More short selling signals

The growth in assets is perhaps the most counter-intuitive – it's almost been drummed into investors that a growing asset base is a good thing as it signifies a growing level of shareholder equity and a successful firm. But in their analysis sample covering the period 1968-2003, US academics Cooper et al, found that companies with low asset growth outperformed those with high asset growth by 20 per cent a year equally weighted. Even when controlling for market, size and style, low asset growth firms outperformed high asset growth firms by 13 per cent a year. Another leading analyst, Joseph Piotroski, an accounting professor at the University of Chicago, takes a slightly different take on the same issue, looking at two measures, the growth in assets related to the growth in sales. According to Mr Piotroski: "An improvement in asset turnover signifies greater productivity from the asset base". Such an improvement can arise from more efficient operations (fewer assets generating the same levels of sales) or an increase in sales (which could also signify improved market conditions for the firm's products). Table 3 details those companies with the greatest increase in tangible book assets and their accompanying increase in sales – in every case the asset base of the business has expanded much faster than sales.

The issue of debt is, by contrast, easily understood – debt is not necessarily a bad thing per se, but a rapid growth in debt is unlikely to be greeted with enormous enthusiasm in a credit crunch. Gross gearing – a measure of total debt to shareholder equity (not including any cash held on the balance sheet) – on its own as a measure is not terribly useful as a shorting indicator. A more useful combination of measures is likely to include high levels of net gearing (after including cash on the balance sheet), plus rapid growth in that measure as well as poor interest cover (how many times the cash flow covers the interest bill) and a declining cash flow. Table 4 features a shortlist of companies using these measures – all of the companies have seen net gearing increase, have interest cover of less than three times cash flow and have seen net debt levels increase in the last year. The big caveat for this table is that just because a company is on this list doesn't mean it's an obvious shorting candidate or is in mortal danger. To be a good short seller you need to do your research – the company may, in fact, have a plan to control debts and improve its financial stability. Remember, though, that inclusion on this list only indicates potential for future research.

There's one last fundamental measure – the current ratio – that's frequently used to indicate companies with deteriorating financials. Unlike many other fundamentals, this shouldn't be used on its own and needs to be considered as part of a broader range of measures. In essence, the current ratio is a snapshot of a company's short-term financial health – it measures a company's ability to pay its short-term debts and any deterioration is likely to indicate some financial distress. It's fairly easily worked out – you take the current assets (cash and stock) and divide by the current liabilities.

The higher the current ratio, the better the chance of a company paying its debts – a ratio of less than 1 indicates that the company will struggle to pay off its obligations if they all came due in the short term. It's important to understand that this wouldn't necessarily mean the company would go bankrupt – it might easily be able to raise finance but it's certainly not a positive sign. It's also important to note the change in the current ratio over time – a worsening current ratio over the past couple of years is a big negative.

In table 5 we've listed some of the companies with the poorest current ratio – we've also detailed the recent negative trend in the ratio plus another similar measure, called the Quick Ratio (or acid test as it's sometimes called by accountants). This looks at easy-to-hand assets, such as cash (and short-term accounts receivables) versus current liabilities. A ratio of 1:1 or more indicates rude health while anything below 1 indicates some potential for concern. Last but by no means least, we've also noted the current level of debt (net gearing).

The Piotroski Screen

One attempt to pull together these various fundamentals-based measures into one relatively straightforward model is based on the work of that Chicago accounting professor we mentioned earlier, Joseph Piotroski. His analysis is usually cited as the basis for going long on a particular share – it's one of the core screens that we run online regularly at www.investorschronicle.co.uk. But you can also turn the screen around and identify potential shorting candidates based on poor balance-sheet fundamentals. The quantitative team at Société Générale use the model in exactly this way and in table 6 below we’ve listed their poorest value UK stocks using something called the F Score. They also combine the Piotroski F Score system with a novel interpretation of a bond modelling system called the Merton Model – it identifies companies with unsustainable levels of debt. Under the Société Générale system, a Piotroski F score of less than 5 is regarded as poor value and less than 4 as very poor value.

Market based factors

No one measure is likely to be used by professional hedge fund short sellers – they're more likely to use a combination of quantitative value-based measures alongside price data and analysis of market positions. Two measures are likely to figure prominently in the latter category: recent price momentum and the number of shares held as 'short interest'.

