{"id":36059,"date":"2013-02-09T18:54:32","date_gmt":"2013-02-09T23:54:32","guid":{"rendered":"http:\/\/countingpips.com\/forex-news\/?p=36059"},"modified":"2013-02-09T18:54:32","modified_gmt":"2013-02-09T23:54:32","slug":"review-whats-behind-the-numbers","status":"publish","type":"post","link":"https:\/\/www.investmacro.com\/forex-news\/2013\/02\/09\/review-whats-behind-the-numbers\/","title":{"rendered":"Review: What\u2019s Behind the Numbers?"},"content":{"rendered":"

By The Sizemore Letter<\/u><\/a> <\/p>\n

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\nIn the opening lines of What\u2019s Behind the Numbers<\/i><\/i>?<\/i><\/a><\/strong>, co-authors John Del Vecchio and Tom Jacobs offer to \u201chelp you find where the investing bodies are buried so you don\u2019t join them.\u201d<\/i><\/b>\u00a0 These are appropriate words to begin a book on the detective work of finding financial chicanery.<\/p>\n

Numbers<\/i> covers the art of short selling\u2014a lonely endeavor that requires thick skin.\u00a0 By definition, you aim to win when others lose. This means that when you\u2019re right, you\u2019re hated; and when you\u2019re wrong, you are shown no sympathy.\u00a0\u00a0\u00a0 In Del Veccio and Jacobs\u2019 words, short selling is considered \u201cun-American at best and criminally manipulative at worst.\u201d<\/p>\n

Moreover, shorting stocks requires taking an unsentimental approach to investing and\u2014perhaps most importantly\u2014keeping the ego in check.\u00a0\u00a0 Very few investors have the disposition to be successful short sellers;\u00a0 John Del Vecchio is one of them.<\/p>\n

Del Vecchio is the co-manager of the Active Bear ETF (NYSE:$<\/span>HDGE<\/a>)<\/b> and the creator of the Del Vecchio Earnings Quality Index that drives the Forensic Accounting ETF (NYSE:$<\/span>FLAG<\/a>)<\/b>.\u00a0 Tom Jacobs is the portfolio manager of Motley Fool Special Ops and a specialist in small-cap value opportunities.\u00a0 In Numbers<\/i>, Del Vecchio and Jacobs reveal some of the tricks of their trade and expose some of the myths that tend to get novice short sellers in trouble.<\/p>\n

To start, overvaluation is not<\/i> a sufficient reason to initiate a short position.\u00a0 A stock that is irrationally expensive can always get more expensive.\u00a0 Likewise, while it is tempting to short a fad stock\u2014think of Crocs (Nasdaq:$<\/span>CROX<\/a>)<\/b>, the maker of colorful rubber clog shoes\u2014fad stocks can stay trendy for longer than you think. \u00a0The same is true of questionable business models\u2014think Netflix (Nasdaq:$<\/span>NFLX<\/a>)<\/b>.<\/p>\n

And what about the stocks of companies engaging in fraud?\u00a0 Well, maybe.\u00a0 But good luck finding them ahead of time.\u00a0 Remember, if management is engaged in something illegal, they\u2019re not likely to mention it in the footnotes of their financial statements.<\/p>\n

What is missing in each of these cases is the catalyst. <\/b>\u00a0What is the sign that the jig is up\u2014and that the stock is due for a tumble?<\/p>\n

Some traders rely on contrarian indicators, gauges of investor sentiment towards a stock, or simply the feeling in their gut.\u00a0 But Del Vecchio and Jacobs take a more rigorous approach.<\/p>\n

The key is aggressive accounting<\/b> and specifically aggressive revenue recognition and inventory management: \u00a0\u201cThe time to sell or short is not when you think a business model can\u2019t survive.\u00a0 The time is when the numbers suggest that management is covering up poor performance.\u201d<\/i><\/p>\n

And how might you know when this is the case?\u00a0 Del Vecchio and Jacobs spend most of the book telling you, but I\u2019ll give two examples that I found to be particularly insightful.<\/p>\n

The first is a metric called Days Sales Outstanding (DSO),<\/b> which measures accounts receivable in proportion to sales.\u00a0 \u00a0An unusual increase in DSO can mean that future sales and being pulled forward by looser payment terms or special financing.<\/p>\n

This hurts future profitability in two ways.\u00a0 The most obvious is that sales that might have happened in the following quarter have now already happened.\u00a0 But\u00a0 worse, those sales might have come with more favorable pricing had the company not been in such a hurry to book revenues.\u00a0 In order to keep Wall Street happy for another quarter, management makes the eventual day of reckoning worse.<\/p>\n

A second, similar metric is Days Sales in Inventory (DSI),<\/b> which measures inventory build-up.\u00a0 You don\u2019t need to be a CPA to see why this metric is important.\u00a0 Inventory build-up suggests that the company\u2019s products are not selling as briskly as forecast.\u00a0 It also means that discounts will probably be needed move the merchandise, which will lower profit margins.<\/p>\n

All inventory is not equal, of course.\u00a0 A build-up of raw materials inventory may mean that demand is stronger than ever.\u00a0 It is the build-up of finished goods that should be a major red flag.<\/p>\n

What\u2019s Behind the Numbers? <\/i>is full of little tricks like these, explained in simple terms that non-CPAs can understand. \u00a0Before you attempt to short another stock, read and re-read this book, particularly the chapters on aggressive revenue recognition and aggressive inventory management.<\/p>\n

I\u2019ll leave you with two final nuggets of wisdom from Del Vecchio and Jacobs.<\/p>\n

First, don\u2019t be too eager to jump into a short position.\u00a0 As the authors point out, \u201cYou make as much money shorting a stock that falls from $70 to $5 (93 percent) as one that falls from $100 to $5 (95 percent).\u201d\u00a0<\/em> Getting into a trade too early will turn a would-be profitable short into a frustrating loss.<\/p>\n

Second, watch out for crowded trades.\u00a0 Don\u2019t short a stock if the short interest is too high as a percentage of the float.\u00a0 This puts you at risk of being short-squeezed as your fellow sellers all scramble to buy at the same time and send the share price to the moon.<\/p>\n

If you are a serious investor, pick up a copy of What\u2019s Behind the Numbers?<\/i> and keep it close at hand. \u00a0More than anything else, it will help you to win by not losing.<\/p>\n

SUBSCRIBE <\/a><\/strong>to Sizemore Insights<\/em>\u00a0via e-mail today.<\/p>\n

The post Review: What’s Behind the Numbers?<\/a> appeared first on Sizemore Insights<\/a>.<\/p>\n

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