Notes on The Art of Short Selling

"For the last week I've been carrying "The Art of Short Selling"
around with me just about everywhere. Every time I get a break, I
just open to a chapter. Doesn't matter if I've already read it. I just
read it again." - Michael Burry
These are my notes on Kathryn E Staley's Art of Short Selling. I
found this to be a stellar book filled with interesting market history
and techniques to help short sellers. The book was published in
1997 so the examples are bit aged and recommends slighted dated
sources for idea generation but I believe the foundation is timeless. I
do not detail all the vignettes -- I recommend buying/borrowing the
book for them -- but I tried to emphasis the players in short selling
and the techniques needed to be a more skillful short seller. I hope
you find these notes useful. All ideas belong to Kathryn F. Staley,
any misinterpretations are my own - Joshua Wallis
(http://www.amazon.com/The-Short-Selling-MarketplaceBook/dp/0471146323)
Art of Short Selling Chapter 1: Overview: Wealth with Risk

Short sale candidates are in three categories

1. When management lies to investors and obscure events that

affect earnings
2. Companies with inflated stock prices
3. Companies that will be affected in significant ways from
external events
Signs that a company might be a good candidate for a short
1. Accounting gimmickry
2. Insider problems: insiders using the company as a personal
bank or are selling the stock
3. Company has a consumes too much cash
4. Assets are overvalued or balance is in terrible condition
You can get subscriptions of insider transactions in 13Ds, they are
reported in Barron's and the Wall Street Journal. There are
newsletters such as Vickers and Insider Chronicle that also do this.
Standard and Poor's Daily Stock Price Record and the Quarterly
History Tape also provide short-interest data.
[websites like www.dataroma.com already do a good job of this]
Be careful of companies with small floats due to higher risk of buy
ins. 10M shares are less is generally considered a small float.
Art of Short Selling Chapter 2: Short Sellers

Well known short sellers: Robert Wilson (profiled in Money Masters),

George Soros, Michael Reinhardt, Julian Robertson
Julian Robertson of Tiger Funds
Example of his short would be generic drug stocks. They had high
multiples (30 to 40 times earnings) but Robertson felt these
companies had no franchise value, no sales force and therefore
would produce a commodity product.
Alex Porter of Porter, Felleman
Shorts stocks to reduce risk in the overall portfolio during protracted
declines. Generally shorts stocks where management does not own
much stock, the company is leveraged, the management is not
realistic about the company's prospects or has a fatal balance sheet

flaw. Alex Porter looks for companies where you can stay short
without pain or expense.
Joe DiMenna of Zweig Funds
Shorts five types of situations (1) frauds (2) earnings
disappointments (3) hyped stocks where there are holes in the Wall
Street's consensus estimation (4) industry themes were macro
forces are negative (5) a deteriorating balance sheet. He tends to
avoid stocks with strong earnings momentum solely based on
momentum. He waits for the stocks to break before getting
involved. He will avoid short candidates in a crowded field unless the
company is terminal
The Feshbach Brothers of California (Kurt, Joe, Matt and the nonFeshbach Tom Barton)
They founded their short found in 1982, at one point they managed
a lot more money than any other short sell fund. In 1990 they
managed $600 million. They look for terminal shorts with these four
characteristics
1. Stock prices overvalued by at least 2X IV
2. A fundamental problem at the company
3. A weak financial condition -- working-capital problems or high
long-term debt
4. Weak or crooked management
The brothers consistently look for dodgy stock promoters like the
OTC Review's editor, Bob Flaherty
(http://articles.chicagotribune.com/1989-0226/business/8903080465_1_penny-stocks-penny-stock-stockmarket) . Their first success short was Universal Energy. Feshbachs
work intensively and have information overkill. They don't short a
stock unless there can be a price decline of 50%.
An example of their work is Kirschner Medical. Any analyst could
show they had 400 days of inventory but their analysis showed they
had $10M of obsolete inventory. "The reason we put so much
emphasis on phone calls to competitors, suppliers, and customers is
that's where we get our edge --in discovering what drives the
numbers. Everybody knows that the numbers are on historical basis.

