Eyes Peeled for Those "Big Red Flags"

That's what author and short-selling specialist Tom Taulli looks for when picking stocks that seem poised to take a tumble

The stock market these days is "a short-seller's paradise," according to Tom Taulli, author of a new book, The Streetsmart Guide to Short Selling (McGraw-Hill). Taulli expects the bear market to last at least till yearend.

Short-selling, loosely defined, is the practice of contracting to sell stock at a given price. If the price falls below that level, you buy the stock at the lower price, deliver it, and pocket the difference. That's what makes a bear market so attractive to those who play this way, and Taulli points out that studies show that stocks fall faster on the downside than they rise on upturns. He also notes that investors tend to react swiftly to negative news, pointing to the example of Electronic Data Systems on Sept. 19, when its price plunged 50%.

To minimize losses on short-selling, Taulli recommends setting an automatic trigger to sell a stock when it rises 15% to 20% above the price where it was shorted. And he urges rigorous study of a company's balance sheet, with particular attention to the cash-flow statement, which he says is difficult to manipulate.

These were some of the points Taulli made in an investing chat presented Sept. 19 by BusinessWeek Online on America Online, in response to questions from the audience and from Jack Dierdorff and Karyn McCormack of BW Online. Following are edited excerpts from this chat. A full transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Q: Tom, the bears were really growling today -- the Dow flirting with the low of last July perhaps. What's your macro view of the market these days?


Well, I think this is a short-seller's paradise and will remain so for the rest of the year. I think there's nothing on the radar to move this market in a significant way on the upside. Judging by recent earnings warning announcements, it looks like the economy is still rudderless...although, for next year, I do think that we will see a comeback in the market, and it will be a good time to go long. But right now, this is certainly not a good time to go long in an aggressive way.

Q: Can you tell us about your new book? What strategies for short-selling do you advise?


I came up with the idea for the book several years ago because there was very little information on the subject. The last book on short-selling had been written in 1996, and, given the bursting of the bubble, I thought it would be a great time to short stocks, so I started doing so. But it was also a great time, I thought, to write a book on the subject.

Most of what I say to look at is statement analysis and finding red flags on financial statements. I also listen to the conference calls...to get an idea of the direction of the company. I study some of the macro factors of the industry and see if there are signs that growth is starting to diminish. I will even look into technical-analysis factors, such as charting, which can be a good way to find opportunities for shorts.

Q: What is it about this kind of market that makes it "a short-seller's paradise"?


The reason I think it's a good time to short is, simply put, we're in a bear market, and I think we will be in this market for the rest of the year. This gives you a lot of wiggle room when you're looking for short-sell opportunities, because investors are looking for negatives, not positives, and will act quickly on those negatives. A good example is EDS 's (Electronic Data Systems) stunning collapse in its stock price today...when the announcement came out, investors had no problem in dumping as much stock as possible.... And studies have shown that stocks tend to fall faster...than stocks going up.

Q: Since most stocks are depressed, where are the short opportunities?


I want to look at companies that have already shown weakness, but not tremendous weakness, although that's hard to find, because stocks in general have come down very significantly. But I still think there are some good short-sell candidates to look at. But, as with anything, short-selling is a very risky strategy, and if you're starting in the short-selling game, start slow and don't put too much of your money in it. If you do short a stock, watch it vigilantly, and if the position goes against you, make sure you get out of it quickly.

Q: Tom, you mentioned watching a company's balance sheet when selling short. What items and trends should you watch?


The key parts of the balance sheet that I look for include accounts receivable and inventory levels, and comparing those to the growth rate in sales. If there's a great discrepancy -- say, if sales are growing much less than the inventory and receivables -- it's a big red flag that the company is having some problems. I also like to look at the footnotes in the financial statements and try to see if there are any changes in accounting policies. A big red flag is when a company changes its appreciation or amortization strategies to a more aggressive stance in terms of lengthening the time period for making those charges.

Q: This is a bit late, but for the record, to define short selling, could you give us an elementary example of how it works?


Let's take an example where a stock is trading for $20 per share and you short 100 shares. That would be $2,000. Since you sold $2,000 of stock, that amount is put into an escrow account. You do not have access to that money until you close out your short position. To allow for that short-sale transaction, you have to set up a margin account with your broker and put up a certain amount of cash against that position, depending on the policies of the brokerage house.

