25 Good Short Candidates

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 (OMX) also continued to trend lower, as did beleaguered homebuilder Pulte (PHM), both of which dropped 7%.

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

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

Disclosure: none

Comments

[MDCigan:]

Interesting. Quite a few of your short picks actually look interesting to me from the long side with the top 2 being GE and ATVI. You mention these selections are purely the result of your quantitative model. I can understand if you'd rather not share, but I'd be interested to know what quantitative factors lead to GE and ATVI being short candidates. What is the time frame on your model? Are these selections intended to capture 6-month price movement? 1-year? 3-years?

In GE, you've got an above-average company selling at a market multiple, earnings growth rate that appears to be accelerating, and a pretty hefty dividend yield, and from a technical perspective it appears to be breaking out of a long-term consolidation pattern. We're at 40ish right now. I'd bet we see 50 before 30. It looks a little overbought here, but the entire market looks overbought. Maybe we see a pullback to 35-37, but I just don't see any reason to forecast substantial market underperformance over the next 1-2 years which makes me wonder what specific quantitative factors lead you to that conclusion.

I think your qualitative comments on the video game makers miss the mark. The fact of the matter is if you look at the really long-term performance (past 5-10 years) both ERTS and ATVI have created substantial shareholder value. Historically, the gamemakers have rallied from the summer to late fall/early winter in anticipation of the strong holiday sales. This particular year is likely the sweet spot for this current cycle roll-out and ATVI has a pretty compelling game line-up. From a technical perspective, the stock appears to be consolidating around 18 with some high volume up days (big money accumulating the stock).

2007 Jul 17 11:01 AM

[James Cullen:]

MDC,
All of the data is fundamental; I update long and short once per month and judge them accordingly, but I think one could extend each hypothetical portfolio 6-12 months and still do fine.

As a rule, I don't filter picks - but I was torn about leaving GE in there because I agree with many of the things you are saying. At the same time, the company just doesn't excite me enough to say I would buy it either - I'd prefer to grab more focused companies in areas I like than get all the diversification that is GE.
I can't argue the past with ERTS or ATVI, but I can say that with ERTS, their development seems primarily geared to Sony's platform, followed by Microsoft. Nintendo is far in the distance in terms of product offerings and hence revenues, but with the Wii outselling the PS3 I can't see how that translates positively for ERTS in game sales. PS2 was the dominant console for a long time, and many game developers certainly benefitted from that because Sony wasn't focused on game development and let others control that space. That just isn't the story with Nintendo...

Thanks for the comments.

2007 Jul 17 05:25 PM

[Christopher...:]

Most of these are crowded picks. Too vulnerable to a short squeeze. You need to go back to the drawing board.

2007 Jul 17 12:13 PM

[Investment ...:]

Your reasoning behind your CVS short is fine, but your closing sentence: "should not be trading near their 52-week high." is a first line risk control measure that immediately eliminates this as a "good" short candidate for any professional trader I know, including myself. In a general bull market, we do not short stocks at, near or just above their 52-wk high. On the contrary, it's generally a good idea to buy in these situations, although I wouldn't want to own CVS for reasons you mentioned, as well as other internal research we have on the sector and CVS in particular. Remember markets will stay irrational longer than you can stay solvent.

2007 Jul 17 06:37 PM

[James Cullen:]

Mr. Hamidi,
I never understood the logic of "if it has gone up already, it must be good." Essentially you are saying because a stock (like CVS) is more expensive, that makes it better. CVS is bad at $36, so at $39 I believe it would be worse...

2007 Jul 18 10:13 PM

[MDCigan:]

"MDC,
All of the data is fundamental; I update long and short once per month and judge them accordingly, but I think one could extend each hypothetical portfolio 6-12 months and still do fine."

Perhaps I'm missing something here, but I don't follow this. In my view, there is absolutely no connection whatsoever between 1-month stock price performance and fundamental factors. Over a 1-month time frame, stock price behavior is probably some combination of technical factors (I do believe in things like stock price trends and oversold/overbought) or just statistical noise (for those more inclined to random walk theory).

