One of our analysts, John Del Vecchio, has been at this game for a while now. Long before he became Dent Research’s resident forensic accountant, he was a successful short seller and the co-author of what I consider to be the best book written to date on the subject: What’s Behind the Numbers?
In the opening lines of Numbers, John and co-author Tom Jacobs offer to “help you find where the investing bodies are buried so you don’t join them.”
These are just the right words to start a book on the detective work of finding financial chicanery. Our joke around the office is that John is the “Horatio Caine” of finance. Well, if the shoe fits…
Short selling can be a lonely endeavor that requires thick skin. By definition, you aim to win when others lose. This means that when you’re right, you’re hated; and when you’re wrong, you are shown no sympathy. Shorting stocks requires taking an unsentimental approach to investing and – perhaps most importantly – keeping the ego in check. Very few investors have the disposition to be successful short sellers; John is one of them.
So let’s dig into some of John’s secrets.
To start, high valuation is not a sufficient reason to short a stock. A stock that is already expensive can always get more expensive.
We’ve seen it over the past year in the “FANG” stocks: Facebook, Amazon, Netflix and Google (now Alphabet). Shorting these based on valuation would have wrecked your portfolio. In fact, Rodney made Triple Play Strategy subscribers a lot of money trading some of these in 2015.
And what about shorting the stocks of companies engaging in fraud? Good luck finding them! Remember, if management is engaged in something illegal, they’re not likely to mention it in the footnotes of their financial statements.
For John, it comes down to aggressive accounting and specifically aggressive revenue recognition and inventory management. As he writes in Numbers: “The time to sell or short is not when you think a business model can’t survive. The time is when the numbers suggest that management is covering up poor performance.”
John already mentioned in today’s letter that a company might be in a hurry to book revenues, and pull sales forward that otherwise would’ve happened next quarter.
A second, similar metric is Days Sales in Inventory (DSI), which measures inventory build-up.
You don’t need to be a CPA to see why this metric is important. Inventory build-up suggests that the company’s products are not selling as briskly as forecast. It also means that discounts will probably be needed to move the merchandise, which will lower profit margins.
All inventory is not equal, of course. A build-up of raw materials inventory may mean that demand is stronger than ever. It is the build-up of finished goods that should be a major red flag. (This is where it pays to be an accounting sleuth.)
I’ll leave you with two final nuggets of wisdom from John’s book.
First, don’t be too eager to jump into a short position. “You make as much money shorting a stock that falls from $70 to $5 (93 percent) as one that falls from $100 to $5 (95 percent).” Getting into a trade too early will turn a would-be profitable short into a frustrating loss.
Second, watch out for crowded trades. Don’t short a stock if the short interest is too high as a percentage of the float. This puts you at risk of being short-squeezed as your fellow sellers all scramble to buy at the same time and send the share price to the moon.
Of course, you should listen to John’s Earnings Exposed presentation Thursday at 4 p.m. ET (and again at 8 p.m.) to hear it all from the man directly. He’ll walk you through what he believes you need to look out for to spot companies that are engaged in mischief.
Editor, Dent 401k Advisor