I got an email a few nights ago from a friend of mine who noticed how negative I have been lately asking me what I look for in a short. I gave it some quick thought as to how to respond, as I haven’t formalized my set of “rules”. In fact, I don’t have as much experience selling short as I do buying stocks. I recall selling Dell (DELL) short in 1998 as my first short ever, and it wasn’t very successful – I think I about broke even. That led into my shorting several internet stocks in 1999 (again too early for the most part). Subsequent to that, I had a lot of great “avoids” on stocks, but I didn’t start shorting again until this summer. Having given it a lot of thought over the years, I have certainly tried to improve my odds. Here is how I responded to the question:
Stock should be in downtrend already or at least signs of topping
Stock should not be "oversold" already
Company's estimates should not be rising (unless EPS are "overstated")
Company should have competition or regulation (i.e. never short ISRG)
Avoid companies in consolidating industries unless likely acquirer
With that list in mind, I perused a screen that I had developed using StockVal earlier this year to identify potential shorts. The goal of this screen is to find stocks that have been recently underperforming the market, have flat estimates and are pretty close to the 52-week low and not too far down from the 52-week high. My screen also has a floor on how short-term oversold the stock can be. In other words, the goal is to find stocks that have been in a tight trading range, but lagging the market and not experiencing fundamental improvement.
A stock that shows up on my screen is Texas Roadhouse (TXRH) (12.23, $900mm). I don’t have a position in the stock and admit to never having eaten there. The company has “260 restaurants in 44 states” and plans to open “many new locations in 2007” according to their website. In their recent 10-Q, the number of restaurants is now actually 270 (180 company-owned, 90 franchisees).
As far as addressing some of my points above, this one looks worth investigating further from the short perspective. First, the stock is in a downtrend and has been underperforming the market (as the PE as been compressing). The stock is a bit oversold, but not below the minimum that my screen permits. As far as the earnings estimates, the 2008 estimates have been unchanged now for 6 months. The stock is hardly unnoticed despite its small market-cap: 12 analysts (modestly bullish in aggregate). As far as competition, this is a highly competitive industry. As far as the short-interest, this one qualifies as somewhat crowded (and thus requiring extra caution if shorting). 10% of all shares are short (6 days of volume). Finally, at least by my initial cut to identify possible shorts, acquisition seems unlikely at this point.
So, as the company appears to fall into the category of worth investigating (and I will to a greater extent), what are some other things to consider? The thing that really stands out to me is that the company’s capital expenditures are very high due to their expansion plan. In fact, the company generates negative free cash flow (operating cash flow less capex). This makes me excited to continue my work, as the cost of capital has been going up (except for the U.S. Treasury and very solid credits). This is important because most of the growth for the company comes from expansion (guidance at the beginning of the year was for only 2-3% same-store sales growth, though it has been 1.5% thus far). The company recently increased its borrowings (it pays LIBOR + 50 on its revolver). Here are a couple of other things I quickly noted: Heavy insider selling (CEO mostly and recently), 8.75 IPO price has never been penetrated, but very little volume has traded below 12, and some big institutions bailed recently (FMR and Westfield)
I intend to spend some more time on this one, but TXRH intuitively appeals to me as a potential short. The stock looks weak, and the fundamentals have already been somewhat under pressure. If the current economic situation plays out as I expect, it could challenge the growth plans of this company as well as the comparable restaurant sales.
Disclosure: No position