Short sellers look to profit from falling share prices. They borrow a share from an existing owner – paying a fee to do so – and then sell it. They then hope to buy the share back at a cheaper price later and make a profit.
Short selling is a hard way to make money and is very risky. That’s because share prices can only fall to zero, limiting the potential gains. As share prices theoretically can go higher and higher, the losses for short sellers are potentially unlimited.
That means that short-sellers have more incentive than most to get their sums right. And while you might not want to short a company yourself, knowing what sorts of red flags a short-seller looks out for can at least give you a good idea of what to avoid. So what makes a company a target? Here are some pointers.
Quite often you can come across a company that says it has broken the mould of an industry by doing something different. This may allow it to earn much higher profits than similar companies in the same line of business, and deliver stellar rates of profits growth. This tends to lead to a lofty share price.
The trouble is, it’s often hard to know whether the company is genuinely on to a winning formula or whether the profits are too good to be true. This kind of situation is often the first signal to a short seller to start digging around for more information.
Company accounts tend to be ignored by many professional investors. This is a shame because they contain a wealth of information if you’re prepared to put a bit of work in. They are gold mines for short sellers.
A big red flag is how companies account for revenues or sales. You can find this out by looking at the accounting policies note. Are sales booked when an order is placed or when it is completed? Fast-growing companies may be booking sales that may never turn into cash.
Have a look at the ratio of receivables (money earned, but not paid) as a percentage of sales. Is it high compared to other companies? Is it increasing? If so, this might be a sign of trouble. Calculate revenues per employee and see if this stacks up with similar firms. (It’s easier to boost revenue by bending the rules than to boost head count.)
Depreciation is another classic area where finance directors can play games. Depreciation is a cost for the use of fixed assets, such as machinery. It’s spread over the life of an asset. Companies such as manufacturers can lower the depreciation charge by extending the useful lives of their assets.
You can spot this by calculating the ratio of depreciation to gross fixed assets as a percentage. Compare it with other similar companies. A falling ratio may be a sign of dodgy accounting, or that assets are worn out and a big bill for new kit is not far away.
Look out for costs being put on the balance sheet as an asset rather than set against sales. If you’re buying a piece of machinery that will be used for a long time, it’s legitimate to class it as an asset. But sometimes more short-term costs are classed as assets and this can be misleading.
In the past, telecom and pay-TV companies have done this with the costs incurred to woo subscribers. These costs are arguably regular expenses. Another warning sign is the regular use of exceptional items – one-off expenses.
It’s amazing how these can crop up year after year in relation to things such as restructuring of businesses, writing down the value of businesses, or contract costs. Yet, the savings from these items are treated as ongoing profits the following year. Calculate exceptional items as a percentage of pre-tax profits and look at the trend. A frequent high percentage could be a warning sign of aggressive accounting.
Also look at the difference between basic earnings per share, which includes these ‘exceptional’ costs, and normalised or underlying earnings per share, which don’t.
Companies that regularly buy other ones need to be watched closely. Buying other companies can give the illusion that profits are growing quickly. This is partly because the company has grown, but also because there may be opportunities for cost cutting.
To get profits to grow quickly, each new acquisition has to be bigger than the previous one to get bigger savings. Sooner or later the opportunities for cost savings run out and profits can stop growing and often fall.
Buying companies can also be used to mask the fact that the existing business is not growing or is actually shrinking. A falling return on capital (ROCE) is a good way to spot problems here.
Poor cash flow
Over a short period of time, it is not unusual for there to be differences between a company’s profits and cash flow. That’s because it may be investing in new businesses or products where cash is spent up front, but takes some time to turn into sales.
However, big and persistent differences between cash flow and profits need to be looked at as it may be a sign of poor profit quality.
Look at the ratio of operating cash flow to operating profits, known as cash conversion. Ideally, this should be a high percentage. A shortfall is often due to increases in receivables and unsold stock. This might be fine if the cash is eventually received for these items, but needs to be watched closely.
The same goes for free cash flow as a percentage of net income. A big difference here is often explained by big purchases of fixed assets. Compare this with the depreciation figure. A persistent difference between the two needs to be investigated.