Gain Through Shorting

 | Jan 06, 2012 | 1:00 PM EST
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As we end of the first week of the year, I want to discuss stocks to avoid and even consider shorting early in the year. For the most part these are stocks that are overvalued or have a poor business outlook going forward. The one thing we know about the market in 2012 is that the volatility of the past year is likely to continue, and the gyrations should give us a chance to make money going up and coming down. Given the extreme global risks, it just makes sense to have a few chicken shorts on the books this year.

My first pick is a stock I have been short for some time, and I will probably keep rolling over my options positions until it falls or until the Mayans are proved correct about the end of the world. Apollo Group (APOL) is not rich in the numbers, but it is a company in a very bad business with poor prospects. The for-profit education industry has been described by several fund managers as one of the worst in the nation. Hedge fund manager Steve Eisman has been among the most vocal critics of the industry, pointing out that the default and dropout rates are too high and the schools' revenues are too reliant on federal loan guarantees.

Apollo is the industry leader in for-profit education, and 86% of their students use federally guaranteed loans. New regulations regarding repayment rates and the debt-to-income levels of students take effect this year and could potentially hurt Apollo's ability to receive federal funds. Even if they dodge that bullet, which they probably will this year, enrollments are still slowing throughout the industry. Total student enrollments in the University of Phoenix degree programs dropped by 15% year over year. The stock price has stayed stubbornly high, but it is a struggling company in a bad industry. Eventually, I expect this stock to trade in the single digits and I will continue shorting it until it falls to that level. Apparently, I am not the only one concerned about Apollo's prospects, as insiders have sold more than 1.8 million shares in recent months.

BJ's Restaurants (BJRI) is another stock to consider shorting. I just do not buy BJ's growth story since it relies on new location openings, which almost, always run out of steam at some point without a new groundbreaking concept. BJ's operates brew-pub style casual dining restaurants, and although brew pubs are popular right now, many have already staked their claim in the marketplace. I may be kidding myself, but I think that most of the likely brew pub customers would prefer locally owned and operated establishments to a chain location.

BJ's is not doing badly; it brought in 6.5% same-store sales growth last quarter and plans to open 15 new stores this year. However, it is spending quite a bit of cash to fund the growth, and I think they will have to have an equity offering later this year to continue opening new locations at a pace that makes Wall Street happy. At 45x trailing and 33x the 'always-accurate' Wall Street analyst estimates, the stock is priced for perfection in 2012. I doubt the company can deliver. I would not own it, and if it moves back above $50, I will start looking for option spreads to short the shares.

Another stock I will add to my short list this year is a stock I started buying put spreads in last year. Ulta Salon (ULTA) is not a bad company, but essentially, it sells cosmetics and hair products, and provides salon services. This is not exactly a business with high barriers to entry, but the shares are priced as if they have the deepest and widest moat in the world. It is a decent business, but 42x current and 30x expected earning is just too high for a retail business in a competitive segment. The 8x book value and an EV/EBITDA ratio of more than 17 are just not sustainable valuations for this stock.

I will never be net short, and I only use put options and spreads to short stocks since I am a well-known chicken. However, having some exposure to overvalued stocks or bad businesses just makes sense in this market.

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