The red flags that tell you stocks are set for a slide

What short sellers do "should be illegal", tweeted Tesla CEO Elon Musk earlier this month. He's hardly the first person to lambast those who seek to profit from falling share prices. Shorting entails borrowing shares and selling them with a view to buying them back later at a lower price, before returning them to the owner. In the early 17th century regulators in Amsterdam banned them, holding them responsible for forcing down the share price of the Dutch East India company. Napoleon declared the practice treasonous. Shorts were also blamed for exacerbating the 1929 and 2008 market slumps.

Their bad reputation is unwarranted, however. By taking a sceptical view of indices or individual shares, they temper exuberance and stop market bubbles developing. "Much of the Wall Street [or City] infrastructure is built around promoting stocks whether it be sell-side analysts who have little to gain from airing sceptical views or promotional management teams that grant themselves stock options and sell them at inflated prices," saysSahm Adrangi of Kerrisdale Capital Management. Shorts can help root out fraud and bolster overall liquidity by providing sellers to match buyers. What's more, "as a group they are clever stock pickers", as The Economist points out. Studies suggest that heavily shorted shares (those with a large percentage of the stock being shorted) tend to underperform their lightly shorted counterparts by up to 16% a year.

Seller beware

Nonetheless, it is an extremely risky undertaking. If you sell a stock short then the most you can make is the price at which you sell it after the company falls to zero. But your losses are theoretically infinite since there is no upper limit on a share price. Given that equities have historically returned around 5% a year, after inflation is taken into account, it's no surprise that most short-sellers struggle to make money from their short positions alone. Even legendary short-seller Jim Chanos has ended up losing money on his short positions over his career (his long' portfolio has offset this). Still, well chosen short positions can add value to your portfolio by hedging against market or industry downturns. Given the current state of the decade-long bull market, it could be worth considering. Even if you don't intend to short shares, though, studying what short-sellers do can give you an idea of which type of shares you should ditch or avoid. Here are some key "red flags" that short-selling experts look for.

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Unrealistic valuations

At MoneyWeek we consider ourselves fans of value investment, the idea of buying shares that have a higher "intrinsic value" than their current share price would suggest. So shares that appear wildly overpriced would logically make good shorting candidates. However, apparently excessive valuations can persist for an irritatingly long time; certainly often longer than many short-sellers can remain solvent. Sometimes it's a case of the market getting (years) ahead of itself. If the idea takes hold that a company "is going to be materially larger five or ten years from now, shorting based on valuation can be a losing strategy", says Adrangi; the market will just keep assigning higher multiples of earnings or sales to fast growers. Amazon, for instance, has had a sky-high price-earnings (p/e) ratio for years. Nonetheless, "if a market cap is based on a concept or product that will never be commercialised, or the business is rapidly shrinking, then you can make a more sound argument for why a stock price should be lower".

Investors learnt that lesson during the dotcom boom, as it finally dawned on them that most of these new whizzy websites would never makes sales, let alone profits. Today, a sector that appears ripe for a fall is cannabis, reckons Chris Brown of Aristides Capital. Canadian pot stocks have soared in price as a result of Canada's decision this summer to allow retail sales of cannabis for recreational use. A technical indicator may be of use to short-sellers here. Gil Morales, short seller and founder of The Gilmo Report, likes to focus on shares that have surged in price over an extended period, but have recently started to fall back, a classic sign of a trend reversal.

Poorly performing industries

It's not just individual companies that can have poor fundamentals. Entire industries can end up struggling. This can be due to a number of factors, such as regulation, increased costs, changing tastes, or technology. One group that will find it hard to deal with new challenges is regional American supermarkets, which are struggling to fend off competition from general online retailers, notably Amazon. Amazon's decision to buy Whole Foods suggests that it is going to try to take home deliveryof groceries mainstream.

