Going in search of companies that show signs of shoddy accounting practices isn’t exactly what many investors would think of first when it comes to buying stocks or running the rule over an existing portfolio. Yet, this sort of homework can produce some useful pointers on what to avoid, areas of concern or, if you’re particularly minded, shares that could even be sold short.
Formulas for finding potentially wayward companies are nowhere near as numerous as those designed to find positive opportunities; after all, most of us are searching for reasons to buy rather than sell, right? Well, for smart money investors such as long/short institutional funds, getting to grips with companies that raise more questions than answers when they publish their accounts is often a proven way to profit.
Digging the dirt
When the City regulator, the FCA (then the FSA) began publishing details about which funds were short selling which stocks late last year, it offered an insight into where hedge fund managers see the best prospect of falling share prices. Companies such as Argos and Homebase owner Home Retail (LON:HOME), engineering group Weir (LON:WEIR) and stationery retailer WH Smith (LON:SMWH) are among the most heavily shorted stocks in the market right now. In the case of Home Retail, more than 11% of its stock is currently ‘on loan’ to funds that think its price will fall at some point. That’s not to say they are always right, of course. Grocery delivery company Ocado (LON:OCDO), another heavily shorted share, has dealt some painful blows to hedge funds this year by failing to deliver a share price fall that was widely expected.
But while short sellers, particularly institutional ones with deep pockets, tend to attract ire and acclaim in equal measure depending on who you talk to, their tactics are well worth a closer look. As renowned economist and quant researcher James Montier wrote on the eve of the financial crisis five years ago:
“In good times, few focus on such ‘mundane’ issues as earnings quality and footnotes. However, this lack of attention to ‘detail’ tends to come back and bite investors in the arse during bad times. There are notable exceptions to this generalisation. The short sellers tend to be amongst the most fundamentally driven investors. Indeed, far from being rumour mongers, most short sellers are closer to being the accounting police.”
Montier was inspired to devise a so-called C-Score of six common signs of earnings manipulation that a company might display. You can read more about the detail of the C-Score here but it includes questions such as: is there a growing difference between net income and cash flow from operations; are accounts receivable growing faster than sales, and is inventory growing (meaning that sales might be slowing)?
Combined with a measure of overvaluation, in this case the price-to-sales ratio (PSR), the C-Score was intended as a potentially useful way of spotting short candidates. In fact, Montier found that the right combination of high C-Score (more than 5) and high PSR (more than 2) produced a portfolio of shares that between 1993 and 2007 underperformed the market by around 8% and 5% per year in the US and Europe respectively.
At Stockopedia we track a screen that mimics the C-Score and it too has performed admirably as a short selling guide for during the past 18 months. Over 12 months it has produced a negative return of 9.6%, handily underperforming the FTSE 100 by 21.9%.
Now it’s worth pointing out that, individually, all of the factors that make up the C-Score can be perfectly legitimate. Moreover, short selling, particularly some of the smaller stocks qualifying for the list, may be practically very difficult and certainly very risky; there is theoretically no limit to the losses that can be sustained when short selling. However, as a guide to red flags and issues that need further investigation, the C-Score is a handy starting point.
Interestingly, several of the shares in the current C-Score portfolio are also listed by the FCA as those where more than 0.5% of the total stock is being shorted by funds. Among them is FTSE 100 quoted Aggreko (LON:AGK), which supplies temporary power generation units. Brokers have slashed their forecasts on this stock (see chart) following a lot of uncertainty about its trading outlook, with the shares now down about 30% on where they were a year ago. Another FTSE 100 company making the list is gold producer Randgold Resources (LON:RRS), which hasn’t been helped this year by the falling gold price and has been trying to boost production and cut costs as a result.
Among the mid-cap companies here is industrial printing specialist Domino Printing Sciences (LON:DNO), where brokers have also been cutting their forecasts for next year. Earlier in September it reported that economic conditions were still problematic in many of its markets even of it was still on course to grow this year. Another ‘dominos’ worth a mention from this list is investor favourite Domino's Pizza (LON:DOM), which has grown rapidly in recent years and is planning to open 60 new stores in the UK and 18 in Germany this year. Brokers have cut their EPS forecasts for the company through the year and the share are currently trading down 19% from where they were at the end of May.
Red flags to watch
When Montier first introduced the C-Score back in 2008, he highlighted Apple, Amazon and Rio Tinto as stocks that raised red flags according to the test. That clearly shows that not every company that trips up deserves to be called a shorting candidate. However, for investors that want an extra set of checks for shares in a current portfolio or to use against potential purchases, the performance of the C-Score screen suggests that it could well be worth a look. You can check the C-Score of any stock on the market by using our tool here.
To see the list of shares currently qualifying for on any of Stockopedia’s short selling screens or to check any company in the market for potential red flags, why not take a free trial?
Filed Under: Short Selling,