Identifing Stocks to Short

The process of shorting a stock starts with the identification  of potential candidates to add to a watchlist, but, how do we go about finding targets to put on that watchlist in the first place?

The following list, though not exhaustive, includes some factors that may help increase our odds in taking a short position. Ideally, this blog post as well as my previous blogposts, Characteristics of Failing Companies, Why Bank Failures Occur? and Instruments used to take short positions, should all be read in tandem when trying to come up with a shortlist of stocks to short. 

The factors covered below range from high level macroeconomic to company specific factors.

• Evaluate Economic and Market Conditions

• Economic Cycles : In bear markets or recessions, cyclical stocks (e.g., luxury goods, discretionary consumer spending) tend to suffer as consumer and business spending declines. Likewise in bull markets utilities, consumer staples may underperform.
• Interest Rates and Inflation: Rising interest rates can lead to declines in high-growth stocks, and high debt companies. You only need to look how the Russel 2000 (^RUT) has underperformed against the S&P 500 and DOW during the current bull market. A high inflation environment affects discretionary goods, luxury goods, electronics etc.

• Identify Industry or Sector Weakness

• Weakness in the Sector: Stocks in struggling sectors (e.g., retail during economic slowdowns or energy during low oil prices) tend to be more susceptible to declines.

• Sector Underperformance Relative to Competitors: If a specific sector underperforms the overall market, the stocks within that sector could be vulnerable to additional pressure.

• Identify Weak Financials

• Declining Revenue and Profit Margins: Companies with slowing or negative revenue growth and shrinking profit margins may have a hard time maintaining their stock price.

• High Debt Levels: Look for companies with significant debt relative to assets or cash flow. High debt levels make them vulnerable to economic downturns and rising interest rates, a good example of this is Spirit Airlines (SAVE) which after two failed attempts to merge with JetBlue and Frontier has filed for bankruptcy.

• Check Technical Indicators

• Overbought Indicators: Stocks showing overbought signals (e.g., RSI above 70) may face downward pressure soon, making them potential short candidates.

• Downward Trend: Stocks showing consistent lower highs and lower lows indicate a bearish trend, which could continue.

• Moving Averages: Stocks trading below their 50-day or 200-day moving averages, particularly if these levels are acting as resistance, often suggest a bearish outlook.

• Look for Negative Market Sentiment

• High Short Interest: Stocks with high short interest (the percentage of shares being shorted) often indicate a bearish consensus among investors. However, these stocks can also be volatile due to short squeezes, from above Spirit Airlines had a short interest of over 34 per cent.

• Insider Activities: When company insiders, such as executives or board members, start selling shares heavily, it can signal a lack of confidence in the company’s future performance. Also when key executives, CEO or CFO, depart unexpectedly with the reason of wanting to "spend more time with their family", there is something awry within the company.

• News and Analyst Reports

• Negative News or Downgrades: Stocks with significant negative news, such as regulatory investigations, lawsuits, or product recalls, often decline. Analyst downgrades or negative coverage can also lead to bearish sentiment. Sometimes short sellers will publish reports on companies that cause a decline in the stock.

• Poor Earnings or Revenue Guidance: Companies that release weak earnings reports or revise their guidance downwards often experience a decline in their stock price as investor confidence wanes.

• Red Flags in Financial Statements

• Earnings Manipulation or Accounting Red Flags: Sudden changes in accounting practices, inconsistent cash flows, or unexplained write-offs can indicate financial instability. In this regard, I will refer you to read Hindenberg Research's report on Super Micro Computer Inc. (SMCI).

• High Inventory Levels or Slow Turnover: Companies that have high inventory or are unable to sell their products efficiently may face lower revenues and profit margins.

Considerations

It should be borne in mind that shorting stocks are inherently risky, as stocks can rise indefinitely, exposing you to potentially unlimited losses. I would strongly advise stern risk management through stop-loss orders, position sizing, and careful monitoring is essential to mitigate risks associated with short selling.