The Art of Short Selling

346 Pages·1996·7.43 MB·English

by  Kathryn F. Staley

Kathryn F. Staley
ears can make money only if the bulls push up stocks to where they are
overpriced and unsound.
Bulls always have been more popular than bears in this country because
optimism is so strong a part of our heritage. Still, overoptimism is capable of
doing more damage than pessimism since caution tends to be thrown aside.
To enjoy the advantages of a free market, one must have both buyers and
sellers, both bulls and bears. A market without bears would be like a nation
without a free press. There would be no one to criticize and restrain the false
optimism that always leads to disaster.
BERNARD BARUCH
n the 1980s, short selling was a discipline practiced by a cadre of smart
investors who made returns in excess of the market in good years and bad. The
analytical methods of those investors were characterized by prodigious analysis
attentive to the quality of earnings, quality of assets, and quality of management.
They believed that the market, inefficient in the short run, would eventually
recognize a bad business run by incompetent managers and that inflated stock
prices would settle to levels consistent with the earnings power of the bad
businesses they had uncovered.
The years 1991 to 1993 decimated the population of short sellers and the net
worth of anyone that persisted in believing that the truth of financial statements
would win out. Those years saw the ascendancy of mutual funds, of momentum
investing, and of the short squeeze as an accepted investment philosophy. What
happened was that companies with questionable financial statements had a
heyday of stock-price appreciation. What also happened was that short sellers
got killed.
In 1994, the problem companies, one by one, began to give up the ghost,
and short selling worked again for a year. Snapple, Cott, Scoreboard, Bell
Sports-reading their financials mattered, and the flaws within the company
structure again affected the price.
By 1996, the concept of shorting for profit was thought by the smart circles
of Wall Street to be extinct or the province of fools. Nobody would admit
publicly that they did it.
Then came the setback of the summer, and short sellers once again got
respect-and made money.
In recent months, the massacre of the most visible short targets (Iomega,
Diana Corp., Presstek) suggests that perhaps we can get back to reading financial
statements and doing analytical work and forget about on-line stock touts, short
squeezes, and thundering mutual fund purchases.
Those bull-market years taught all of us who continued to practice the
arcane art of short selling to beware of manias, and they taught us fear. But, even
in the worst of times, the curiosity and pleasure of detecting the truth kept some
of us idly punching our calculators, watching inventories and cash flow, reading
an occasional prospectus.
"What's the point?" we were asked, particularly by the money managers
who had sworn off shorting. The point is that the toughest call for investors-even
in a bull marketis when to sell. The best managers either sell stocks soon with a
small loss, realizing a mistake, or sell stocks later, noting a change in prospect
after gains, when prices begin to drop. Short-selling skills teach us the discipline
of anxiety, of when to be scared. The analytical wisdom shows us when the
numbers start to turn bad in a sacred-cow holding or which stocks not to buy at
all. The simplest techniques work year in and year out. Rising inventories
predicted the decline of U.S. Surgical and Royal Appliance and Scoreboard and
Snapple and Bell Sports, even in our dumb years. Selling shareholders alerted us
to Autotote and Michaels Stores.
I have used classic examples to illustrate the analytical methodology of
short sellers, examples of how to find the rotten apples before they drop.
Accompanying these examples are tables showing short interest, balance sheets,
income statements, and so on. There are also figures showing short interest and
graphs of stock prices. Chapter 3 starts with the simplest short sale: the bubble
companies complete with new issue prospectus and products that might not exist
at all. Chapter 4 talks about fads and franchises and shows how to uncover
nonrecurring revenues, how to track insider transactions, and how to evaluate
business plans. Chapter 5 follows several full-blown growth companies and
suggests ways to determine when they stop growing. Chapter 6 attempts to detail
more complicated accounting tricks that companies use to obscure the truth
about the health of their business. Chapter 7 is about tracking cash flow and
financing needs in companies that suck money from the financial markets
without paying stockholders in earnings. Chapter 8 tells the stories of companies
that resort to selling out when access to money fails (via earnings or financing
streams). Chapter 9 is about leveraged companies and cyclical business
downturns.
As the company complexity increases, so do the analytical skills: A no-
product company is easier to analyze than a one-product company, one store
easier than a franchise system. Each case should show you the detecting exercise
for at least one of the quality problems. Chapter 10 brings them all together-
quality of earnings, quality of assets, and quality of management-in a classic
short story.
When I first started selling short, only one book, written in 1932, detailed
the practice. The veritable demise of short selling during the great bull market
has silenced the few talkative short sellers who remain. These collected case
studies should remind all of us how to sell stocks or how to sell them short-
particularly when the market turns flat or down and investors are not as
forgiving of bad business plans and bungled earnings efforts. Short selling or
merely selling might be fun or profitable again as it has been off and on for
centuries. And for a certain group of cynics with a penchant for quality, the
sound of a stock crashing nicely will evoke a knowing and whimsical smile.
KATHRYN F. STALEY
y particular thanks to the short sellers whose ideas and analytical methods
appear in this book, as well as to the money managers who shared their thoughts
on short selling.
In collecting data on case studies, I was assisted by Jim Chanos, Scott
Bessent, Charles Hobbs, Andrea Lerner, Bill McGarr, Caroline Ford, Sue
Hardiman, Deborah Lamb, Amanda Macklowe, and Jeff Perry. The stock price
charts and shortinterest data following many of the case studies were compiled
from public information.
K. F. S.