIM shares are way overpriced. "It has a $10 billion market cap with only $175 million in revenues," he says. "This company is a day-trading fool's special."

What about short-selling ideas in nontech industries? A good rule of thumb: Look for earnings that don't reflect steady cash flow from an ongoing business. For instance, Sunrise Assisted Living Inc. (SNRZ), which provides services to the elderly, has increased earnings through a novel strategy: selling off its most profitable facilities to a partnership in which it holds a 25% stake, and reporting these one-time gains as net income. Worthington argues that this practice makes the quality of its cash flow suspect. Sunrise execs say the company has enough properties to sell for some time to come.

FALTERING. Faulty business strategies can also cause future blowups. Multilevel marketing schemes, which increase sales by continuously hiring more salespeople who must recruit other salespeople, can sometimes lead to disaster when the addition of new salespeople falters. One such company to keep an eye on is PrePaid Legal Services Inc. (PPD), which markets legal services for a monthly fee through a multilevel network of 234,000 sales associates. Its revenues grew 30% last year. But in the third quarter, the increase in new sales associates slowed to 23%, down from 42% a year ago--a sign that PrePaid may not be able to sustain its rate of revenue growth. Company execs explain that this year's decline is due to tough comparisons following a major sales-recruiting drive in Canada in 1999.

Short sellers also say PrePaid is not making adequate reserves against uncollectible commissions. The shorts note that 64% of the company's assets are prepaid commissions, which aren't likely to be recoverable if an employee quits. While commission advances have increased 160% since March, 1998, reserve for bad debts as a percentage of advanced commissions has declined by half, to a mere 2.8%, which some fund managers feel doesn't adequately protect its balance sheet from a slowdown. Randy Harp, PrePaid's chief operating officer, says the company monitors its advances to individual sales associates quarterly and has determined that the reserve is sufficient.

SCOOT. Retailing is facing lots of woes. One item in huge oversupply is scooters, which have plunged in price this year. An interesting short-seller strategy is to look at outfits that sell a lot of scooters--such as Sharper Image (SHRP), Children's Place (PLCE), and bicycle distributor Huffy (HUF). As one hedge-fund manager sees it, all three may be vulnerable to sales declines.

And problems at Children's Place, a leading seller of children's clothing, aren't limited to scooters. Sales growth has eased in the most recent quarter, to 41% from 52% a year ago, and short sellers note that the average time required to collect accounts receivable increased more than 50%. Seth Udasin, chief financial officer for Children's Place, says that growth is still strong and he's not concerned about accounts receivable, since those payments are coming chiefly from landlord rebates and credit-card users.

While falling stock prices seem to be the norm these days, picking the right stock to sell short can entail difficult analysis--and great risks of being wrong. But professional short sellers couldn't be more delighted. After five years of slim pickings, they finally have the kind of rocky market they need to rack up some fat rewards.