If they don't, they're either illiterate or just lazy. Sometimes, they

misinterpret them."
The brothers also shorted Circle K after doing heaps of homework.
They discovered that due to sale/leasebacks the valuation for Circle
K was much lower than previously thought of. They realized the
company had a large amount of debt off the balance sheet as well.
Circle K also started to out price their customers, during the same
time the other competing stores were providing 24 hour service. The
company had Wall Street coverage but the Brother's eventually
covered their positions at $1.
The Feshbachs do not cover for a quick 20% decline profit -- they
have specific price targets ad buy back when it hits those price
targets. They will close a position if proven wrong or will add to a
position as more data is uncovered. The Feshbachs find talking to
Wall Street or the management is not helpful. They are too biased in
the positive to be useful.
[The Fesbach Brothers are pretty interesting. They were massively
into Scientology and based their short selling prowess on the
teachings of dianetics. They eventually went bust. Here are some
great articles about the Feshbach Brothers:
1.
Los Angeles Times: Short Road to Success : Investing: The
Feshbach brothers of Palo Alto have made a fortune betting that
stocks will go down. But some critics question their short-selling
methods. http://articles.latimes.com/print/1990-10-14/business/fi3720_1_short-selling October, 19
2.
New York Tims: No Guts, No Glory: Short-Selling in a Bull
Market http://www.nytimes.com/1992/01/12/business/no-guts-noglory-short-selling-in-a-bull-market.html January, 1992
3.
Tampa Bay Tims: Scientology nearly ready to unveil Super
Power http://www.sptimes.com/2006/05/06/Tampabay/Scientology_n
early_re.shtml/ May 6, 2006
4.
An Hour long video with John Hempton of Bronte Capital where
he (partly) discusses the Feshbach Brother's and their
downfall https://soundcloud.com/the-odd-lot/john-hempton-audiointerview ]
"McBear" -- launched his fund in mid-1983 at 40.

Major short ideas are based on extensive credit work. When shorting
Caterpillar Tractors in 1984, he the main customers (oil drillers,
mining companies, South American countries) were now broke or
short on cash. Even though their customers were now broke, Wall
Street was still expecting earnings of $4 in earnings per share. The
company ended up losing $5 a share and because McBear realized
the industry was changing it gave him insight into a structural
problem in the economy.
Jim Chanos
At 24 he called the Baldwin-United bankruptcy. (note, book was
published in 1997, so things might have changed.) He doesn't short
frauds with small floats because of size restraints and generally
doesn't have a problem with buy ins because he focuses on largecap stocks. He maintains a concentrated portfolio of about 30 stocks
with 10 positions accounting for more than 50 percent of his
portfolio.
He typically shorts stocks where there are secular problems and the
equity value is worth 0. He uses return on invested capital as a key
financial indicator. "That ratio will reveal a lot of wormy companies
and poor businesses. It's a tough number to screw around with. "
Chanos on financial companies "leverage inherent in some of these
companies is incredible. When the accounting gets murky, people
tend to shy away from rigorous analysis and rely on management
and just take earnings per share at face value. Therein lays the
opportunity."
When Chanos analyzed Baldwin-United he had to dig deep into tax
accounting, research affiliated company transactions which
convinced him the stock was a zero. The stock went from 20 to 50
dollars during his sell recommendation,and then Baldwin-United
went bankrupt.
[This book was published before his famous Enron coup]
Art of Short Selling Chapter 3: Bubble Stocks

Often times the most brutal shorts are with companies with no
assets or revenues. They are companies with a pipeline, either a

technology or medical products company. Management can help

push these stocks to unreasonable valuations.
ZZZZ Best
This was a hot growth carpet cleaning company that was headed by
Barry Minkow. ZZZ Best announced a contract to clean to large
buildings in Sacramento for $8 million. Carpet cleaning competitors
told Feshbachs that the two largest contracts were MGM Grand and
the Las Vegas Hilton and were capped at 3.5 million, so the
Feshbachs knew something was wrong. The Fesbachs shorted
aggressively but stock still went up. ZZZZ Best eventually went
bankrupt sending Barry Minkow to jail for 25 years. The company
had no contracts, no revenues and was a money-laundering scheme.
Harrier, Inc
This was a medical-products company that was headquartered in
Utah. There were no assets, no sales, no products and a $30 stock
price with a market capitalization of $84 million. The March 31, 1988
10Q showed a typo, repeating 1987 twice, insinuating the financial
statements were not proofread. In the initial public offering or
prospectus, the original owners were formed by a blind pool lead by
Merlin Fish, the owners included a real estate developer in
Charleston, Merlin's former California client, Merlin's brother who
owned a construction company and a furniture company
manufacturer's representative in Utah.
The first public offering included 25 million shares at $0.01 where
the proceeds were for unspecific use. The company went on to do a
50-to-1 reverse stock split and start a company based
on gobbledygook businesses including "biodynamic water",
Hungarian polarized light and sold shares to a Liberian company.
The most cheerful recommendation for Harrier, Inc came from the
Merlin Group! The company eventually traded for pennies but not
until he reached over $20 a share.
Medstone
The prospectus of Medstone provided the following information. (1)
the product was not patented. (3) The competition was large and
international with significant installed base (3) the gross margins
were 60% but were not sure since expenses and revenues were not
appropriately matched.

