How to Be a Chicken Short

 | Sep 21, 2011 | 12:30 PM EDT
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I have learned over the years that it generally pays to establish and hang on to a few short positions during most trading periods. I have pointed out before that I do not outright short shares unless its part of an arbitrage strategy. I prefer to find stocks that I think are vulnerable and then use either puts or put spreads to short them.

This helps me avoid getting chewed up and spit out by momentum stocks. I can keep setting up positions in stocks such as LuluLemon (LULU) or Netflix (NFLX) until they finally fall apart without putting a serious dent in my equity. This strategy usually works but sometimes a stock will totally fall apart -- like Netflix has done -- or go into a long protracted decline like Greenhill (GHL) did earlier this year.

 When I look for good candidates for establishing "chicken shorts," I want to find stocks where the price and the story just make no sense to me. Companies such as Amazon (AMZN) certainly qualify on price but the story is intact and strong. It is a great company that executes very well and should be able to maintain a strong growth track. I will not own it because of its price -- but I am not going to short a great company either. In contrast, Netflix had the high price and valuations and I never bought its story. I tried the product and it just was not that good -- I could not see the growth rate continuing.

When I run this type of screen, I also want to see very high institutional ownership in the shares. When the thundering herd gives up on a mo-mo stock, the exits get crowded fast and the stock price often goes into a free fall. When I ran the screen this morning my old nemesis is right at the top. I do not buy the story at Green Mountain Coffee Roasters (GMCR) and I believe the stock will eventually crack. Although at 100x trailing and 42x expected earnings, the valuation is in the nosebleed territory -- so I just have been wrong about the stock so far. I want to be short it again but I will wait until the market is in a strong overbought condition. For now, I am avoiding being short the stock like boxer Floyd Mayweather is avoiding Pac-Man (Manny Pacquiao).

One stock that looks more vulnerable to me right now is Ulta Salon (ULTA). I get that the company has room to grow, as it currently operates in only in 36 states with 345 stores. I also understand that management has done an impressive job and that its comp sales, as well as opening sales, have been running strong. I have seen a reasonable case made that the company could post 20% annual earnings growth for the next several years. To me that would be worth, at most, a 30 multiple. This stock trades at more than 40x trailing and a little over 30x the always optimistic and highly accurate analyst estimates. The stock is up more than 140% over the past year. It appears to be a pretty good company. However, it is just a hair salon that sells cosmetics. There is no moat or barrier to entry, and it is a very crowded industry. At some point, the enthusiastic analysts who follow the stock are going to raise the estimate too high and it will get an earnings miss. This stock is very vulnerable at these levels and if it strengthens further during this quarter, I will look to establish put spreads in the shares.

I truly am a chicken short. I like to find stocks that fit my criteria -- but I much prefer to buy down markets. I like to establish a short in a stock after it has had an extended run in the stock market. I am tracking shares and options of Ulta Salon for a good entry point.

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