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…

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