How C-scores can protect your portfolio

You don't have to approve of short sellers to admire their guts. Placing a down bet on stocks is hugely risky and can backfire spectacularly if a share price rises rather than falls. So for the professionals who do it, it pays to do their homework first.

What are they looking for? Investment writer James Montier, a member of the asset allocation team at GMO, has an answer. And his tips on spotting a potential short-selling candidate can help long-only investors to avoid disaster too.

The Montier method

Stocks that are ripe for a fall share two key characteristics, says Montier. First, they often sail very close to the wind when it comes to their accounting. In a bid to boost reported income, some firms will push the limits of the accounting rules to squeeze out every last bit of profit.

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A high C-score' which we'll get to in a minute should flag this up. Combine this with evidence of a share-price overvaluation and you have a short candidate, says Montier. But even if you don't fancy shorting stocks which can be very risky C-scores are a very useful red flag' tool to help you avoid shares that could be about to tumble.

In a nutshell, the C-score looks at six common "accounting manipulations", as Montier calls them. A firm scores one point for each one it uses the more of these red flags that are present, the higher the score (out of six) and the dodgier the numbers. The good news is that even for someone who isn't an accountant each test is relatively straightforward to answer.

Low cash cover: "A growing difference between net income and cash flow from operations" is Montier's first red flag. Cash is harder to mess with than profits, which are stated after various estimates. These include amounts set aside for bad debts, depreciation and amortisation (charges based on estimates of how long assets will last) and pension costs.

Montier is not suggesting you become an expert on these areas. All you need to do is to check whether the firm's profit figure from operations (in the profit and loss account), is supported by the "cash flow from operating activities" towards the top of the cash-flow statement. If they are miles apart, be wary.

Rising sales outstanding: "Channel stuffers" are firms that send stock to customers on credit just to be able to book a sale before the end of the accounting period. But how do you spot them? Take debtors ("receivables"), then divide by sales per day.

So if trade receivables from the balance sheet are £80m and turnover is £400m, days sales outstanding (DSO) is ((80/400) x 365), or 73 days. If this is rising fast it may suggest a firm is doing all it can to boost sales, without necessarily making sure those will turn into cash.

Rising stock days: Every pound sitting in a firm's warehouse in the form of unsold stock is a pound that is not earning a return. Worse still, rising stock levels can indicate that a firm is struggling to make any sales at all. Take stock' from the balance sheet, divide by cost of sales, and give the result in terms of days. So if stock is £75m and cost of sales is £300m, stock days are ((75/300) x 365), or 91 days. If this number is rising fast, watch out.

Rising other current assets' to sales: Finance directors know you may well check the above two numbers, and so might try to keep these numbers "clean". So compare "other current assets" to sales (in days) to check they are not using this line "to hide things they don't want investors to focus on".

Disappearing depreciation: To beat a short-term earnings target, a firm may alter its estimate of how fast assets wear out. This cuts the depreciation charge and boosts profits. Say an asset costs £100m. The directors decide that it will generate sales for ten years. The depreciation charge is £10m (£100m/10).

But at the start of year four, when the asset's 'book value' is £70m, the directors decide the asset will be useful for another ten years. Now the depreciation charge is only £7m (£70m/10). That £3m reduction directly boosts profits. How do you spot this? Divide the depreciation charge for the year by the gross (pre-depreciation) asset figure. A sharp rise is a possible red flag.

High total asset growth: Some firms are "serial acquirers" and use this to boost profits. Here's how. Say one firm buys another halfway through the year. The target makes £100m a year in profits. Under the accounting rules for the combined predator and target, last year's "group" profit and loss account will show no contribution from the target; this year's will show £50m (half of this year's profits); and next year will show the full £100m. Yet the target isn't growing at all! Does it work?

Between 1993 and 2007, US stocks with C-scores of five or more underperformed the market by about 8% a year, with an annual return of 1.8%. In Europe, the underperformance was 5% or so, giving an absolute return of a more respectable 8%.

But one final test really reveals the troublemakers. The firms most likely to tumble combine iffy accounting with a high valuation. So look at the price-to-sales (p/s) ratio (if a firm's market capitalisation is £1bn and sales are £500m, the p/s is two). Above two is considered high.

In the US, blending this with high C-scores reduced the return to -6% a year and in Europe to -10%. Sure, a firm with C-score of six and a p/s ratio of two or more may still be a sound investment but you'll need to be doubly sure, says Montier.