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Stock Strategist

Six "Cheap" Stocks to Consider Shorting

Sometimes what appears to be cheap really isn't.

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We at Morningstar are mostly known for recommending undervalued great franchises for the long haul. But the same skill sets that we use to identify these situations can also be used to make money on the opposite side of the table: finding stocks to short.

"Shorting"--where one borrows stock for immediate sale, hoping for the price to decline so one can buy it back more cheaply--can be a dirty word on Wall Street, evoking images of insidious hedge funds flaying a buck off the backs of honest shareholders. Open any financial publication and one may find mentions of "bear raids," "naked shorting," or "deteriorating confidence," usually cast in a negative light. Although some of these sentiments have a lot of merit, shorting is a vital component of our capital markets, and its prudent use can allow investors to control risk and to enhance returns.

Making money on shorting, in many ways, is much more challenging than making money buying and holding. An investor must first overcome the natural tendency of stocks to rise over time and is exposed to potential losses of many multiples of his or her initial investment. Furthermore, it's not enough to just know that a stock is overvalued, as many veteran investors found out in the late 1990s. It's helpful to point to potential catalysts that may move the stock lower.

Keeping these factors in mind, we have crafted a screen to identify some attractive short candidates. The screen applies to companies that possess the following criteria:

1. A Morningstar Moat Rating of none
2. A Morningstar Star Rating of 1 or 2
3. A consensus forward price/earnings ratio of less than 10 or a current dividend yield
    greater than 10%

First, we concentrate on moatless companies because these have less defensible business models and are more likely to have difficulty coping with worsening economic conditions, especially if they employ a lot of debt. Second, it's helpful if the companies are overvalued from the start.

These are fairly self explanatory, but the trick is in the next two criteria, which may seem counterintuitive. Usually a low P/E ratio indicates a cheap stock, but this is not always the case, especially when one is dealing with forward earnings estimates. Instead, a low P/E can mean several much less savory things. For example, the company may be under pressure, but the analysts are simply behind the curve. When events catch up to the analysts, they scramble to lower their estimates, making a previously cheap-looking stock dear instead. Another example can be with a deeply cyclical company that might be reaching its peak. Although the P/E ratio looks reasonable, earnings may not be sustainable; for instance, homebuilders traded at 4 times forward earnings at their peak in 2005-06. Last, an industry might be in terminal decline. Although the P/E is low, the company probably has little to no future prospects. A high dividend yield can signal some of the same things, especially if the company carries a heavy debt load. Often the dividend is not sustainable, and the company may be crushed under its debt or be forced to dilute existing shareholders.

This screen will usually capture fewer candidates than a more conventional "short" screen, perhaps focusing on stocks with high P/E or price/book ratios. However, these candidates are often already experiencing difficulties. Add a dollop of debt, and an investor's work is already half done.

Here are a few companies we uncovered with this screen worth a further look:

Air France-KLM
Moat Rating: None | Fair Value Uncertainty Rating: High | Morningstar Rating: 2 Stars

From the Analyst Report: "The shotgun marriage of Air France and  KLM (AFLYY) is one of the first in a potential wave of consolidation, but the deal is unlikely to produce all of the intended benefits... The firm's cost structure remains uncompetitive with its low-cost brethren.  Ryanair (RYAAY) and EasyJet, Europe's dominant low-cost carriers, have unit costs (excluding fuel) that are still nearly 50% lower than the merged airline."

Moat Rating: None | Fair Value Uncertainty Rating: High | Morningstar Rating: 2 Stars

From the Analyst Report: " Earthlink (ELNK) has reassessed its strategic direction and eschewed investment in its municipal Wi-Fi network and wireless phone business. The progression from dialup Internet access to broadband has inherently rendered the dialup segment a declining industry with no growth prospects."

Felcor Lodging Trust
Moat Rating: None | Fair Value Uncertainty Rating: High | Morningstar Rating: 2 Stars

From the Analyst Report: " Felcor Lodging Trust's (FCH) collection of hotels has been struggling for years to keep up with the broader lodging market. We like that the firm has sold off its noncore properties and reinvested the proceeds in its remaining hotels, but given the accelerating downturn in the travel market, we remain unconvinced that Felcor will be able to turn itself around and have assigned a high fair value uncertainty rating to the firm."

Hertz Global Holdings 
Moat Rating: None | Fair Value Uncertainty Rating: Very High | Morningstar Rating: 1 Stars

From the Analyst Report: " Hertz (HTZ) competes in the commoditized car and equipment rental industries. The company faces tough negotiations with manufacturers and intense price competition, leaving the company with no economic moat... Hertz and other car rental companies have seen fleet costs skyrocket during the last few years as ailing car manufacturers aimed for greater profits. We expect less dramatic fleet price increases in the near future, but we see pricing pressure from manufacturers as a trend that is here to stay."

James River Coal
Moat Rating: None | Fair Value Uncertainty Rating: Very High | Morningstar Rating: 2 Stars

From the Analyst Report: " James River Coal (JRCC) declared bankruptcy in March 2003 as a result of rising industry costs and long-term contracts priced well below the market... Despite improving industry conditions, we expect continuing challenges for James River... Central Appalachia is the oldest mining region in the United States, and most of the best reserves are already depleted... The environment is even more unfavorable for small operators like James River, which tend to have lower profitability as well as financial and operational flexibility. This can create a vicious cycle of underperformance."

MEMC Electronic Materials
Moat Rating: None | Fair Value Uncertainty Rating: High | Morningstar Rating: 1 Stars

From the Analyst Report: " MEMC (WFR) has been propelled by a strong pricing environment for silicon wafers because of a supply shortage in the market. However, the firm is one of many players in a commodity industry that has seen its fair share of difficult downturns... We think industry dynamics will eventually take their toll on MEMC. Wafers are commodity products and are subject to long-term price declines... We think the current strong pricing environment makes it compelling for suppliers to expand wafer manufacturing capacity, and this will bring increased competition and subsequent price erosion."

To run this screen and see all the stocks that passed,  click here. Note: The stocks mentioned above passed our screen as of Aug. 30, 2008. The results of the screen may change because of daily price fluctuations or other factors. After clicking, you can save the search to use later by clicking the Save Criteria button in the bottom right-hand corner of the screen. (You will need to be logged in as a Premium Member to view and save the complete screen.)

Michael Tian does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.