25 Good Short Candidates

by: James Cullen

Every month, I publish my Top 25 stocks, on both the long and short sides, as determined by my quantitative model. With the S&P 500 rising 1.21% in the last month, the average return for my most recent short portfolio was -2.05%, meaning the shorts underperformed by more than three full percentage points - not bad for less than a full month.

The declines took place across the board, with 18 of the 25 stocks (72%) failing to beat the S&P. Sym’s (SYM), a discount clothing retailer, fell nearly 14% to lead the decliners. Shares of OfficeMax (NYSE:OMX) also continued to trend lower, as did beleaguered homebuilder Pulte (NYSE:PHM), both of which dropped 7%.

The new “Short 25″ portfolio for the next month is:

1. Thoratec (NASDAQ:THOR)
2. Sonus Networks (NASDAQ:SONS)
3. GenCorp (GY)
4. General Electric (NYSE:GE)
5. Activision (NASDAQ:ATVI)
6. PAR Technology (NASDAQ:PTC)
7. Candela (CLZR)
8. Thermo Fisher (NYSE:TMO)
9. Callaway Golf (NYSE:ELY)
10. Radvision (NASDAQ:RVSN)
11. Itron (NASDAQ:ITRI)
12. Baldor Electric (BEZ)
13. Peabody Energy (BTU)
14. Macquarie Infrastructure (NYSE:MIC)
15. Allscripts Healthcare Solutions (NASDAQ:MDRX)
16. Electronic Arts (ERTS)
17. Federal Signal (NYSE:FSS)
18. Sapient (NASDAQ:SAPE)
19. Playboy (PLA)
20. UMH Properties (NYSEMKT:UMH)
21. Integrys Energy Group (NYSE:TEG)
22. Temple Inland (NYSE:TIN)
23. Pulte Homes (PHM)
24. CoStar Group (NASDAQ:CSGP)
25. CVS Caremark (NYSE:CVS)

Several of the stocks are making repeat appearances, and the underlying theses that I can rationalize typically remain unchanged. I’m not enthusiastic about video game makers (ERTS or ATVI), as most of their profits - which are spotty and highly dependent on the release dates of a few anticipated blockbusters - go right back in to making new games. Gaming consoles aren’t getting simpler, and development is thus going to be a more intensive and costly process. Another troublesome trend for companies like Electronic Arts has been the success of the Nintendo (OTCPK:NTDOY) Wii. Looking at Electronic Arts’ offerings for the various consoles, it comes clear that the Wii was not a priority for game development, as both Microsoft’s (NASDAQ:MSFT) XBox 360 and Sony’s Playstation 3 feature many more games; with the Wii handily outselling PS3 and pacing sales of XBox 360, Electronic Arts could feel a pinch simply from not having a large enough customer base to sell to.

It seems like everywhere I go, a new CVS is being built. Even ignoring the fact that I can’t remember the last time I went to a CVS, this is not a good thing. While I’m all for an aggressive expansion strategy, I can’t see how CVS is going to convert all these new locations into something of value for shareholders, and that makes this expansion reckless. CVS is a $60 billion company, and even doing a quick calculation and backing out their capital expenditures related to new store openings, the stock is still trading for around 35x normalized cash flow. Comparing FY2006 to FY2005, CVS added about $5 billion in assets and $150 million in profits. Do I really want to invest in a company with a 3% marginal return on capital? Even excluding the growth in intangible assets, return on marginal “hard capital” is still under 5%. Yes, we could have a very academic debate about CVS’ cost of equity, WACC, etc., or we can skip that and say we definitely require more than a 5% return on capital given that money markets yield that much; further, companies that are likely destroying value by continuing on reckless - not just aggressive - expansion should not be trading near their 52-week high.

When I first placed Itron (ITRI) on the short list, I received an email from a reader not just calling me an idiot, but actually giving me reasons why I was wrong in calling it a short. The logic, according to the email, was that infrastructure buildouts and ethanol production were creating huge demand for their products. For the time being, I will admit that ITRI has not been a good short position. At the same time, I refuse to buy into anything on the assumption that ethanol demand will continue to propel demand for whatever products. Ethanol is not, has not, and will not be the solution to America’s energy problem for a variety of reasons, and gambling on companies that rely on ethanol is not a sound investing strategy. All ethanol subsidies have given us is soaring food costs (I recently read that the price of milk is up 70% in the last year - not that you’ll find that reflected in core inflation, Mr. Bernanke) and another dimension of political pandering in Iowa (see: Sens. Obama and McCain). Forget ethanol, solar, wind, geothermal, or McDonald’s cooking grease, I’m sticking with coal-to-liquids technology and Sasol (NYSE:SSL) on the alternative energy front.

Disclosure: none