I’m very superstitious. It’s almost to the point of being a bit off the wall.
When it comes to the markets, I rarely trade the same stock twice, especially if I made a big profit the first time around. When the Market Gods give you a nice winner, take it and move on. I fear that if I touch the stove too many times I might burn a finger.
But back in April I re-entered a short position that I made a big profit on previously in Forensic Investor.
The stock ranked among the worst of my earnings quality model. It was too hard to ignore.
That stock was GIII Apparel Group, Inc. (Nasdaq: GIII).
GIII was creamed this week as the company missed sales and earnings estimates badly. And, the forward guidance was even worse. The stock has gone from about $45 to $30 during our short trade.
Initially the trade went against us, which it seems like almost all of them do! But eventually the fundamentals play out.
The anatomy of the GIII short trade was very straightforward. Here are the six factors that piqued my interest in re-entering the trade…
#1: Insiders are huge sellers.
Last fall, there were a bunch of stock sales from insiders. The stock wasn’t much higher then than it is today. A net of over 320,000 shares have been sold over the last 12 months and outpaced purchases by about three to one.
#2: The stock chart looks vulnerable.
If you printed out the stock chart, taped it to the wall, and looked at it from about five feet away, you’d see that the uptrend is clearly broken.
Upon closer inspections, you can see that, in 2016, the rally off the lows was pretty weak. Not a single time was the weekly volume above the 20-week average. Yet, when the stock sells off, it sells on higher volume. Over the last 50 days, down volume has been about 1.5-times higher than up volume. So, sellers are in control.
And, the stock has no momentum. Its relative strength rating is just 16, meaning it’s significantly lagging the broader market.
#3: Revenue growth has imploded.
GIII was a key growth stock for a lot of money managers. But growth is starting to fade. In January, its revenue grew just 3% year-over-year. But a year ago the company was growing at 9%. Slowing growth weakens the rationale for growth managers to hold the stock.
There’s still over 450 funds that own shares of GIII. But, while the stock has been pounded, it’s not a value idea either. Shares still trade at a premium to the S&P 500.
#4: Inventory levels are increasing.
Whenever I see slowing growth and building inventory levels, I get concerned. Inventory is up on an absolute basis and on a days-basis is at 127 days. That’s up seven days year-over-year. It means that stock is sitting in the warehouse for seven days longer than it did last year… and last year it was taking about four months to move. My concern is that the company will have to heavily discount merchandise to sell it. As a result, profit margins get crushed.
#5: It’s taking the company longer to convert the sales process to cash.
The build-up of inventory doesn’t help because inventory eats up cash flow until it’s liquidated. But, GIII’s whole cash flow picture is poor when accounting for all of the working capital. The cash conversion cycle is up 16 days year-over-year to 120 days in January. The cash conversion cycle is the number of days it takes to convert the sales cycle into cash. So, the longer it takes, the more risk there is. It’s also up year-over-year in each of the past four quarters. This increases the risk of earnings pressure in the future. It’s a big red flag.
#6: Short interest is building.
The bears are closing in and have ramped up their short positions in recent months. In 2015, short interest was about 2.7-3.1 million shares. In 2016, it increased to 3.2 million… then 3.3 million. Just recently it hit 4.1 million shares! The bears must smell blood in the water.
The combination of slowing growth, rich valuations, a lot of funds owning the stock and short sellers circling the wagon gave me comfort that the odds favored a new leg down.
So, I instructed my Forensic Investor subscribers to short the stock. Yesterday, I followed up with instructions to cover their shorts. We banked a healthy 30% profit on this play!
By watching earnings quality and cash flow, you can identify plenty of opportunities to short stocks. The environment may be even more ripe considering stretched valuations and optimistic investor sentiment.
If you don’t want to do it alone, consider joining us at Forensic Investor. Our most actionable idea right now is still a live trade – meaning you still have time to get in and make some money – and if it plays out like I think it will, it could lead to a bumper crop of a year on the short side!
John Del Vecchio
Editor, Forensic Investor
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