"At the same time, the company just doesn't excite me enough to say I would buy it either - I'd prefer to grab more focused companies in areas I like than get all the diversification that is GE."

I agree one can probably find stocks with more upside then GE, but that is different then saying the stock is an attractive short.

"I can't argue the past with ERTS or ATVI, but I can say that with ERTS, their development seems primarily geared to Sony's platform, followed by Microsoft. Nintendo is far in the distance in terms of product offerings and hence revenues, but with the Wii outselling the PS3 I can't see how that translates positively for ERTS in game sales. PS2 was the dominant console for a long time, and many game developers certainly benefitted from that because Sony wasn't focused on game development and let others control that space. That just isn't the story with Nintendo..."

This is true, but it might prove dangerous from the short side to underestimate just how quickly ERTS might be able to turn the ship around and ramp up development for the Wii and start having success on that platform. In my view, the video game industry is still one of secular growth, and in general I think one of the best investment strategies is to go long companies in long-term growth industries which are experiencing "temporary" problems. The key question is are ERTS' problems "temporary"? Time will tell, but if I were forced to bet, I'd bet on them fixing the issues and developing a strong line-up of titles for the Wii that bring the company back to strong profitability.

I appreciate the discussion.

2007 Jul 18 01:35 AM

[James Cullen:]

MDC,
I too would assume there is no connection either between one month's performance and fundamental factors, but doing the monthly count is purely for fun - the real reason is to continue to build a database that I can use to judge six month, one year, two year performance. I wouldn't be surprised if there was something to be said for F/A though; although it might be a dying breed with the ultra-margin hedgies out there with black-box models, don't discount it.

Re: General Electric, I tried to make it clear that I personally wouldn't be short, but it is "suggested" by my model. I'm the guilty party for programming it, but I also know why GE is there - the model is doing its job. My usual refrain for a stock like GE appearing is that the real value-added work is to figure out the best of the bunch... which I see as stocks like CVS and ERTS.

2007 Jul 18 09:59 PM

[MDCigan:]

"but your closing sentence: "should not be trading near their 52-week high." is a first line risk control measure that immediately eliminates this as a "good" short candidate for any professional trader I know, including myself. In a general bull market, we do not short stocks at, near or just above their 52-wk high. On the contrary, it's generally a good idea to buy in these situations, although I wouldn't want to own CVS for reasons you mentioned, as well as other internal research we have on the sector and CVS in particular. Remember markets will stay irrational longer than you can stay solvent. "

I completely agree with this sentiment. One ticker comes to mind. CROX. I think at some point this probably becomes a great short, but I am not stepping in front of a freight train to get run over. In my view the valuation is somewhere between absurd and insane in terms of pricing in future growth expectations, but who knows how high the market can build this "castle in the sky".

2007 Jul 18 01:37 AM

[ntwining99:]

With regards to ATVI,
A short term loss could be expected for ATVI if you a speaking of only a month. However, like most of this industry ATVI is Q4 heavy and has their biggest products lined up for late Q3 (Quake Wars) and into Q4.
Quake Wars won't sell absurd amounts because they are limited to the PC, for now. What is very good for the game is the fact that it comes out at the right time. No other FPS has been released for the PC in this vein since Battlefield 2042 or, to a lesser extent, Stalker. It has a full two weeks before anything worthwhile comes along to challenge it (Bioshock) so it has a chance to ship a good amount during that oh so important launch.
Furthermore, the lackluster sales of Call of Duty 3 will not be evident with COD4, in my opinion, given that the developer for COD4 is the original Call of Duty developer. Tony Hawk and Guitar Hero should have decent sales as well, especially given the expanding market share of the music based games and a dedicated player base who already own the peripheral Guitar. All in all I feel that by December you will see a very healthy ATVI.

2007 Jul 20 11:51 AM