Know What Stocks to Short in Our Dangerous Economy

John Del Vecchio is a principal of Ranger Alternrnative Management, L.P. and co-portfolio manager of AdvisorShares Ranger Equity Bear ETF (NYSE Arca: HDGE), an actively managed all-short ETF that shorts individual stocks without the use of leverage or derivatives. His professional experience includes working for well-known short seller David Tice and renowned forensic accountant Dr. Howard Schilit.

Mr. Del Vecchio is also the creator of an index that tracks the earnrnings quality of companies, and co-author of the book What’s Behind the Numbers? A Guide to Exposing Financial Chicanery and Avoiding Huge Losses in Your Portfolio.

You can follow him on Twitter @AdvisorShares.

For more on John Del Vecchio, click here.

Teresa, managing editor of Economy & Markets, recently reached out to me with some questions about what I’ll be bringing to the table (or podium) at the Irrational Economic Summit in October.

Naturally, I don’t want to give away all of my secrets at this point (otherwise why should you attend the conference, besides the fact that it’s in Miami). So, instead, I thought I’d offer you a useful precursor…

TvdB: How do you identify stocks to be sold short?

Me: We use a combination of fundamental and technical analysis. We focus primarily on companies with deteriorating fundamentals or aggressive accounting.

For example, we seek to identify companies that are aggressively booking revenue, which may signal a slowdown in demand for their products. Or, management may be using accounting techniques to overstate the sustainability of the reported profits on a quarterly basis. They may reverse a reserve and get a 100% margin boost to earnrnings. Wall Street gets excited because margins are improving, but it’s accounting fiction and the results aren’t sustainable.

The reality is, Generally Accepted Accounting Principles (GAAP) leave a lot of room for management interpretation. But a good guideline to follow is: The more aggressive the assumptions, the greater the risk of an earnrnings shortfall in the following quarters.

Technically, I like to see companies selling off on higher volume than they rally. I also like to see momentum waning. Stocks that are vulnerable may be showing bearish divergences between price and relative strength, for example.

TvdB: Is there a different approach to evaluating when to cover a short position, compared to selling a long position? When do you get out?

Me: Short selling is the ultimate contrarian bet. So, we cover when the consensus view starts to match our own. Generally, there’s less downside when everyone else is also bearish.

We also cover when the issues that we identified are no longer relevant. That includes losing positions. We’re not emotional about the stocks in our portfolio. If the fundamentals truly get better, we cover our position and move on.

I’d suggest you do the same, where possible.

In the short-term we may cover a bulk of the position if momentum improves. Momentum is a powerful force and we then look for better opportunities to add back the position when the price-to-volume relationships start to weaken.

TvdB: What is the number one criteria for selling a stock short?

Me: The spread between the companies with the highest quality revenue-recognition policies to the lowest, and the quality of the highest cash flow quality versus the lowest, is hundreds of percentage points over the last 10 years. That’s to say, the high-quality companies vastly out-perform.

So, we look for companies that are “stuffing the channel” and borrowing revenues from the future, or that are reporting very low cash flow quality, signaling that management is using a lot of accounting chicanery to pretty-up the income statement and mask a deterioration in their business.

TvdB: What is a current example of a company that will potentially drop dramatically in valuation, and why?

Me: 3-D Systems (NYSE: DDD) is the lowest-rated stock we follow. It initially rallied quite strongly, but now trades well below where we first identified it as a short selling opportunity.

In our view, the company has questionable revenue quality, with receivables up while it pushes product into the sales channel.

Growth in the U.S. has slowed dramatically. Yet 3-D Systems has made numerous acquisitions that have clouded its sustainable results.

Cash flow quality is sub-par and management has issued more stock, so it scores poorly in shareholder-yield metrics.

Furthermore, the 3-D printing space is enveloped in hype, so the stock trades at a massive multiple to its revenues at a time when revenue quality is suspect.

The combination of high expectations and low earnrnings quality is often deadly for a stock’s performance. Watch out for this.

TvdB: What is your outlook for the economy over the next two years?

Me: This is possibly the biggest question on investors’ minds right now. For me and my colleagues at AdvisorShares, the most important factor in our economy affecting our confidence is jobs. While the unemployment rate has fallen dramatically, the labor participation rate has plunged. It’s below that of the recession of the early 1980s.

To boot, when people are able to find a job, it’s often at less pay. Real wages aren’t growing fast enough to offset ballooning costs in food, energy, and services such a medical care. Regardless of what the governrnment says about inflation, those are real costs people face every day. Escalating costs in those areas puts a huge crimp on the economy as it depletes discretionary income that could be used elsewhere.

What’s more, kids graduating from college today are saddled with a trillion dollars in loans and many of them can’t find quality jobs. This negatively impacts savings and investment.

While the stock market is at new highs, only a small fraction of people own the vast majority of stocks. So, I’m highly skeptical of the so-called “wealth effect” here, where stock market highs compel people to spend more money in the economy.

Much longer-term effects are a stable job market and growing wages. The absence of these in the economy leaves me very concernrned about continued weak growth and vulnerability to nasty recessions.

And I know Harry and Rodney agree.

That’s why they’re holding the Irrational Economic Summit. Because people like you — people on the ground — need to find ways to invest successfully in a very dangerous environment.

I, along with the 11 other confirmed speakers at the conference in October, plan to give you the information you need to do just that.

Make sure you get to this summit. It’s important.

John Del Vecchio