Shorting stocks: how to profit from disaster

With the credit crunch hitting stockmarkets and a US recession looming, many Western stocks look ripe for shorting. So how can retail investors take advantage – and which stocks look most vulnerable?

With the credit crunch affecting stockmarkets and a US recession looking ever more likely, it's no great surprise that an unusually large number of European and American stocks currently look ripe for shorting, according to James Montier at Socit Gnrale. But how can retail investors take advantage and which stocks look most vulnerable?

What is shorting?

Professional investors, such as hedge funds, are able to borrow "surplus" stock from pension funds in return for a fee. They then "short sell" it. A short seller might borrow 1,000 Bradford & Bingley shares when the price is 70p, and sell them. If the shares then fall to, say, 60p, they are repurchased in the open market and returned to the original lender. The short seller takes away £100 (1,000 x 10p), less any lending fee. But should the shares rise instead to 80p, they still have to be repurchased and returned, costing the short seller £100, plus the fee.

Stock loans are not normally available to private investors, but spread betting firms, such as IG Index, allow you to place down bets on either individual shares or whole sectors. You bet a fixed amount per "point", usually a 1p change in the share price. So a down bet on Bradford and Bingley at £10 per point could make around £100 (less dealing costs), should the share price fall by 10p. But which companies are worth shorting? Montier reckons there are three criteria to monitor.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

Shorting stocks: a high price-to-sales ratio

Traditional measures for checking whether a share price is over (or under) valued include the price-to-earnings (PE ratio) and price-to-cash flow (PER) ratios. Some analysts also like to compare price to sales, or turnover. Say a firm's share price is £2.50, its turnover is £2m, and there are 1.6 million shares in issue. That gives you sales per share of £1.25 (2m/1.6m); giving a PER ratio of 2 (£2.50/£1.25).

Some believe this indicates a fast-growing company, but Montier thinks that any stock with a ratio above one is overvalued. That's because the ratio is an unreliable guide to value. After all, many firms grow sales impressively quickly, but then struggle or even go bust due to a lack of earnings or cash flow.

Montier's scepticism is backed by research from Socit Gnrale on the performance of European stocks between 1985 and 2007 those that were cheapest on a price to sales basis (with a ratio below one) outperformed the most expensive.

Shorting stocks: the Piotroski score

The next screen uses nine accounting measures across three areas profitability, capital structure and operating efficiency, with each of the nine earning the firm a score of either zero or one. The result is an "F score" between zero and nine, which, broadly speaking, shows how efficient the management team is at turning assets into sales.

For example, if return on assets is greater than zero, the firm scores one point, and if not it gets zero, with the same process repeated across eight more measures (see The Graham Investor for the full list). Taking European stocks from 1985 to 2007, Montier found the average market-adjusted return for firms with a low F score between 0 and 3 was 4.4%, whereas for high scorers 7 to 9 it was 15%.

Shorting stocks: a habit of wasting money

In a McKinsey survey, frontline managers admitted that 21% of the money invested by their firm went into "underperforming projects that should be terminated". About the same went on investments that "should never have been approved in the first place". Half of respondents admitted they were too optimistic about the impact a project would have on sales.

This explains a report from analysts Cooper, Gulen and Schill, which shows that for the period 1968-2003, US firms with low asset growth (ie, low capital investment and slow growth) outperformed those with high asset growth by an eye-opening 13% per year, taking account of market, size and style. For the European market between 1985 and 2007, the gap is around 10%. So when it comes to stocks to be shorted, asset growth of 10% or more is a warning sign it probably means money is being wasted.

Shorting stocks: what to short

Montier claims that his "unholy trinity of characteristics" a price-to-sales ratio above one, an F score between 0 and 3 and asset growth above 10% would have produced a portfolio that declined by 6% a year between 1985 and 2007, against a 13% annual rise in the market. In recent weeks, the length of his list of European short candidates has risen by five times, and for America nearly six times.

These lists contain some surprises, such as energy firms Dana Petroleum (LSE:DNX), Cairn Energy (LSE:CNE) and Imperial Energy (LSE:IEC), but given the strength and volatility of oil and gas prices, this isn't a sector we would short just now.

One that we would, though, highlighted by Data Explorers, is recruitment, as a recession means fewer jobs. That means firms such as Michael Page (LSE:MPI), Robert Walters (LSE:RWA) and Hays (LSE:HAS). Other vulnerable-looking sectors include British banks (see chart above) and builders, which are also likely to face more price falls as the economy deteriorates further.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.