Medstone was considered a "doctor stock". Doctors are considered

to be suckers on new drug or medical-products. The doctors
promote the stocks to peers and friends and enthusiastically inflate
the market value. The founder and president sold shares before the
deadline on insider trading. The chairman and founder resigned. The
company ended up selling for pennies.
Reading prospectuses is extremely important in finding shorts.
Information can be found on prospectuses that can't be found
anywhere else. It's extremely useful information. You can find out
about past problems the company has.
The Happiness Express
86% of the sales came from Power Ranger toys, and 56% came from
sound effect gloves alone. It was an obvious fad stock with an
eventual decline.
The "ShortBuster Club" was run by Ray Dirks. Dirks would try to
organize short squeezes. Most of his companies he tried to protect
eventually succumbed to failure -- not because of short sellers but
because of fundamental failures of the business.
[More information on Ray Dirks:
1.
New York Times: Wall Street;A Fast-and-Loose 'Short
Buster' http://www.nytimes.com/1992/08/02/business/wall-street-afast-and-loose-short-buster.html 1992 written by Susan Antilla
2.
Businessweek: Tops With The
Shortbusters http://www.businessweek.com/stories/1998-11-22/topswith-the-shortbusters 1998
Art of Short Selling Chapter 4: High-Multiple Growth Stocks, Part 1: High Risk,
Low Return

Fad companies don't always as quickly as short sellers would like.

Coleco Industries promised a cheap home computer for under $600.
The computer didn't arrive on ship date and the computer boards
were poorly assembled. The company would have died quicker but
the cabbage patch doll fad helped them limp along. Other examples
of fad stocks that lasted too long were Scoreboard that repackaged

baseball cards and sports memorabilia, J. Bildner & Sons that offered
upscale yuppy 7-Elevans, Jiffy Lube with its aggressive financing to
franchisees and competitive landscape.
Art of Short Selling Chapters 5-10:

The book goes on to detail on a number of companies. There are too

much information to go into detail in each company. Here is the a
list of the rest of the companies covered -- definitely read to the
book to understand the context of each short candidate.
Chapter 5: High-Multiple Growth Stocks, Part 2: High Returns, Faltering Growth

Beverages:
Cott Corporation
Snapple Beverage Corporation
High Tech: Media Vision
Chapter 6: If You Can't Read It, Short It

National Education
Autotote
The Weasel: Western Savings and Loan
Insurance Companies: Who's on First?
Check out insurance commission filings at NAIC
(https://eapps.naic.org/cis/) Kathryn Staley offers a roadmap on how
to go through NAIC filings to check asset allocations and reserves of
insurance companies. Staley recommends: Clair and Joseph
Galloway's Handbook of Accounting for Insurance
Companies. (http://www.amazon.com/Handbook-AccountingInsurance-Companies-Galloway/dp/0070227454) This book goes for
70+ on Amazon.
"Experience suggests that if you cannot understand a report,
officers are hiding something worse than you expect. It's almost an
iceberg phenomena: If you find five or six serious questions in
financial statements, you can be sure that there are many more that
you cannot see. If a call to the company for explanation receives a
garbled response that sounds suspiciously like the company official
is speaking in tongues, you have go a live one."

[This reminds me of the chapter of Too big to fail where Warren

Buffett reads Lehman Brother's 10-K but passes because there are
things he doesn't understand]
Quote from Sorkin's Too Big to Fail "Buffett decided to hunker down
that evening at his office and pick apart Lehman's 2007 annual
report. After getting himself another Diet Cherry Coke, he began to
read Lehman's 10-K, its annual report, when the phone rang; it was
Hank Paulson. This seems orchestrated.
Paulson began as if it were a social call, knowing all too well that he
was walking a fine line between acting as a regulator and a deal
maker. Nonetheless, he quickly moved the discussion to the Lehman
Brothers situation. "If you were to come in, your name alone would
be very reassuring to the market," he said, careful not to push his
friend too far. At the same time, in his roundabout way, he made it
clear that he wasn't going to vouch for Lehman's books--after all, for
years Buffet had heard him, as a top executive at Goldman; rail
against other firms he thought had been too aggressive in both their
investments and their bookkeeping.
After years of friendship, Buffett was familiar with Paulson's code:
He was a hard-charging type, and if he wanted something badly
enough, he would say so directly. He could tell now that Paulson
wasn't pressing too hard. The two promised to stay in touch then
bade good night.
Buffett returned to his examination of Lehman's 10-K. Whenever he
had a concern about a particular figure or issue, he noted the page
number on the front of the report. Less than an hour into his
reading, the cover of the report was filled with dozens of scribbled
page citations. here was an obvious red flag, for Buffett had a
simple rule: He couldn't invest in a firm about which he had so many
questions, even if they were purported answers. He call it a night,
resolved that he was unlikely to invest. "
Chapter 7: Money Suckers: Coining Money to Live

The Nine Lives of Integrated Resources, Inc

Summit Technology, Inc.

