This framework is based on the book "The Art of Short Selling" by Kathryn Staley.
I. Short Sale Categories and Characteristics (There are some overlap):
1. Companies in which management lies to investors and obscures events that will affect earnings.
2. Companies that have tremendously inflated stock prices-prices that suggest a speculative bubble in a company's valuation.
3. Companies that will be affected in a significant way by changing external events.
4. New Concept stocks that draw a lot of attention and hypes. Fad or bubble stock pricing: usually marked by a stellar price rise over a short period.
5. Accounting gimmickry: clues that the financial statements do not reflect the true state of corporate health.
6. Insider sleaze:signs that insiders consider the company a personal bank or think the stock should be sold.
7. A gluttonous corporate appetite for cash.
8. Overvalued assets or an ugly balance sheet.
9. Concepts stocks with no or low barrier to entry. (Groupon for example)
10.IPOs of stocks in hot industry that is overhyped and has a lot of competition. (similar to 4)
II Research the Short Candidates:
1. Work from at least 2 years of 10Qs and 10ks and analyze balance sheet, cash flow and financial ratios.
2. Track insider activity and management's compensation vs company's performance.
3. Look at the products, the competitors, the suppliers of production inputs.
4. Read analyst reports and determine consensus.
5. Read and keep up with the news of the company over time to see what happens, how earnings and price progress, what changes.
6. Clear catalyst that will send the company's stock downtown.
7. Keep track of key metrics that indicate trouble such as AR, Inventory, Prepaids and compare them to sales and CGS and operating income.
III.Important Points to Keep in Mind:
1. The accounting based analysis is not difficult to do but it takes time, patience, and a suspension of belief. The lack of attention by other professional investors to these financial details provides the inefficiency in information dissemination that is so central to the short seller's art.
2. Even successful short sellers are consistently too early when they sell stocks, sometimes even years too early. David Einhorn's Allied Capital, Bill Ackman's MBIA, Witney Tilson's Netflex.
3. Short seller fear most a sustained rally in a stock followed by a forced buy-in of their position, resulting in a loss out of their control, particularly in companies with smaller floats.
4. Valuation bets on price alone make bad short sales, i.e shorting a stock just because you think the stock is overvalued may be dangerous. There must be either a fundamental change in the outlook for the company or a major misconception by the stock-buying public.
5. You have to be able to articulate in clear logic what mechanics will impact the income statement and balance sheet negatively. The best way may be talking to competitors and suppliers. The point of short is when those mechanics become overwhelmingly apparent and the stock is still up.
6. Jim Chanos use return on invested capital calculated by EBIT/(All Interest Bearing Liabilities+Equity+Deferred Taxes+Short Term Debt).
7. High ROE makes for a lousy short sale because the company can finance its growth without caring a fig what the Wall Street Pubahs think about the business plan.
8. When a company switches or expands its business line into something completely different, it generally means management fears that growth will slow in the main line. When they expand into a highly competitive business that costs money for product development (like software game titles) when the base business eat money as well, you sit back and watch with relish for the train wreck to happen sooner.