Reader Mailbag: Is (CRM) a Good Short Candidate?

Tim writes:

“Hi Chad, you’ve probably looked at CRM as a “short,” any chance we’ll see a blog update with your thoughts on this one?”

Thanks for the question, Tim. I have several thoughts that pertain to and other high-flying, excessively priced growth stocks in general.

Shorting these kinds of stocks is very dangerous. As a value investor, I certainly believe that excessive valuation is a huge red flag for any stock, but the key question is whether or not that sole factor alone is enough reason to bet on the price declining meaningfully, as opposed to simply avoiding it completely on either side. Unless there is a clearly identifiable deterioration in the company’s fundamentals, I tend to avoid shorting stocks merely because they are extremely overvalued.

The problem is that the market tends to give high growth companies elevated valuations as long as they keep delivering results. As a result, the short trade can go against you for a while, making it such that you must time the trade very well, and market timing is tricky. It is quite possible you will lose money for a while, and even if you are eventually right about a price decline, most of your gains by that point might only really recoup the losses you sustained initially. Without a negative catalyst (a breakdown in the operating business) it is very hard to time valuation-based short trades well enough to make good money consistently.

Now, in the case of (CRM), the stock trades at about 90 times 2011 earnings estimates. Even for a company that is well positioned to grow for many years to come, one could easily argue that even at an elevated price of 40 or 50 times earnings, there is plenty of room for downside here. And I would not disagree with that. It really is just a matter of whether you want to explicitly bet on a huge decline, because you not only need to be right about the price, but you need such a decline to begin relatively soon after you short the stock, because momentum names like CRM can keep rising for longer than most people think.

Unless the market in general has another huge meltdown, these situations typically result in the stocks moving sideways for a long time, in order to grow into the hefty valuation Wall Street has assigned to them, assuming that their business fundamentals are not deteriorating. While I do not follow CRM as closely as many others do, I am unaware of any reason to think their business is set to take a dive. If that thesis is correct and the company continues to grow nicely, I would feel more confident betting on the stock moving sideways even as rapid growth in their software business continues.

To illustrate this idea, let’s consider past examples of stocks that were excessively priced, but still burned the shorts since the business fundamentals remained strong. (AMZN) is a prime example of a stock that many people have tried (unsuccessfully in most cases) to short in recent years. Amazon has continued to post phenomenal growth as it takes market share in most every category it expands into. In fact, just over the last few years many investors have argued it was a prime short candidate (and still do, at the current price of 52 times 2011 earnings estimates). As their business has continued to grow, Amazon shares have actually risen from around $70 two years ago to $165 per share today. Shorts over this period have gotten crushed.

If we go back in time, however, we can see that Amazon shares really have underperformed (relative to their underlying business fundamentals, anyway) for a long period of time. The stock peaked in December 1999 at $113 per share, when Amazon’s annual revenue was a mere $1.6 billion. Today, more than 11 years later, Amazon’s sales are on track for $45 billion annually, but the stock is only about 50% above 1999 levels. This is entirely due to the fact that the valuation in 1999 was so high that it already factored in years and years of stellar growth. Sales at Amazon have grown 28-fold (2,700%) since 1999, but the stock is up only 50% during that time. Believe it or not, that makes the investment a disappointment for those who had the foresight to predict Amazon’s explosive growth potential a decade ago. The valuation simply mattered more because it was already factoring in tremendous growth opportunities. Perhaps the same situation may be brewing with

As a result, I would personally prefer to avoid CRM rather than short it today. In more cases than not, shorting a stock based on valuation alone can get dicey pretty quickly, whereas finding a company with deteriorating fundamentals AND a high valuation has a much better risk-reward profile. Think Crocs, circa 2008, as one example.