In an article that I wrote on October 14, entitled “How to Select Stocks Poised for Big Gains”, I discussed some of the key criteria that I used over the past 20 years to generate big returns in stocks.
In this article, I discuss some criteria that you can use to identify stocks that are poised to decline sharply, and how to make substantial gains from those impending declines by selling those stocks short.
For those of you who aren’t familiar with selling a stock short, that’s a transaction whereby a person sells a stock that he/she does not own by borrowing shares of the stock from a securities brokerage firm. In the event that the stock sold short were to decline, the short-seller could make a profit by purchasing the stock that he/she borrowed and returning those shares to his/her brokerage firm.
In essence, the only difference between buying a stock and later selling it, and selling a stock short and later buying it, is that the short-seller sells the stock before purchasing it – by borrowing the stock from his/her brokerage firm.
Although some stock market pundits and financial academics claim that selling a stock short is very risky, I have found that doing so is no more risky than buying a stock that one expects to appreciate.
After all, a short-seller can always buy back any given stock that he or she sold short in the event that it were to rise in price after he/she sold it short.
So, how can you identify stocks that appear to be poised to decline sharply?
The answer to that question is to use the opposite of some of the criteria that I discussed in my October 14 article. Specifically, I recommend selecting the stocks of companies that possess the following criteria:
1. Poor or Deteriorating Financial Condition: The underlying company is weak financially, meaning that it has high levels of debt and/or it has difficulty in paying its recurring bills from the company’s cash or trade accounts receivable.
2. High Stock Price Accompanies by Persistent Losses: The price of the company’s stock is relatively high (i.e. above $20, and preferably above $50), but the company has persistently generated net operating losses.
3. Overvalued Relative to the Company’s Estimated Future Earnings Growth: The company’s stock is trading at a premium to the company’s estimated future growth in its profit – the stock’s price-to-earnings ratio is substantially higher than the estimated future average annual growth rate in the company’s net earnings.
4. Declining Stock Price Accompanied by Big Increases in Trading Volume: Price declines in the company’s stock are accompanied by substantial increases in the stocks’ volume of trading, indicating that persons who had bought the stock previously are now selling the stock in droves in anticipation that it will decline further.
5. Declining Institutional Demand: Transactions in the stock by institutional investors indicate that an increasing number of those investors were either reducing their purchases or increasing their selling of the stock.
Note: You can review charts of those transactions by visiting www.gurufocus.com and entering the following in the address line of your Internet browser: www.gurufocus.com/ownership/[stock ticker symbol]. For example, if you wanted to see a chart of recent transactions by institutional investors in Tesla Motors (TSLA), you wound enter the following in the address line of your Internet browser: www.gurufocus.com/ownership/TSLA.
Some examples of stocks that I recommended for financial market participants to either avoid or sell short over the past two years – as a result of those stocks meeting the criteria outlined above – include 3D Systems (DDD), Rovi Corp. (ROVI), Twitter (TWTR) and GoPro (GPRO). Persons who did sell short those stocks would have generated the following returns as of November 11 of this year: DDD (+840.9%), ROVI (+156.7%), TWTR (+112.4%) and GPRO (+85.6%).
Until next time,
David Frazier is President and Chief Market Strategist of Frazier & Mayer Research, LLC, an independent investment research firm that offers customized research and analytical services to registered investment advisors, hedge funds and high net-worth individual investors. You can check out his latest insights at: www.investorsmonitor.com.