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…