Companies with no profit and little revenue can survive longer than
rationally expected if they can promise prospective shareholders a
bright future. Mining companies, technology companies
and pharmaceutical companies are commonly guilty of this -- look at
the Cash Flow from Financing to see if the cash normally stems from
equity raises.
[Bronte Capital mentioned a pharmaceutical company that is guilty
of this. Galena Biopharma (GALE) -- consistently goes to the market
for equity raises. Bronte Capital outline's dodgy business practices
here: http://brontecapital.blogspot.com/2014/02/get-your-opiatesfor-free-capitalism.html]
Chapter 8: If You Can't Fix It, Sell It

Harcourt Brace Jovanovich Escapes Maxwell's Money

Texas Air: Flying with Frank
Kay Jewelers Sells Out (or Tries to) at the Annual Sale
Morris Knudsen
Chapter 9: Industry Obsolescence: Theme Stocks

The Arizona Land Race

American Continental: What's All the Ruckus About?
Sun State Savings Acquired on Margin
Valley National: Uncharacteristic Wall Street Battle
Chapter 10: All of the Above: Crazy Eddie

An Identifiable Story Stock

A Private Family Bank or an Electronics Chain?
Does a Medical School Count as Vertical Integration?
Wall Street Hysteria and Home Shopping
The Plot Develops
The Big Break
Notes
Extra Crazy Eddie Information
1: http://business2.fiu.edu/1048733/www/Spring_2010_ACG6686_RD
4/Crazy%20Eddie.pdf
Extra Crazy Eddie Information
2: http://business.pages.tcnj.edu/files/2013/02/2011-09-07-TheCrazy-Eddie-Fraud-by-Sam-E.-Antar.pdf

Art of Short Selling Chapter 11: Shortcomings

Three sins of short selling: sloth, pride and timing

Sloth
Doing too little work is always a problem for investing -- without
proper doing the proper work (spreadsheets, notes, readings) you'll
lose conviction when the position runs against you and you'll
inevitably take a loss. "Shorting's easy. You short a stock, watch it
double, cover in panic, then wait for the inevitable bankruptcy"
Pride
The pride problems comes out in two different areas (1) using
formulaic analysis to short companies. An example of that would be
seeing six great savings & loan shorts and shorting the seventh
without deeper analysis. The real estate or economic environment
might be different for the seventh bank causing your thesis to be
proven wrong. (2) shorting good companies. Julian Robertson and
Jim Chanos have both identified this error. This is another way of
saying don't short just based on valuation. Good management is
tends to fix problems, which when solved cause already overvalued
stocks to shoot higher.
Timing
There is no solution for this. You find a great short
selling candidate only only to see i turn into a 2% annualized rate of
return because you were too early. First reason for bad timing is
underestimating the insanity of the public market. Horrible
companies can continue to exist on the promise of great products.
Drug companies tend to have this problem. The second reason for
band timing is the investment bankers ability to raise money to keep
bad companies on life support. Sometimes companies end up
resolving their problems before the market realizes the fatal flaw.
Sometimes the macroeconomic environment changes and lifts the
company out of it's problems, such as a change in interest rates.
Short sellers might also underestimate a company's ability to grow
out of their debt load. When the business environment is good -business might survive a surprisingly long time with a crushing debt
load.

Short sellers have several techniques to try to remedy the timing

problem. Michael Murphy covers automatically after a 25% price
run-up and waits to short again. Other managers wait until the stock
cracks, after the first drop when earnings and price momentum have
slowed. Joe DiMenna never shorts a stock with great relative
strength.
Other small problems with short selling
1.
Don't short commodities through a stock. It is easier to short
companies based on their financials than it is based on their
commodity production. If you do short a company that is highly
influenced by the commodity, make sure you understand the
commodity cycle of that product, for example if you are a short a
chicken stock make sure you understand how weather and corn feed
prices will affect chickens. Sometimes you'll find companies that are
growing their inventories faster than revenue, but if that is the case
your thesis should be built on bad financials but not the underlying
commodity of the inventories.
2.
Many short sellers avoid technology stocks. Normal signs of a
good short do not apply to these companies. Often inventories will
rise when a new products is coming. Insiders will own and sell stock
without regard to the company's condition. Margins can fluctuate
based on product cycles and pricing curves. Tech stocks have
infamously caused problems with short portfolios -- American
Online, US Robotics and Iomega.
3.
Squeezes tend to be a self-inflicted wound for short sellers
when they don't recognize the importance of float. Since short sells
are based on getting loans for stock, when shares are no longer
available for a lend it is inevitable you'll have a buy-in. Companies
who want to be aggressive toward short sellers may ask their
shareholders to take theirs take their shares out of a margin account
(therefore hard to borrow) and into a cash account. They could also
issue cash dividends or preferred shares that could make short
selling more expensive. These tactics don't work well for companies
with large float but might work well for companies with a small float.
The books gives examples of infamous short squeezes such as Total
Systems, General Development and Chase Medical.
4.
Leveraged buy-outs s can cause stocks to be bought out at
ridiculous valuations. Especially be worried during a flurry of deals -private equity groups can start paying outrageous prices.

