Arts

I am an investor. A long-only investor. Sure, I dabbled in shorting a little bit some years ago, but my reaction was much like former President Clinton's explanation of his experimentation with marijuana: "I experimented with shorting a time or two, and didn't like it. I didn't inhale, and I didn't try it again."

Some might go as far as to call me a Warren Buffett fanboy. As such, I'm dead set on finding high-quality, well-run businesses selling at discounts to their intrinsic values. It's as simple as that.

Or is it ...
My fellow Fool Matthew Argersinger penned an article recently titled "Forget Buy and Hold, Think Buy and Short." "Outrage" best describes my reaction to the article's title. 

"Great," I thought, "one more attack on the tried-and-true idea of investing in stocks as businesses and profiting from their long-term growth and success." But I bit my tongue and read on.

As it turns out, Matt made a pretty compelling case, citing, among other things, a study of individual stocks between 1983 and 2006 -- a period that saw the price of the S&P 500 index multiply 10 times over. The study wasn't terribly promising for those looking to find outperforming stocks. It found that:

• 64% of stocks underperformed the Russell 3000 during that span, dividends included.
• 39% of stocks had a negative lifetime total return.
• 19% of stocks lost at least 75% of their value.

Ouch!

Of course, the long-only investor in me would rebut that it's often not all that hard for investors who do their homework to separate the investment wheat from the chaff. Even just looking at valuation can go a long way toward keeping you away from stocks headed the wrong way.

Take Wal-Mart (NYSE: WMT) and Pfizer. Both stocks would have been considered big winners among the group of stocks in action over the 1983-2006 period. Wal-Mart soared 5,826%, while Pfizer was up more than 1,700%. And that's without dividends.

The past decade hasn't looked quite so good for either company, though. During the decade ended in January of this year, Wal-Mart's stock lost 23%, while Pfizer slid 44%. What happened? Very respectable operating income growth of 9.3% per year for Wal-Mart and 8.6% for Pfizer couldn't fight the enormous valuations both companies carried 10 years ago.

Not quite the whole story
OK, that's not even close to the whole story. While valuation plays a big part in stock returns, there's a lot more to the results of the study above than high earnings multiples. Quite simply, in terms of business model alone, there are a lot of very mediocre companies trading on the public markets, not to mention some downright ugly companies. (Remember Webvan?)

But wait, there's more! Father Time isn't always kind to businesses and industries -- ask Eastman Kodak (NYSE: EK) and New York Times about that. As Lehman Brothers, Citigroup, and a host of other big banks showed, execution is often nothing short of pathetic. And sometimes, as with Enron, management is just plain criminal.

Perhaps I could like green eggs and ham?
I surely am not interested in giving up my focus on buying quality companies. But the more I thought about it, the more intrigued I became about the idea of selectively shorting companies. So I reached out to Matt Argersinger to find out more about what he and forensic accounting expert John Del Vecchio, CFA, have been focusing on in their shorting efforts.

I came away from our exchange with three reasons to consider adding shorting to my toolbox:

1. Hedge: I don't think our economy is in for a horror show, but I do recognize that there are some very real challenges ahead. A few short positions could provide a hedge against losses across the rest of my portfolio.
2. Making the most of research: Research enough companies looking for long opportunities, and you're bound to stumble across a few that make you scratch your head and say, "How in the world is this company in business?" You can leave those stocks alone and move on, or you can spend some time to dig in and potentially make money on the downside as the rest of the market comes to the same conclusions that you did.
3. Non-correlation: Finding the right short can potentially hand you a trade that will make money no matter which way the market moves. If the company in question has poor quality earnings or appears to have other accounting shenanigans going on -- a specific area that John and Matt are focusing on -- it may not matter what the market is doing when investors begin to realize the company isn't on the up-and-up.

A starting point
One of the primary ways John and Matt are looking for short opportunities is by keeping an eye out for red flags in financial performance. One of those red flags is when a company's cash flow lags its accounting profits. Wall Street tends to focus on income statement earnings, but if a company can't turn those earnings into cold, hard cash, then those earnings aren't worth a whole lot to investors.

Using Capital IQ, I was able to find a handful of companies currently waving this red flag. To make the numbers comparable, I looked at the net income-operating cash flow disparity as a percentage of net income.

Source: Capital IQ, a division of Standard & Poor's, and author's calculations.
Disparity percentage is net income less cash flow from operations divided by net income.
*Ares Capital cash flow was negative for LTM and 2008 periods.
**Fifth Street Finance cash flow was negative for all periods shown.

Nota bene! I am not recommending that you rush out and short these stocks. Often there are good explanations for why cash flow is trailing accounting net income.

In the case of the companies above, a variety of reasons might be proffered for the disparity between net income and cash flow. Both Ares and Fifth Street are specialty finance companies that use cash to make new investments. These investments are included as operating activities and drag down operating cash flow.

Each company also recognizes accounting income from payment-in-kind interest, which is more or less an IOU -- generally from a company that's struggling and can't pay cash interest.

Patriot Coal is working off below-market sales contracts that it inherited when it acquired Magnum Coal. Lumber Liquidators is sinking lots of cash into inventory, a mark of a company that's trying to crank up its growth quickly. And, finally, WebMD has all kinds of moving parts, from deferred tax gains to asset sales, investment impairments, and discontinued operations, all of which are making it difficult for investors to get a good sense for what the business can actually earn.

These all can be reasonable explanations; however, investors need to make sure to dig in and verify that there's nothing to worry about. For Ares and Fifth Street, those PIK payments are only as good as the companies behind them. And Lumber Liquidators needs sales growth to keep up in order for those inventory investments to pay off.

After digging in, if an adequate explanation of a persistent gulf between accounting income and cash flow can't be found, or the explanation smells fishy, you may just have short-worthy shenanigans going on.

© 2010 UCLICK L.L.C.

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