5 Companies to Short Now

SHORT-SELLERS ARE THE PERENNIAL UN-AMERICANS, vampires intent on driving down the prices of shares, destroying companies and greedily sucking the blood out of innocent investors.

That's the mistaken image that many people have of shorts. In reality, there's nothing unfair or devious about betting against a stock that you think will decline, just as there's nothing wrong about betting against the NFL team that you believe will lose the Super Bowl. And over the past decade, investors who shorted some stocks probably would have done much better than the vast majority of individuals, who go only long -- buying shares in the hope of eventually selling them at a higher price. Shorts reverse the process. They borrow stocks and then sell them, hoping that their prices tumble, which would let them replace the borrowed shares for less than what they paid for them.

Why don't more individuals short stocks? Short sellers' unwarranted slimy image repulses some of them. In addition, many people consider bull markets to be the long-term norm -- a belief that recent events have sorely tested. Lastly, shorting is considered to be very risky, even though it needn't be more volatile than using a long strategy. There is, however, one big danger. Whereas the most a long can lose is the price he paid for a stock, the price of a shorted stock theoretically can rise infinitely, making it immensely expensive to buy shares to cover a short position and creating losses far in excess of the original investment.

But, done intelligently, shorting can be enormously lucrative. Just consider the trading record of Short Alert, a small North Carolina-based research firm that has been producing reports recommending stocks to short since 1998. In the 10½ years ended June 30 of this year, about 75% of the 86 recommendations it made would have turned a profit, even if they were judged based on the conservative criteria used by Barron's in examining Short Alert's record. In other words, the firm offers an excellent window on how to pick stocks to sell short.

Barron's found that the firm, led by managing partners Nat Guild and the ironically named Michael Long, produced annual returns averaging 18.3% from 1999 through 2008. If the period studied is stretched through the end of June, the annual returns jump to 20.3%. But beware: Short selling isn't always a route to easy money: 2004 would have produced a terrible loss of 37%, followed by three years in a row of 13% losses.

In judging Short Alert, Barron's tracked the short positions for a year after they were implemented. Thus, the most recent of the 86 reports we reviewed is dated June 19, 2008.

Currently, Short Alert has five short recommendations. Two of them -- j2 Global Communications (JCOM) and Middleby (MIDD) -- are companies that it successfully recommended shorting last year but that it contends still have room to fall. The others are Compass Minerals (CMP), K12 (LRN), and Pactiv (PTV).

Specifics on these stocks are given later, but obviously, these aren't household names. In fact, the companies targeted by Short Alert tend to be small, with stock-market values around $1 billion. Small stocks are especially prone to becoming overpriced, says Baruch Lev, a New York University finance professor. "There is a great deal of information on large companies," he observes, "which makes it very difficult to hide protracted overvaluation. In comparison, very few people watch the prices of the billion-dollar companies, so most of the earnings manipulation takes place on that level."