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Short Broken Companies, NOT Overvalued Companies

|Includes: CMG, Facebook (FB), JCP, RSH

Evaluating the fundamentals is a process that doesn't change regardless of whether you would like to establish a long position or a short position in a stock. A lot of times, investors get caught-up in valuation, and with good reason-at the end of the day, valuation is an incredibly important metric to judge a stock

However, I believe this often comes at the expense of looking at the long-term characteristics of a business. Whether a stock is valued on a price-to-earnings ratio, PEG ratio, dividend discount model, book value, or a discounted cash flow model, there are actual judgments about the future of the company baked into these valuations, and often times, those judgments can be totally and completely off, rendering the valuation pretty useless.

We've learned the lesson time and time again, most recently with Facebook, that companies can be drastically mispriced when the market is uncertain of the future earnings potential. Once the firm started posting significant mobile advertising revenue, analysts followed the company higher, raising price targets as shares more than doubled to the IPO price and beyond.

At the end of the day, I'd rather short a stock with a "cheap" valuation with a broken business model like RadioShack, J.C. Penney, or Pandora-though I'm avoiding a Pandora short for other reasons. Just as investors underestimate the earnings potential of "overvalued" stocks, investors often overestimate the earnings potential of "undervalued" stocks.

One observation I've made in my investing career is that management tends to make baffling capital allocation decisions while the business is falling apart. I'm sure RadioShack would love to have the hundreds of millions of dollars back that it spent repurchasing stock over the past few years to invest in creating a viable business entity. The degree that businesses degrade thanks to technological innovation never ceases to amaze me.

The bottom line: as a short seller, I think investors should look for broken companies, not "expensive stocks." Just as it is better to buy a fantastic business at a fair price, it is better to short a terrible business at a fair price than to short a fantastic business at an expensive price.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.