Shorting the short sellers.

Counterintuitive investors, so-called short busters, may stand to pocket big gains--partly by capitalizing on short sellers' losses.

Having profited handsomely in recent years from short selling, some investors are now going against the shorts. Heavily shorted stocks with sound fundamentals may represent exceptional opportunities, either for individual investors or executives who are actively seeking to enhance the return on their corporation's business, pension plan, or profit-sharing portfolios.

Indeed, when shorts prove to be wrong, those who bet against them can chalk up big gains. Here's why: As opposed to going long and possibly losing no more than the total amount invested, the short seller might suffer a loss many times the value of his position. The grand slam of "short busting" is a situation in which short sellers can't borrow the additional shares needed to cover their obligations.

Investment strategies aside, many CEOs now monitor short positions in their companies because they recognize the havoc abusive shorting can wreak on their reputation and value. The litany of "dirty tricks" may range from spreading false rumors to instigating baseless class action suits.

In conjunction with consultants and investment specialists, some chiefs have devised pre-emptive strategies to guard against the possibility of a short attack. Valuable insights can also be obtained from the Chief Economist of the House Subcommittee on Commerce, Consumer, and Monetary Affairs. The subcommittee generated the Shareholders Protection Act, now pending, to curb short-selling abuses.

BACK TO BASICS

Not all shorted stocks are equally promising investments. You must also consider traditional criteria of value, including net income, earnings per share, profit margins, quality of management, and price/earnings ratio. In effect, short busters bet the shorts are wrong in their analysis of such fundamentals.

Some investors find it difficult to short any stock. "I simply don't feel comfortable hoping for the price of a stock to go down rather than up," one of my clients recently told me. Others find it hard to believe a substantially shorted stock doesn't have something wrong with it.

But the fact remains: There are lots of short sellers, and like the rest of us, they do make mistakes. Fortunately for short busters, when they do, their errors tend to be costly. (Think of a giant snowball made of $100 bills rolling downhill faster and faster.)

SQUEEZE PLAY

Conseco, an insurance company with $12 billion in assets, is a case in point. The company's stock climbed from 4 to 7 in the summer of 1990, when rumors about accounting and invesment improprieties pushed the short position from 0 percent to 19 percent of outstanding shares in three months. Some investors, motivated in part by our assessment that Conseco continued to warrant a "buy" recommendation, went long on the stock just as its price began to move upward. When the stock price hit $41, the shorts were forced to cover.

Pay dirt. Total short losses and long gains: more than $100 million.

Only in America. In the case of Conseco, those with the courage to put their dollars behind a stock with fundamental value pocketed returns of up to 10 times their original stake.

A footnote to this episode: My experience with the seamy side of short selling in the Conseco incident prompted me to form the ShortBusters Club to squash deceptive rumors about companies and to identify promising investment opportunities.

PROMISING PICKS

Examples abound of how miscalculating shorts can be hoist by their own petards. At the first meeting of the ShortBusters Club in New York last August, we recommended six heavily shorted stocks. Within two months, the six posted an average gain of 37.5 percent. Based on their underlying value and large short positions, we still recommend all of them:

* Conseco: successful in acquiring other insurance companies and streamlining their operations; an annuities specialist that has grown 70 percent a year in gross revenues and book value.

* Clinicorp: progenitor of a chain of 82 chiropractic clinics in Texas, Florida, New Mexico, Louisiana, and Tennessee; an effective regional and national television advertiser; the first public company in a promising $10 billion industry.

* HMO America: large, independent health maintenance organization in Chicago; involved in coverage of Medicare and Medicaid patients. This niche may be even more lucrative under the Clinton administration.

* Scoreboard: small-cap maker of baseball cards that is now branching out into other memorabilia; recently landed licensing agreements to market Star Wars and Indiana Jones figures and other products.

* Employee Benefit Plans: offers surplus insurance to medium-sized companies that assume most of the burden and risk of health-care coverage and reinsure the remainder.

* Cheyenne Software: leader in software used to back up data in case of network failure; revenues are growing at 100 percent annually; offers so-called Netware Loadable Module, or NLM, file-server software that works in conjunction with vastly popular Novell Netware.

WHERE AND HOW TO FIND SHORTS

Major short positions of NYSE, AMEX, and NASDAQ stocks appear regularly in the financial pages of leading newspapers, along with month-to-month percentage changes for each stock. Ideally, the short position will represent an excess of five percent of the total number of shares outstanding and/or 10 percent of overall float. Also to be watched is the ratio of shares shorted to a stock's daily trading volume. This indicates how many days will be needed to cover the short position. The greater the number of days, of course, the greater the potential problem for the shorts--and hopefully the greater gain for you.

However, merely noting that a stock is heavily shorted is not enough. You should also be aware of the reasons that may underscore the rise in its short position. For example, arbitrage may have been a factor--this information is generally footnoted in the published short listings. Or a stock's previous fundamentals may have simply fallen out of bed. Neither of these instances provides a sound basis for going against the shorts.

Short busters generally target only companies that are the focus of abusive shorting. One-sided or one-sourced stories about a company may provide a clue that something fishy is going on. Frequently, misguided shorts "leak" negative information to the media to drive a company's price down.

Often, unscrupulous shorts also peddle hearsay to a company's shareholders, customers, suppliers, and bankers in an effort to undermine its credibility.

In sum, shorting the shorts isn't for the novice or timid investor. Even CEOs who fancy themselves "street smart" may benefit from checking any hunches with a specialist who knows the short market and the modus operandi of short sellers. Such firms can provide ongoing, comprehensive analysis of the underlying fundamentals that justify a long position. Moreover, they are able to keep tabs on unethical individual and institutional investors.

SHORT-CIRCUITING A SHORT ATTACK

Unprincipled short sellers look to strike it rich at the expense of unsuspecting companies. Yours may be next.

If short sellers circle the fort, here's how to repel their attack:

1. Check with your attorneys. It may help if they work in coordination with a firm that specializes in identifying and thwarting abusive short sellers.

2. Seek advice from appropriate state, federal, and industry regulatory bodies.

3. Talk with other CEOs who have faced a short attack.

4. Identify the shorts. This may be tough, because they are not required to formally disclose their activities. Moreover, they generally don't leave paper trails because they communicate verbally, rather than in writing.

5. Hire private investigators if necessary.

6. Carefully monitor the trading activities of identified short sellers.

7. Talk to key institutional investors to ask them not to lend out their stock. That will make it more difficult for the shorts to borrow the shares they need.

8. Contact your congressional representatives. Ask them to bring abusive short selling to the attention of the SEC and other government agencies.

9. Consult with media experts to establish a program that publicizes your side of the story. Rely on key print, radio, and TV news outlets.

10. Communicate fully, frankly, and often with your shareholders--particularly with large institutions.

11. If the shorts resort to initiating class action suits against your company, be prepared to reply with countersuits.

SIX STOCKS TO WATCH
Company                    Exchange     Symbol
Conseco                      NYSE        CNC
Clinicorp                    OTC         BACK
HMO America                  NYSE        HMO
Scoreboard                   OTC         BSBL
Employee Benefit Plans       NYSE        EBP
Cheyenne Software            ASE         CHYE

Ray Dirks is the founder and director of Ray Dirks Research, a division of New York-based brokerage RAS Securities. He also serves as a de facto head of the 3,000 member ShortBusters Club, which focuses on shorted stocks that appear to offer sound investment opportunities.