5.
Fear causes short sellers to buy back their positions after a
large run up. Generally if it scares you to death to short more of a
company, the better move is to short more.
6.
Be able to change your outlook if the facts change. Don't stick
with the same thesis if the facts change.
7.
It is easy to fall in love with your own analysis if the problem is
highly complex. If you spent loads of time in the analysis it is easy to
say you must have an opinion on the stock, when one might not be
recommended.
8.
Crowded short positions are also a problem. Amateur short
sellers might buy a position when one might not be recommended.
9.
Last but not least, shorting a company that is going through a
"hiccup", instead of shorting a company that's having it's core
business being overwhelmed. When a company is growing you can
hide bad accounting practices for a while. Never short a good
company.
Art of Short Selling Chapter 12: History and Controversy

This is chapter describes history of short selling, dating back to the

tulip bubble to present day; the history of regulation
and prohibition of short selling in different countries and at different
times. The chapter offers vignettes on famous early 20th century
short sellers like Jesse Livermore, Barnard Baruch, "Sell 'Em" Ben
Smith, and Joseph Kennedy.
The history of short selling can be summarized by a cycle
of prohibition and constant suspicion. Companies that
have squealed about the terror of short selling, almost inevitably
succumb to failure due to bad business practices rather than
speculators.
"No law can protect a man from his own errors. The main reason
why money is lost in stock speculations is not because Wall Street is
dishonest, but because so many people persist in thinking that you
can make money without working for it and that the stock exchange
is the place were this miracle can be performed." Bernard Baruch
Art of Short Selling Chapter 13: Six Pillars of Fundamental Short Selling

The Short Seller's Random Walk for Ideas:

Some of the best ideas are found in Barron's, Wall Street Journal and
Forbes. Generally after a good short expose on Barron's, the stock
drops immediately after publication and recovers. It takes about a
year for it to become a great short -- that is when the short thesis
becomes fully saturated. Companies with large short interest
increases can good places to hunt, this companies have generally
developed fundamental problems therefore causing the short
interest increase and making them good candidates. The one thing
short sellers need to be aware is the short interest relative to float.
In the early 1990s, short positions in excess of 15% of float seemed
to cause buy-ins. Other good short candidates can be found by
observations, such as toy fads that aren't meeting the expectations
of your child because they have not hit stores before the holiday
season.
1. The Pessimist's Guide to Financial Statements
Short sellers attempt to discover the meaning behind the numbers
and what drives the business. Books to read to increase your
understanding of financial statements include. Leopold
Bernstein's Financial Statement Analysis, anything written by
Abraham Briloff, and Thornton O'Glove's Quality of Earnings.
Short sellers should research the company's last six 10Qs; the last
two 10Ks, proxies and annuals, and any 8Ks. After studying these
documents a short seller might need to go back farther
chronologically.
Quality Control
The most useful part of the financials will be the footnotes.
Start with the last dated balance sheet and look for assets of
suspicious value:

securities not marked to market

inflated real estate values

obsolete inventories

aggressively booked receivables

receivables with low loss provisions

bad loans

fuzzy or empty assets

Accounts receivable and inventories should be tested by looking at
the growth in receivables and inventories versus previous year and
comparing that to the growth in sales and cost of goods. If
receivable growth is substantially greater than growth in revenues,
problems with earnings will be likely. Growth in inventory versus
growth in cost of goods is the single most reliable sign that a
manufacturer or retail company will stumble. That red flag urged
investors to sell U.S. Surgical, Cott Corp., L.A. Gear, Snapple,
Royal Appliance, American Power Conversion, and Sofamor Danek in
advance of dramatic stock price collapses. Deferred charges might
also been an area of abuse -- deferring expenses can cause earnings
reversals if revenues stop growing.
Goodwill and other intangible costs might be signs a company has
overpaid for acquisitions, failing to expense drilling costs or software
development. Check footnotes for the schedule of expenses for
policy manuals which might have capitalized over too long of a
period.
If accumulated depreciation drops when gross PP&E rises, the
company might have changed average life assumption and run a
reversal through in the income statement.
On the liability side of the balance sheet, look for odd descriptions or
uncommon types of liabilities. Be especially suspicious of liabilities
approximated or the present valued with assumptions made by
management. Check footnotes for and notes on financial conditions
to see if the company has any off-balance-sheet liabilities, any debt
guarantees, or recourse-factored receivables. Check for growth in
short term and long term debt.

