• Declining industry. If an industry is going from good to terrible, companies who participate in that industry are likely to suffer. This is what happened in NovaStar's subprime mortgage market and there was plenty of evidence of that back in December. A weakening industry was less of a factor for Bally.
• High debt load. I like short sale candidates with a reasonable chance of filing for bankruptcy. This is only possible if the company borrows money. And the more money it borrows relative to its equity, the more likely the company is to be at risk. This was certainly the case with NovaStar -- with an 8.0 debt to equity ratio -- and Bally whose liabilities exceeded its assets by $1.4 billion.
• Weak accounting. For a short sale candidate to work well, it helps if analysts have trouble understanding its accounting. This is important because when the industry goes into reverse, investigators will look into whether the company is committing securities fraud and the company will likely need to delay financial filings. The result could be a violation of lending agreements which would give banks an excuse to ask for their money back. NovaStar -- whose accounting was criticized as opaque by a leading analyst -- and Bally -- which identified 11 material weaknesses -- both have weak accounting.
• Negative cash flow. Of course banks will only get nervous if they think there's a chance that they won't get repaid. And this fear is more likely to emerge if the company uses more cash than it takes in. When I first analyzed them, NovaStar faced a risk of losing access to critical wholesale financing and Bally had negative cash flow.
• Low-rated bonds with high yields to maturity. If a company issues bonds and their credit rating is weak, generally the market will demand higher yields on the bonds to convince investors to take the risk that the company might default on its payments. While I did not use this test to pick NovaStar, it triggered me to look at Bally.
• Heavy short interest. If a high proportion of a company's shares are sold short, this is an indicator that other investors have figured out that they can make money selling the shares short. In Bally's case, 11% of its outstanding shares were short as were 32.1% of NovaStar's shares. I was a bit worried that I might be late to the game but that turned out not to be a big problem.

I was in Florida last week and read some excellent coverage of the collapsing real estate development market there. This led me to some publicly-traded local banks that are heavily exposed to the defaulted loans. I welcome your comments on which ones would be good short sale candidates and why.

Peter Cohan is President of Peter S. Cohan & Associates, a management consulting and venture capital firm. He also teaches management at Babson College and edits The Cohan Letter. He has no financial interest in Bally or NovaStar.