Biggest four month share price increase

Perhaps one of the simplest ideas for spotting potential shorting candidates is to look at those stocks that have produced the biggest gains in the past few months. Economists tend to have a very precise understanding of the concept of mean reversion but there is some sense to the idea that what goes up must simply come down – and that whatever goes up the fastest will probably come down the fastest. On that basis we’ve listed the fastest-rising shares on the London market (excluding tiny micro-caps valued at less than £10m) between January 2009 and the end of April 2009. If you've got some of these shares – congratulations, you've made some truly heroic profits in the first four months of 2009. Our only warning is that they're also more than likely to start coming down again in price as their financials are terrible, their debt levels are ghastly (although some have decent balance sheets, to be fair) and most are likely to experience a sharp slowdown in earnings over the next year.

The long race to truth

Dedicated short sellers are fairly focused, ruthless folk who tend to harbour few emotions about investing – many, such as Bruce Berkowitz in the US, actually use short-selling analysis not to sell shares but as a methodology for managing a long-only fund. Mr Berkowitz uses a combination of measures to quite literally 'kill' a company – only if a company survives his repeated assaults does it make it on to his portfolio.

Here's Société Genéralé's equity strategist James Montier's account of Berkowitz's murderous ways: "We look at companies, count the cash, and then try to kill the company. We spend a lot of time thinking about what could go wrong with a company whether it's a recession, stagflation, zooming interest rates or a dirty bomb going off. We try every which way to kill our best ideas. If we can't kill it, maybe we're on to something. If you go with companies that are prepared for difficult times, especially if they’re linked to managers who are engineered for difficult times, then you almost want those times because they plant the seeds of greatness. Here are the ways you implode: you don't generate cash, you burn cash, you're over-leveraged, you play Russian Roulette, you have idiots for management, you have a bad board, you de-worsify, you buy your stock too high, you lie with GAAP accounting."

Mr Montier also reports on another king of the shorting firmament, Jim Chanos, boss of New York-based hedge fund Kynikos. He outlined four broad categories of short candidates in an interview with Value Investor Insight in 2005:

"The first and most lucrative are the booms that go bust. We've had our most success with debt-financed asset bubbles, as opposed to just plain asset bubbles where there are ticking time bombs in terms of debt needing to be repaid and where there are people ahead of the shareholders in the bankruptcy or workout process. The debt-financed distinction is important. It kept us from shorting the internet in the 90s that was a valuation bubble more than anything else. The second group of opportunities are those created by technological obsolescence. Economists talk quite rightly about the benefits of creative destruction, where new technologies and innovations advance mankind and grow GDP. But such changes also render whole industries obsolete – what is playing out now is the transformation from analogue to a digital world."

The next group of categories revolves around poor accounting. According to Mr Chanos: "This can run the gamut from simple overstatement of earnings to outright fraud. We're trying to find cases where the economic reality is significantly divorced from the accounting presentation of the business." The final category is what Mr Chanos calls "consumer fads" – where investors become way too optimistic: Cabbage Patch Kids in 1980s, NordicTrack in the early 1990s and Salton with the George Forman grills.

Mining data on shares on loan

One of the most powerful ways of working out which shares to short is to look at how many are out on loan – it's a useful indicator of what companies professional investors are most bearish about. The data that points to stock on loan is usually only analysed by professional firms such as Data Explorers – who sell it on to investors including hedge funds – but some private investors are also mining this data for their own trades. One such private investor is Gerald Williams, who combines a passion for stock-picking with a background in IT (giving him the programming skills to crunch the data). He's constantly sifting through the loan data for key patterns that might help his investing decisions – he normally only uses the data on a personal basis but he's made his results available to Investors Chronicle. On a sector-wide basis his data indicates a fairly bearish outlook for retailers, food producers and technology companies.

■ Looking at individual shares at the end of May Gerald's data suggests a fairly chunky number of companies where more than 10 per cent of stock is out on loan, including property groups Liberty International, Shaftesbury and Berkeley as well Thomas Cook, Travis Perkins, Daily Mail & General Trust and perennial shorting favourite HMV.

Table 3: Balance sheet candidates

Table 4: Cash flow candidates

Table 5: Current ratio candidates

Table 6: The Piotroski F Score Sysyem candidates

Table 7: Candidates based on biggest gains