Another thing to consider, is that you may not even be able to short the stock, because a broker needs to be able to find shares to borrow. This is known as the "borrow." And these shares are borrowed from other investors' margin accounts. If the stock begins to increase, the broker will insist that you put up more margin to account for the stock. However, if the stock begins to fall, you will begin accruing more credit in your account and can even buy more shares. Say the stock falls to $1 per share -- to close out your position, you would buy out those shares for $100, and deliver them back to the broker and get to keep the $1,900, which would be a nice payday. But if the stock price increases, say, to $30, you would have to buy back the shares for $3,000, and you would lose $1,000.

Q: Is this activity for the average small investor?


That's an excellent question, and my opinion is that average investors, or any investor, should have the freedom to engage in any investment technique they want. When I talked to financial-service companies while writing my book, they disagreed and thought investors should have someone else to oversee their actions. To me, this is paternalistic, and I think that everyone should be free to control their own investments.

Q: I do a lot of short-selling, but it's difficult, especially when you see your targeted stock going up. When do you sell? It's tough to know the right time.


My approach is to set an automatic trigger, say 15% or 20% above the price I shorted the stock. Short-selling is about strong discipline, hard work, and lots of research. But like anything in investing, you will never be right all the time -- and that means setting these trigger points to get out of trouble. For short selling, I think this is particularly important, because stocks can continue to go up and up, and you will continue to rapidly lose value in your portfolio if you hold on to that position.

Q: Can you cite any of your past success stories with short-selling? Or perhaps mistakes as well?


In terms of successes, I have shorted a variety of stocks. One was Homestore.com (HOMS ), which I shorted in, I think, the mid-30s and rode it down to about $8 to $9 a share. It was an example of what I saw as a disconnect between a company and its sector. Of course, the Internet sector was getting crushed, and yet Homestore continued to maintain a strong stock price. But I looked beyond this and delved into the financial statements, and found some red flags that convinced me it was a good short position.

In terms of bad shorts, I've had a variety of those as well. It's inevitable, but as I mentioned before, I will put a trigger of about 15% to 20%, and that has been very helpful in getting me out of big trouble on the short side. So I don't have any horror stories, but while researching the book I was able to learn of others' horror stories, unfortunately.

With short-selling, you can be 100% right about the stock and still lose a tremendous amount of money, because markets can be irrational and go against you. And the market was certainly irrational in the late 1990s. Being in the short market at that time was a loser's position.

Q: Everything else being equal, is it better to short an expensive stock or a cheap one?


That's an excellent question. I like to see stocks that have already started to fall. When stocks are at a high price and moving upward, they have a tendency to keep moving upward. There's a momentum built into stock prices, and they keep moving up. It will be impossible to figure out when they'll come back down.

I'll take a look at the charts and look for breakdowns in the stock price on heavy volume. Those are good signs to me that it should be considered as a short-sell candidate. And then I will look at the industry trends and the financial statements to back up my decision as to whether to short the stock. But before jumping in, I would prefer to see the stock fall, say, 25% to 30% on heavy volume. When stocks fall like that, they tend to fall a good bit more.

Q: Do you tend to look at stocks one by one, or does a particular sector draw your attention sometimes in seeking a candidate for shorting?


I'll do both. A short-seller will look at any type of information that comes their way. For example, one of the top short-sellers, Jim Chanos, learned about Enron as a short-sell candidate by reading a local Houston edition of The Wall Street Journal. From there, he looked at the company's financials, and then the industry, and saw Enron as a great short-sell candidate. So, in other words, I will look at individual cases as well as industry trends.

Q: I assume that p-e (price-earnings ratio) is a factor in shorting. What other financial factors can you name? Besides the balance-sheet items you mentioned earlier.


Actually, I usually don't look at the p-e because it can be a misleading indicator. P-e's can be volatile, and the income statement on which the p-e is based is also subject to manipulation. One thing I look at that many investors don't is the cash-flow statement. I compare that to the income statement. If the latter is showing growth but the former showing some problems, that's a red flag. That's what happened with EDS. The reason I focus on the cash-flow statement is that it's hard for companies to manipulate it.

Q: What percentage of a long-term portfolio would you suggest be allotted to shorting?


It really depends on the person and their tolerance for risk -- and also, their ability to engage in strenuous research. Perhaps, as a rule of thumb, 10% to 15% or so. But there are alternatives to shorting individual stocks. For example, a variety of mutual funds short the market. There are some that short indexes, which can be great hedges. One example is the Rydex family.

But, like I said, when making investment decisions, you must look at things in a holistic manner and see how everything relates to everything else, and be careful of focusing in one area too much.

Edited by Jack Dierdorff

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