Most of the time, I recommend stocks to buy and hold. I sell when stocks reach what appears to be their full gains potential or, less often, when the company fails to live up to my expectations. Occasionally, I’ll also give out lists of stocks to avoid because of their subpar outlook.
At this point in the market cycle, though, I see another opportunity shaping up — for aggressive investors only. If you’ve got the nerves and the financial resources to play the game, I believe there’s good money to be made selling individual stocks short.
Short sellers borrow stock (from a broker) and sell the shares, hoping to buy them back later at a lower price. The difference, minus commissions and any dividends payable to the owner of the stock, represents the short seller’s profit.
In a strongly uptrending market, it’s tough to find many stocks that seem due for a fall. However, the market climate has changed during the past few months. “Accidents” are proliferating — and some short sellers, at least, are cleaning up.
A fresh-perked example: In October, hedge-fund manager David Einhorn disclosed at an investment conference that he was shorting Green Mountain Coffee Roasters (NASDAQ:GMCR). Not only did Einhorn denounce the stock as overvalued, but he went further and accused management of accounting shenanigans.
Naturally, the company’s legion of supporters poured cold water on his arguments. But then … uh-oh! On Nov. 10, GMCR came out with disappointing quarterly earnings — and the stock cratered, off 39% in day. Score one for Einhorn.
Screening for Losers
Where do we find the market’s next set of disasters waiting to happen? I ran a screen recently that focused on three criteria to help identify vulnerable stocks. (You want to short the sickly wildebeests in the herd, not the alpha males.) I looked for names that:
- Already have skidded at least 20% from their 52-week highs — a sign that some investors might know the company has problems.
- Are operating at a much lower level of profitability (return on equity) than the market average.
- Are trading at more than 20 times projected earnings for the year ahead (overvalued stock).
Interestingly enough, certain industry groups popped up repeatedly in my screen: homebuilders and related suppliers, outdoor advertising firms, a sprinkling of faddish Internet-based businesses, and a bumper crop of Chinese outfits — a hint that the next really big market blow-up might be brewing in Shanghai, rather than Athens or Rome.
Stocks to Short
- Aluminum Corp. of China (NYSE:ACH)
- Brookdale Senior Living (NYSE:BKD)
- Clear Channel Outdoor (NYSE:CCO)
- Gaylord Entertainment (NYSE:GET)
- Shutterfly (NASDAQ:SFLY)
- Lennar (NYSE:LEN)
- Pulte Homes (NYSE:PHM)
- Renren (NASDAQ:RENN)
- Youku (NASDAQ:YOKU)
What to Do Now
When shorting these stocks, always remember to set a stop-loss at a reasonable level above your entry (I recommend 15%). Place your stop order soon after your short is executed, and make the order good till canceled. That way, you’ll be taken out of the position automatically if some unexpected development pushes the stock up to your stop-loss. Never short stocks without a stop; you’ll expose yourself to theoretically unlimited losses.