Note all lines of revenue that appear to be nonrecurring:

sale of equipment, land, and real estate

sale of securities

Interest on securities or cash equivalents

tax credits

currency gains as a reduction in cost of goods sold

one-time credits from manufacturers

reduction in provision for doubtful accounts

one-time license agreements

change in account
Check the assumptions the company makes to book revenue and
read the notes that explaining earnings in the current period. Check
for any odd sources of revenue. Readjusted earning per share for
fully diluted shares. Adjusting for the fully diluted shares can be a bit
tricky, add in all convertible shares if they close to conversion or
likely to be converted and any options and warrants.
Important Ratios
Check to see if company is trying to appease the street by giving a
nice trend for earnings per share growth, and if so, see if they are
trying to massage the numbers. Look at capitalization: long-term
debt to equity, total debt to total capital, long-term debt to capital.
Compare several years of balance sheets to see the trend in these
ratios.
Check ROE, ROA and ROIA. ROIA (Return on invested assets) is
calculated by income before interest and taxes divided by equity
plus all interest-paying debt. Look for trends and volatility of returns
over time. It also tells, by comparison how the company does
relative to other companies in the same industry, whether the
company returns more than its average and marginal cost of debt,
currently and historically.

Key valuation ratios are Price to Earnings, price to book, price to

revenue and price to cash flow. If a takeover occurs in
a similar company, these ratios calculate quick comparables. Certain
ratios are better for comparison in different industries. Price to
revenue is higher for retail than for manufacturing. Price to earnings
reflect growth potential. Price to cash flow is a buy-out indicator.

Minimum list of ratios include the following

Checklist of Ratios

Capital Structure

Return Ratios

Valuation Ratios

long-term debt to equity

return on equity

price to earnings

total debt to total capital

return on assets

price to revenues

total debt to equity

Return on invested assets

Price to operating cash flow

Go to the income statement to common size the statement:
Put everything in percentage of revenues to see if the percentage
relationships are changing. R&D or Advertising as a percentage of
revenue declining? Compare anomalies to the balance sheet. If
SG&A is declining as a percent, are prepaid expenses or other assets
rising? Is depreciation flat while fixed assets increase? Compare
pretax operating profits. What is the sequential trend, as well as the
annual one? Does it make sense for the business? Look for
deviations and trends.
Cash Flow is King
It is often difficult to determine what the necessary cost from a
business point of view is. The quickest check is to look at the "Cash
Flows from Financing." See if the company is constantly going to the
markets to keep afloat. Is short and long term debt escalating? Is
there a stock or convertible issue every year?
Find out what the companies spends to do business. This can be
calculated in different ways but here is one. Net income +
depreciation, amortization, deferred taxes - non-recurring items (taxadjusted, if possible) +/- changes in current assets (without cash,
but broke out by lines to see what specifics are causing the cash

drain) +/- changes in other items perceived to be relevant (like

some portions of capital expenditures).
Check how cash flows and capital expenditures change year of year.
Check up on any anomaly. If the company able to meet their debt
repayments? Check the PIK (payment in kind), zero-coupon bonds
and other odd instruments.
Reading the Sleep-Inducing Verbiage
Read the 10K description of the business and the competition. Try to
understand the financials in relation to that business plan. Try to
drive the company, what the two or three most relevant numbers
are. What is the most important number to watch to identify a
developing problem? If it is a low-margin business, the key is
probably revenues and inventory-turnover ratios. If it's a franchisor,
it might be system sales or same-store sales. Does the financial
structure make sense for the business? (do not leverage a cyclical
company too much, do not build inventories too high if there is
potential product obsolescence.)
Think About It
Think of the three financial statements as a 3-D chess game, see
how they interact and see what tugs and pulls on what.
Determining the key variable in the health of a company is the most
complex part of analysis. If this skilled could be mastered, finding
great ideas in the long and short side will come easier. Read Qs and
Ks from first to last to see how things change over time. Read the
annual report and see if the executives say what you saw in the
10Ks and Qs. Watch out for near meaningless buzzwords
like synergism. Look for any oddities in the annual report like
pictures of babies in a defense or drilling company -- suggesting the
executives are a bit clueless. Watch for auditor turnover which can
truly be indicative of trouble.
What was not in the financials but you did not understand? Look for
the lack of:

description of nonrecurring revenues

information on explicit valuation procedures of odd assets

clear disclosure of revenue-booking procedures

fuzzy liabilities

comprehensible breakout of divisions: revenues, income,

assets

description of effect of an acquisition on inventories and

receivables
Determining what the relevant piece of information is the most part
of analyzing a company. What runs or ruins the business.
2. In Search for Greed and Sleaze

