*First see Risks of short selling in practice.
Things I look for:
- Insiders selling massive amounts of shares. Insider selling can sometimes be legitimate as insiders may want to reduce their risk (sometimes this is a BS excuse), support their extravagant materialistic lifestyle, or give money to charity (e.g. Bill Gates and Warren Buffett). Legitimate selling usually occurs slowly and insiders don’t try to dump all their stock in say a single year.
- Insiders are heavily promotional on their stock and project incredible growth, yet they are selling shares. If they know that awesome times are ahead, it makes no sense to sell shares.
- Secondary offerings. A company will sell stock at a huge discount (I call this a fire sale) and pay massive fees to underwriters. Companies will do this if insiders are smart and they know that their shares are overpriced.
On the other hand, underwriters don’t want their clients to get burned all the time. They will promote a stock after a underwriting (the share price will often go up) and they will try to find dumb CEOs who will do secondary offerings when their company is undervalued.
- The company’s profits and numbers are way too high. In commodity-like industries, every company can be expected to make around the same amount of money. Unless the company has some crazy cost advantage or management is incredibly smart, they will be unable to generate incredible profits and extremely high return on assets figures. If they report really good figures, they are probably lying.
- (OTC Bulletin Board / Penny stocks only) There is no actual business. If you read the SEC filings for pump and dump penny stocks, you can see that they spend money on stock promotion and if there is an actual operating business. In promotional materials, promoters have to disclose how much they are getting paid.
Things I don’t put much weight on:
- Aggressive accounting. Such as improperly capitalizing expenses, choosing accounting rules that don’t make economic sense for the business (e.g. capitalizing interest on home communities that aren’t selling), aggressive recognition of revenue and not recognizing expenses right away, any company that reports non-GAAP earnings, etc.Most companies engage in this. But most of these companies don’t strike me as good shorts. And a lot of the really crafty insiders out there will do a good job of concealing their accounting shenanigans.
Things I don’t like to see:
- The underlying business is a high-quality business like RIMM, CRM, NFLX, PCLN. I don’t ever want to short good companies as they can grow 16-20X in the long run.
- Ponzi stocks which continually hold secondary offerings. Yes they are bad companies, but every time they hold a secondary offering the company is actually worth more. The rate of return on shorting these stocks is poor. For example, David Einhorn had a 5% IRR from shorting Allied Capital.
- High borrowing costs. These stocks are crowded by short sellers and ripe for a short squeeze or somebody to engineer a buy-in. On the other hand, this is a characteristic of some really good short selling candidates.
What happens next
While a stock may be overvalued, I don’t want to short it right away. Overvalued stocks can get insanely, unbelievable overvalued. Sometimes this can occur because people start short selling the stock, then they get killed, then they cut their losses and create more buying demand at the top.
I want to be close to the turning point. This usually coincides with the announcement of a secondary offering or an awful earnings release. If a secondary is announced, there is a very good chance that the stock will start going up. Analysts are all slapping a strong buy on the stock, there are crazy rumours about the company being taken over, and devious hedge funds may be buying the stock simply to squeeze the short sellers and force them to cover. So wait for the rally, and then start shorting the stock.
How well does this work?
I don’t really know because I have an extremely small sample size. So don’t take what I say too seriously. Please do your own homework and thinking.