When looking for stocks to short, I tend to look for companies that fall into one of three categories:
- The first category of stocks to short are stocks that are just wildly and insanely overvalued. However, often times, these stocks also tend to be momentum names like Netflix (NFLX), so you have to be careful when you initiate your short.
- The second category of stocks to short are those that are unquestionably going to go bankrupt at some point. JCPenney (JCP) is increasingly looking like one such example.
- The last category of stocks to short are those whose fundamentals and financials make the path of least resistance to be down.
Here are four such candidates if you’re looking for stocks to short:
Stocks to Short #1: United States Steel Corp (X)
United States Steel Corp (X) is battling the biggest problem a company like it can have: cheaper competition — in this case, from overseas.
Steel prices have come up off their April lows, but are expected to drop again because of this competition. U.S. steel price premiums are nearing a high compared to Chinese imports. In addition, several steel mills had outages during the first half of this year, but they have been repaired — that means more supply coming onto the market.
U.S. Steel sits on $1.3 billion in cash and long-term investments but is offset by $3.6 billion in debt. The debt isn’t cheap, averaging around 6.4% in interest, which translates to a little more than $200 million in interest payments annually. X stock is barely breaking even on an operational basis, and the debt payments drive the company into the red.
X stock is a stock to short.
Stocks to Short #2: PHH Corp. (PHH)
PHH Corp. (PHH) provides both mortgage servicing and originates mortgages, though it also handles vehicle fleet services. PHH is struggling with lower total loan margins and refinancing declines.
This is not a space to be in right now, because the housing market is being buoyed by speculators rather than organic demand.
Analysts revised earnings downward substantially, from a $2.53 average to $1.58 per share. Meanwhile, PHH stock earnings have missed estimates each of the past four quarters and by large amounts. I’m not crazy about the balance sheet, with $2.5 billion in cash and long-term investments offset by $5.8 billion in debt. Cash flow has been highly problematic, too. FCF was negative to the tune of $3.16 billion in FY10, jumped to $1 billion in FY11, but then fell to $320 million in FY12.
PHH stock also should be shorted, or at least sold if you hold it.
Stocks to Short #3: Leapfrog Enterprises (LEAP)
Leapfrog Enterprises (LEAP) never felt to me like a sustainable business. My kids never took to their products, and they always seemed to be buried under other more interesting toys at the homes of fellow parents.
Although net income has been on the rise over the past few years, LEAP is faltering this year. The balance sheet is fine with no debt, and free cash flow is OK. The problem really comes down to valuation — I just don’t see paying 20x earnings for a company with limited growth prospects, and that is struggling amidst tremendous competition from tablets that also can entertain kids, such as iPads.
I don’t like LEAP, and neither should you.
Stocks to Short #4: RadioShack (RSH)
You might call me crazy for saying that RadioShack (RSH) is a stock to short at all of $2.67 per share, but I just don’t think RSH stock is going to survive.
Net income has been declining for years, and RadioShack reported a loss in FY12 and $271 million in losses for the trailing 12 months. Meanwhile, FCF went negative in FY12 by $110 million, and cash is almost exactly offset by debt.
Anything you can buy at RadioShack can be bought elsewhere because they are all commodity items — and they’re available from Chinese distributors on the Internet for much less than even ultra-cheap RadioShack.
RSH is going nowhere but down. Short it.
As of this writing, Lawrence Meyers did not hold a position in any of the aforementioned securities. He is president of PDL Broker, Inc., which brokers financing, strategic investments and distressed asset purchases between private equity firms and businesses. He also has written two books and blogs about public policy, journalistic integrity, popular culture, and world affairs. Contact him at email@example.com and follow his tweets @ichabodscranium.