How to make money in falling markets

The spring stockmarket rally seems to have petered out both the S&P 500 and the FTSE 100 are down nearly 5% in the past month. With investors realising the global economy has a long way to go before it's anywhere near back to health, stocks could fall a lot further. That means the time is right for adventurous investors to profit by shorting overpriced stocks.

How shorting works

A City trader might borrow, say, 10,000 Tesco shares at 350p, in return for a fee paid to the lender (often a pension fund). He sells the borrowed shares and waits. Say that two days later, Tesco shares fall to 330p. He buys back the 10,000 shares, making a profit before trading costs of £2,000 i.e. (3.50-3.30) x 10,000 then returns the 10,000 shares to the original lender. That's if all goes according to plan.

The biggest risk is a 'short squeeze'. Imagine our trader had borrowed a relatively illiquid share. But having sold the stock, the price then rises sharply. Our short seller still needs to buy 10,000 shares to return the shares he borrowed. That could prove difficult and very expensive if there are few sellers around.

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How you can go short

Going short by borrowing individual stocks isn't practical for retail investors. But there are two ways it can be mimicked. For speed and flexibility,spread betting is best. You could open a down bet ('sell the spread') on Tesco at £10 a point (where 1 point equals a 1p change in the share price) when the quoted spread is 349p/351p. If the spread when you close out has dropped to 229p/331p, you make 18 points i.e. 349-331, or £180 at £10 a point. Always take out a guaranteed stop-loss to ensure you don't make huge losses should the price rise you'll pay a little more for this, but it's worth it.

Secondly, there are put options. An NYSE Euronext equity option might give you the right to sell 1,000 Tesco shares before the end of September at a fixed 'strike' of 350p. You pay a non-refundable premium of 12.5p a share, or £1,250, to buy ten (12.5p x 1,000 x 10). If the Tesco share price is 330p on expiry of the option in September, you stand to make £2,000 (20p x 1,000 shares x ten options), less the £1,250 premium, so £750 overall.

Spotting short targets

So what do you short? James Montier at Socit Gnral suggests that you screen firms and weed out those with the "very unhealthy combination" of high price and "worrying accounting". High price here means a high price/sales (p/s) ratio Montier suggests 1.5 or above. As Sir Alan Sugar once commented on The Apprentice, a business selling £10 notes for £9 could generate lots of sales (and by extension a decent p/s ratio), but it's pretty obvious why it isn't a good bet.

As for the "worrying accounting", leaving aside pure fraud, there are several ways a firm can stay within the rules but "ensure it can beat analysts' quarterly forecasts". Watch out for a growing gap between operating profits and the cash flow from operations. Cash flow is hard to manipulate. A big gap might mean that in arriving at the profits figure a firm has used some "highly subjective estimates" to its advantage for example, understating bad debts and overstating expected pension fund returns.

Also look for debtors ('receivables') and stocks ('inventory') rising faster than sales. The former suggests a firm is desperately trying to boost turnover by shifting stock onto customers ('channel stuffing'), while the latter can flag slowing sales.

Beware of falling depreciation (the accounting charge against profits made to reflect asset wear and tear) as a percentage of total fixed assets. By lengthening the expected life of an asset to reduce depreciation, a firm can boost profits. The last red flag is fast asset growth. Acquisitions can be used to boost short-term revenue and earnings without adding much long-term value.

What to short

"The last time developing countries got this expensive was October 2007," says Adria Cimino on Bloomberg. The MSCI index trades at 15.4 times reported earnings, compared with 14 for the S&P 500. Meanwhile, current prices put a typical MSCI stock on 1.7 times its net assets "the highest on record" and above the MSCI World average of 1.5. In short, says Matthieu Guilanni, a Palantine fund manager, "emerging market stocks are at risk".

With that in mind, two emerging-markets-focused stocks that pass the Montier screen are South African miner Lonmin (LSE: LMI) with a forward p/s ratio 2.7 and Far East Asian plantation investment group MP Evans (LSE: MPE) on a forward p/s of 13.9.