Three years ago, James Montier, renowned economist, analyst and behavioural investing expert (then working in equity research for Societe Generale), issued a note now famous in investing circles that lent support to short selling. At the time, he felt that market conditions were presenting very few bargain value opportunities, while the number of companies falling into his “sell” basket was growing. In response, he defined an “unholy trinity” of factors that could determine a potential short candidate, looking for highly valued story stocks, with deteriorating fundamentals and poor capital discipline.
As we've discussed, investors that pick stocks on the basis that they are likely to lose value tend to attract ire and suspicion from the wider investment community. Generally speaking, company directors, financial regulators, government officials, analysts and even conventional value investors will have a beef with anyone outwardly questioning or, heaven forbid, taking short positions on a stock. Rooted in the investment psyche there is a perception of something unseemly and negative about potentially making a profit from a share that loses value.
But what if a company looks expensive or makes the wrong decisions or the stock fundamentals are just plain troubling? Can one also make money? And would that be such a bad thing? According to James Montier, it wouldn’t. In his words:
Vilifying short sellers is the equivalent of punishing the detective rather than the criminal.
With that in mind, he came up with the following useful set of screening criteria to identify potential short candidates:
1) It should be a story stock
First, the stock has to be expensive on a price-to-sales basis. In other words, it needs to have a valuation in excess of 4x revenues. By Montier’s own admission, this particular measure of a company’s value is problematic in ignoring profits but he feels that this criterion hones in on the story stocks - those stocks that have lost all touch with reality. To illustrate the absurdity of using sales as a justification for a high valuation, Montier cites Scott McNealy, the then CEO of Sun Microsystems:
"But two years ago we were selling at 10 times revenues when we were at $64. At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes that with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don't need any transparency. You don't need any footnotes. What were you thinking?" (Scott McNealy, Business Week, April 2002).
In addition, an analysis of the performance of stocks in Europe between 1985 and 2007 showed that, when valued on a price-to-sales basis, the cheapest stocks clearly outperformed the most expensive.
2) With Deteriorating Fundamentals
Second, Montier’s short candidates need to have deteriorating fundamentals. To figure this out, he used Piotroski’s F-Score screen, the value investing formula that aims to identify the healthiest companies in a basket of value stocks by applying a set of nine accounting-based criteria. Under Joseph Piotroski’s formula, nine was a green light while anything less than two was a definite avoid. For Montier, as this screen looks for turkeys, any stock that scored three or less had passed his second test.
3) And Poor Capital Discipline
The third criteria involves identifying poor capital discipline – think wayward acquisitions, poorly planned investments and ill-advised and costly projects. Montier’s assessment that corporates are generally not that good at capital discipline means that he felt that analysing total asset growth as a measure of overall investment/ disinvestment performance would be a useful indicator. He cites work by Cooper et al that found, in their US sample covering the period 1968-2003, firms with low asset growth outperformed firms with high asset growth by an astounding 20% p.a. equally weighted and, even when controlling for market, size and style, by 13% p.a.
Does it work?
Putting all three criteria together, Montier's backtesting found that a portfolio of stocks based on this screen would have declined 6% per annum across Europe between 1985 and 2007. Considering much of this period was a bull market with 13% pa returns, it is quite remarkable. It should be noted that during bear market periods such as 2000 through 2002, the strategy performed by 40% or more annually.
Use a Stop Loss!
One caveat is that the model does tends to "pick a few stocks that do exceptionally well on the long side - not good news for a short strategy" (presumably these are the rare 'story stocks' that actually deliver on their promises). As a result, he suggested introducing the use of stop loss to improve the performance of the short basket significantly - "putting a 20% stop loss in place raises the return from -6% p.a. to -13% p.a". As a reminder, for those that are considering short-selling, it’s important to be aware of the risks of doing so as unlike long investing, there’s the potential for (theoretically) infinite losses and the risk that comes with the use of leverage.
If you’d like to run quantitative long and short screens like this across the UK market, sign up now for beta access to Stockopedia Premium, our UK stock screener.
- Piotroski: The Use of Historical Financial Information to Separate Winners from Losers
- Cooper, Gulen and Schill (2006) - What best explains the cross-section of stock returns? Exploring the asset growth effect.
Filed Under: Short Selling,