>>>Some short-sellers work as financial sleuths, digging for business flaws in income statements. A sign of trouble, according to David Rocker of Rocker Partners, is when accounts receivable and inventories rise faster than sales. But a dead giveaway is when a company reports earnings despite a negative cash flow. Then he takes a close look at the business plan. (His hedge fund gained 24.6 percent in the first quarter, largely because of short positions.)
A company that he said fails on several counts is Boston Chicken, the restaurant chain. "Boston Chicken is really not a restaurant company but a finance company," Rocker said. "The only earnings they have are earnings from royalty fees and interest payments from these very same franchises. So if the franchises cannot meet the finance payments in the future, the whole house of cards falls in on itself."
Boston Chicken countered that company-operated stores generated 32 percent of total revenue last year and that interest income accounted for less than 25 percent.
Rocker also looks for expensive companies that have recently missed earnings targets or that appear likely to do so. An example, he said, is Fastenal, a Winona, Minn., retailer of fasteners and tools.
"The stock trades at an incredible 43 times trailing earnings and 11 times book value," Rocker said. "But the company has missed earnings estimates in the last five quarters, and its growth seems questionable." The chain is running out of places to put new stores, and competition is increasing, he said.
Fastenal had 484 stores at the end of the year and sees the potential for 1,500 stores in the United States. At its current price of $38.75, the stock is trading at 35 times its expected earnings.
Anyone drawn to short-selling by its recent success should keep in mind that investment advisers discourage such speculation. For individual investors, they say, shorting is best used as insurance against potential losses. At most, short positions should be 10 percent to 20 percent of a portfolio, Strunk advised. In part, that is because an uncovered short position, in which an investor has borrowed shares from a broker, can result in unlimited losses if the stock price keeps rising.
Most funds that short heavily are limited partnerships, open to investors with a net worth of $5 million. Among the handful of mutual funds that emphasize short-selling is the aptly named Prudent Bear, down 13.7 percent in 1996 and up 2.8 percent this year.
Perhaps the most important consideration is that shorting is going against the tide.
"A person has to have the stomach for this because on most days stocks are rising," Rocker said. "The declines are sharp but brief. Most days you are losing money."
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From Sunday's New York Times. |
