Whatever direction you think the market is heading in over the next few months, there's money to be made in shorting a handful of lousy stocks. Until now, the rally's breadth has been so great and its trajectory so one-sided that many professional bears have been chased from the market. Now, with the market finally producing the 5% correction many had long predicted, the time could ripe for a short strategy, which depends both on overpriced stocks and volatility for success. Shorting is always a risky strategy -- losses can be theoretically infinite if the stock goes up instead of down. Just ask traders who have been waiting for Taser ( TASR) to fall apart. One should also remember that short-selling is subject to the same pitfalls as buying shares on margin, which is to say that if a position starts to show losses, you're likely to get a call from your broker looking for money. There's also risk if your stock is popular with other short sellers. When heavily shorted shares go up, others rush in to cover their positions, and the ensuing "short squeeze" can send the stock even higher. If you don't have the stomach for that kind of action but still want to play the bear side, consider a short-oriented mutual fund like those offered by Rydex or Profunds. If you've got an appetitive for risk and understand how the trade works, however, a few companies seem like good short candidates right now. Consider Cepheid ( CPHD), Power One ( PWER) and Packaging Corp. of America ( PKG). After a 167% jump in share price over the past year, Cepheid now trades at almost 18 times sales and sports a price-to-book ratio of 16. Last month, the firm said it would lose between $10.5 million to $12.5 million this year, or 29 cents to 35 cents per share based on shares outstanding as of Dec 31. Cepheid, which makes devices that detect biological agents, recently sold 5.5 million new shares, possibly in an attempt to spread out its losses.
Investment advisory firm ValueEngine.com said fair value for Cepheid stands at just $5.81, 35% below its current price of $8.94. But some analysts still like the stock. William Blair analyst Winton Gibbons, for example, said investors with a tolerance for risk should add to positions because he expects the firm to lose just 28 cents a share this year, compared to a loss of 53 cents in 2003. As for Power One, it recently disappointed investors by posting a fourth- quarter loss of 12 cents a share after earning 6 cents a share in the year-earlier period. The company, which makes power conversion products, currently trades at almost four times sales, which is above both its historical average and that of its peers. Analysts expect the firm to lose money in 2004, and for this reason they don't expect much, if any, price appreciation over the next 12 months. While Packaging Corp. has more fans in the analyst community, the firm recently said fourth-quarter earnings fell 17%, and it warned of a loss in the first quarter due to high energy and wood costs as well as higher operating costs. Gary Tapp, a quantitative strategist at SunTrust Robinson Humphrey, thinks the stock could be poised to fall because, like Cepheid and Power One, it scored low marks on his Pure Value Model. This model takes into account a wide range of valuation measures, including a stock's price to cash flow, price to book, price to sales and forward price-to-earnings ratio. A Pure Value score under 20% indicates the stock is very expensive; scores below 15% suggest the stock is pricing in perfect performance going forward. "In these cases, the stock could be vulnerable to any deterioration in the story or even to any weakness elsewhere in the industry group," Tapp said. Power One, Packaging Corp. and Cepheid all scored below 20%, with Power One coming in under 15%.
What makes these companies especially susceptible, according to Tapp, is that they are also at risk of missing earnings estimates in the current quarter. "Our thesis in the current environment calls for stock prices to be driven by earnings growth and upward earnings revision trends," he said. "Therefore, in addition to valuations that might be stretched, investors should be cautious about situations where earnings growth may have peaked." Tapp's point is consistent with a warning often heard among professional short-sellers, that it is unwise to short stocks that don't have a near-term catalyst that can drive them lower. Among other companies that Tapp recommends as potential shorts are Merck ( MRK), Gateway ( GTW), Solectron ( SLR) and Ciena ( CIEN). While these companies are at risk regardless of the overall market's direction, they're in even more danger if the recent correction persists. After all, stocks with high multiples and poor earnings predictability have a tendency to crater when the market takes a turn for the worse. For nimble short players, however, that could mean some sizable gains.