Useful forms provided by the Securities and Exchange Commission

(SEC)
Form 144. Key officers of a company are required to file this
form when placing a sell order of their company stock. Barron' and
the Wall Street journal report some insider sales. Vickers and the
Insider's Report, also publish a list. [www.dataroma.com is a good
source for this material now]
Form 4. Insiders of the company must file this form if
purchasing or selling shares. The list needs to be published 10 days
after the last day of the month in which positions are increased or
decreased.
13-D When an entity purchases 5% or more of a stock, they
must file with the SEC in 10 days. These publicized in the news
Barron's, Vickers, and the Insider Report, as well as the proxy.
Proxies: The annual meeting is the trigger for this publication.
The publication tells the stockholders what they can vote on during
the annual meeting. It also reveals how much stock is owned by
management, what their salaries and employment contracts are
(including options, bonuses, and some perks) and the stockholders
who own over 5 percent. The proxy tells who the accounts are, if
there are any pending lawsuits, and other relationships and related
transactions are pertinent. It is a great source for information about
management philosophy. Look under "certain transactions" for some
possible hidden information about creative management contracts
Benchmark Proxies: Pantheon of Stars or Pigs at the Trough?

Watch out for companies with excessive executive compensation

relative to net income. Plenty of good short candidates come from
executives who pilfer the shareholder's coffers with excessive
compensation, benefits or related party transactions.
If you need to read a proxy three times to understand it, chances are
you have hit a likely short candidate
Checklist of Proxy Questions
1. Lookout for exorbitant executive salaries. Look at cash
compensation relative to company earnings.
2. Does the company pay out large bonuses? Why do they pay
out large bonuses, was it for doing an abnormally good job or that
was just a normal bonus. Is the bonus based on increased sales,
return on equity, or some measure or combination of measures?
3. Does the company pay a percentage of pretax profits to the
primary offers in the form of bonuses? Are executives paid a
percentage of revenues? Is the bonus calculated on a quick stock
price appreciation.
Stock Options
4. Stock grants, stock options and stock appreciation rights
(SARs). SARs are the most generous because they guarantee cash
money and are bankable immediately with no stock price
appreciation necessary.
5. Does the company pay for stock options?
6. Does the company pay a bonus for taxes on options?
7. Do executives get special deals if there stock/rights offering of
company or a sub's stock?
8. What percentage of the stock is owned by the primary
officers?
Parachutes
9. Does the company have an unusual severance pay contract,
especially in case of merger or buy-out?
10. What are the terms of retirement contracts?
11. Are there extra perks such as large insurance policies,
apartments, automobiles use, plane us?
"Certain Transactions"

12. Does the company allow primary officers to do business with

the company by owning other businesses? Does the company give
those officers favorable terms in those contracts?
13. Are many of the officers related to each other?
14. Does the company deal with any relatives of the officers?
15. Does the company loan money to the officers? Does the
company charge interest?
16. If the company engages with limited partnerships does it pay
the officers to become general partners or limited partners? Does it
grant bonuses for the participation in those partnerships? Does it
give those partners the tax loss?
Miscellaneous
17. Are there many lawsuits, what is the liability?
18. What is the age range of the officers? Are they all young or
all old?
19. Who else owns the stock?
20. Check the board biographies? Is it a "good ol' boy" club? Is it
an independent board? (Quaker Oats used to pay their board
members $1,000 for each action taken by unanimous written
consent)
Make sure officers are getting paid for doing things before the
stockholders. See what the top employee's total packages are
relative to income. Check proxies over the year see how many
executives have left the company. Attrition is not always free
available data and requires research.
3. The Bigger Puzzle
Research
Review the industry -- the 10K should give you a good overview of
the competitors, customers and suppliers. Check value line and
Stand & Poor's Industry Survey's for the industry fundamentals.
Check trade publications and if see if any government office tracks
data relevant to that industry. Services like Washington Researchers
can provide comprehensive information on any topic. Read other
publicly traded company's financial is a useful source of information.

