How to protect your portfolio from short sellers in market downswings

Wednesday, May 30 2012 by
How to protect your portfolio from short sellers in market downswings

In times of market volatility there’s a dash to the safety of good, strong defensive stocks. The flow of funds as investors rotate their portfolios out of weaker stocks can be disastrous for anyone left holding the bag. While short selling is an art that very few practice, understanding the qualities of a good short sale candidate can ensure that you weed them from your portfolio avoiding the fate of so many in the process. These days identifying stocks at risk is much easier than you think.

James Montier, former Soc Gen global equity strategist, wrote a series of papers on short selling strategies at the last market top in 2007 with some astonishing results. In one paper he identified an ‘unholy trinity’ of fundamental characteristics that weak stocks tend to display. Backtesting showed that a portfolio of stocks displaying these characteristics fell on average by 6% per annum over a 20 year period. Our own model of this strategy has fallen by almost 20% in the last 3 months, underperforming the FTSE 100 by 10%. Given results and history such as this eyeballing the list to make sure you minimise your exposure to companies with these qualities would be extremely wise. Review the full list here.

Characteristics of weak stocks

Montier takes a very common sense approach to finding short sale candidates. He focuses on highly rated companies that exhibit weak fundamental trends. The characteristics used are as follows:

  • High Valuation. Avoiding companies on high Price to Sales ratios allows investors to sidestep ‘story stocks’. As Montier says “whenever i hear someone using price-to-sales to justify a stock I can’t help but think they are trying to hide something”.
  • Poor Financial Health. Montier chooses the Piotroski F-Score as the best quick measure of fundamental momentum in a stock. Low F-Scores (4 or less on a scale of 0–9) indicate a deteriorating trend in financial statements.
  • Poor Capital Discipline. Time and again it’s been shown that company management in aggregate are bad at allocating capital. Companies with high asset growth underperform low asset growth firms by 10% per year!

Montier blended these three characteristics into his ‘unholy trinity’ stock screen by looking for a Price/Sales > 1, F-Score < 4 and Asset Growth > 10%. Perhaps unsurprisingly given the recent levels of investment in the areas the current list of stocks includes a large overweighting of energy and materials…

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About Edward Croft

Edward Croft


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