Value Investing: Tools and Techniques for Intelligent Investment

Chapter 24. Joining the Dark Side: Pirates, Spies and Short Sellers^[24]

What should you look for in a good short candidate? A superficially easy question, but one that most analysts don't seem to like to answer. A fact evidenced by a mere 10–15% of recommendations being sells! We examine three factors that seem to add up to a pretty good indication of a shorting opportunity. Essentially we look for expensive stocks, with deteriorating fundamentals and poor capital discipline. This 'unholy' trinity results in a basket that has historically declined around 6% p.a. Running the screen today reveals the highest ever number of stocks passing the shorting criteria. Perhaps it is time to join the dark side.

• Short sellers have been vilified almost since time immemorial. This has always struck me as strange, the equivalent of punishing the detective rather than the criminal. Perhaps this bizarre outcome has deterred many from exploring this path. However, my own bottom-up valuation work shows few bargains, we suspect that the opportunities may lie far more on the short side.

• What are the hallmarks of a good short candidate? We suggest an 'unholy' trinity of characteristics – a high-price-to sales ratio, deteriorating fundamentals (as measured by a low Piotroski F score) and poor capital discipline (as measured by high total asset growth). Each of these characteristics is a telling sign, but when combined together they become even more potent.

• Over the period 1985–2007 a portfolio of such European ...