You can check a competitor's financials to compare margins, return

on invested assets, growth rates, and inventory and receivable turns
can give an analyst what is out of line and what looks different.
Store Checks
After you have decided what the business of the company is and
what were the important/relevant metrics. Use this information for
checking out the market place. "If the key is store volume, visit a
store and count customers, check average ticket size, talk to the
store manager. If it is a hot new company with a to-die-for product,
see if competitors have heard of the product yet. If it is an oil &
change franchise, count cars at peak hours to see if franchisees are
hitting break-even assumptions"
Do not make conclusions on one store alone. Outliers due (possibly
to do geographic area) might be an outliers on volume. Observing
will give you an idea on the company's execution.
4. Who Owns It?
High institutional ownership and high Wall Street coverage can make
for quick collapse if something unexpected happens. Always follow
short-sale numbers to tell you when a squeeze might develop so
that the relative impact on a portfolio can be monitored. Watch
option volume and relative pricing to note takeover speculation. Pay
attention to 13Ds and 144s.
5. Check the Water Temperature
Accumulate brokerage reports to provide the company-think and
Wall Street's attitude. Brokerage reports can provide pertinent
industry data. Often companies will send brokerage reports if you
ask. Brokerage reports sent from the company bound to be positive.
"As you read Wall Street reports, remember the job description of
analysts: They are not paid to make waves or disagree or to be on
the cutting edge of stock analysis. Analysts are relative: They are
supposed to do a little better than their peers and charm the
institutional clients who vote on the Institutional Investor all-star list.
The problem is that some misinformed clients expect analysts to

read the financials, even their bosses do not. Use analysts for
indications of Street-think and as conduits of management
information. It is not good guys versus bad guys, shorts versus
analysts; the point is how effectively you use the information
presented to you."
"Forbes and Barron's do good, strong, analytical fact-finding. Nobody
fires them if they make waves. Many indexes carry only two or three
years of references, but make sure you have at least five because
ancient history is relevant to corporate hanky panky or to the firm's
cultural tradition of hanky panky"
6. Pay Attention
If you decide not to short a stock based on your preliminary
analysis, it might be a good idea next year. if you short now, watch
it. Events move slowly in the financial world, it can be hard to
maintain concentration.
First watch for earnings releases. Note when they are expected to be
published and what Street expectations are. The date of the
earnings release is also statistically relevant: the later they are, the
worse the numbers. Many companies will fax the PR release,
together with the income statements and balance sheet. Quick
information is important. If it is a large, Street-covered stock small
investors are at a disadvantage because Street analysts get the
faxes and phone calls first, little players sometimes not until days
later.
Next, know when financials are expected out. The 10Qs and 10Ks
are read slowly by Wall Street, so quick attention can yield important
data -- little players can make up for the delay on receipt of
earnings-release information. Waiting for new financials is like
waiting for Christmas. It is fun to see if you were right and how
things are developing. Go first to the key numbers, then the cash
flow statement, finally the verbiage. Read the Qs carefully.
Keep watching -- once a potential target, always a possibility. If you
know a company well, you might recognize trigger, like the Zises'
selling their Integrate stock, or HBJ selling Shamu, or J. Billder's
closing stores or running over expected costs and out of money. Be

quick to admit defeat. If you are shorted the stock because the
investors were too high and the 10Q shows the company has
corrected the problem, cover--NOW.
Do not cover just because of price movements; wait until the
resolution of the scenario. If Integrated looks like death, wait till it is
buried. Short selling can be much like a cat waiting outside a mouse
hole - the level of persistence, patience, and attentiveness is not for
everyone, especially over sustained periods of time.
Concept Recap
The short seller's credo can be summarized into several points:
1. Dissent is Okay.
2. The facts are somewhere, free for the digging.
3. Hard work is old fashioned, so if you do a little, you will be far
ahead. Analyst look at company PR rather than fundamentals and
financials, and that provides opportunities and longer periods of
market inefficiencies.
4. Computers confuse and build false confidence in portfolio
managers, and that also provides opportunities.
5. Some accountants sanction everything, and that helps a lot, too.
6. Finally, Wall Street ices the inefficient cake with compulsive
conformity. Everyone gets on the bandwagon and stays until the
evidence is too compelling, then they all fall off with a jolt.
Conclusion
The key points to remember about selling, short selling or simply not
buying are several

Never assume that a certain investment theme applies to all

stocks. Each company and industry is different, so it is lazy to
measure by the same scale if the yardstick is not relevant. If a
company owns land at 1932 prices, do not worry about earnings or
price/earnings. Think about the business and decide what the
market wants you to pay for (cash flow, assets, earning). Then, after
thoughtful consideration of the prospects, value the company
according to your own analysis.

Do not genuflect in front of a business, an executive, or an

analyst. Keep your distance and you objectivity. The stock market is
about people disagreeing over stock prices. Short sellers are entitled
to their opinions, as are executives and analysts. And so are you. Do
not take it seriously; it is only money

A short seller is a skeptic with a constructive, optimistic bent. If

you are appalled when an executive lies about earnings prospects,
do not just sell the stock consider shorting it.

When the short interest peaks at a staggering percentage of

total volume and the marked has embraced pessimism. This might
be a good time to go long and cover short positions.