Negative catalysts

Many value investors believe in the importance of a "catalyst", a single event that, while perhaps not that crucial in itself, can have a major impact on a company's share price by prompting other investors to take notice of the stock and causing the gap between perception and reality to close. Jamie Clunie of Jupiter's Absolute Return fund, for instance, says he likes to wait for a key catalyst before pulling the trigger on shorting a stock. This could include any major internal events, such as directors leaving, firms missing their earning targets, or breaches of loan covenants. However, it could also involve external events, such as the CEO of a rival company saying industry-wide conditions are worse than expected.

Outliers

It may seem obvious that a company, or an industry, doing badly is a red flag. However, a company appearing to do too well, especially when similar firms are performing badly, can also be a sign that something is not quite right. Anything that seems too good to be true usually is. Classic red flags are firms reporting abnormally high growth rates, or profit margins that seem unrealistically large compared with the sector average. A firm may indeed manage to secure a particular competitive advantage making it extremely profitable. But it could also be cheating.

Aggressive mergers and acquisitions

Mergers and acquisitions (M&A) tend to be poor deals for buyers. They often end up paying a large premium over the market price for their target, as well as huge legal and investment-banking fees. Various studies, including a recent one by S&P Global Market Intelligence Quantamental Research of takeovers between 2001 and 2017, found that the shares of the acquirer subsequently lagged both the market and their peers. So you'd naturally expect firms to think twice before trying to take over another company.

Yet instead of concentrating on deals that could genuinely add value, boards will often embark on a merger to deflect attention from operational problems. Sometimes firms will engage in M&A because it gives them a chance to boost profits with accounting shenanigans. A company that starts "paying big valuations for mediocre businesses" is either badly run, or trying to hide something, concludes Spruce Point Capital Management's Ben Axler.

Management braggadocio

It's only natural for executives to want to portray their firm in the best possible light. After all, part of their job is to get people to invest in their company. Still, if they start taking it too far, then that could be a warning sign. "If independent industry experts, customers, suppliers and competitors portray a situation that's vastly at odds and more pessimistic than what management and sell-side analysts are communicating, then you may have a promising short opportunity," says Adrangi. Another problem with management bluster is that the stock becomes susceptible to a nasty setback when promises go unfulfilled.

Management malfeasance

Management exaggerating is bad enough, says Brown, but one that "lacks honesty and integrity" is a real red flag. Once you know what to look for, it can be surprisingly easy to spot. Individual investors rarely meet managers face to face, but YouTube clips of them speaking could prove highly informative as their general demeanour, body language and response to awkward questions will "provide hints as to whether they should be trusted", says Brown. He strongly recommends Spy the Lie: How to Spot Deceptionthe CIA Way if you want to know more aboutbody language.

Another warning sign is a track record of unethical behaviour, because "if they lie to you once, they will lie to you again". Elon Musk recently resigned as the CEO of Tesla after a tweet suggesting that he was about to take Tesla private and had secured the money to do so. He has now reached a settlement with the Securities and Exchange Commission, America's financial regulator, which will avoid a court battle over alleged securities fraud.

The SEC was not convinced he had the money to take Tesla private when he tweeted, in which case he distorted the market by causing a jump in the share price (and, conveniently, hitting short-sellers where it hurts). That wasn't the first time he has courted controversy. Musk has also been accused of exaggerating the potential of Tesla subsidiarySolarCity's technology, and then taking advantage of his position as Tesla CEO to bail out the struggling energy company.

Other accounting manipulation

In 2000 and 2001 corporate America was gripped by a variety of scandals where managers were revealed to have cooked the books. The most notable of these involved Enron and WorldCom. However, many other firms were forced to "restate" their earnings. Axler thinks that little has changed since those days, especially with the Trump administration relaxing regulations. The good news is that this creates opportunities for "activist" short-sellers (like Axler) who research a company, take short positions and then publicise their research.

Spotting accounting fraud isn't straightforward, especially if you have no experience of going through a balance sheet. But Axler thinks that you should be on the lookout for firms that use strange, or unusual accounting conventions, especially if they allow the company to defer costs, or increase revenue. Be especially sceptical about firms that use "percentage of completion accounting".

This accounting method determines how much of a contract has been completed by the amount of money spent relative to the estimated total cost (so if a firm has spent £1m fulfilling a contract and the estimated costs are £2m, then this method allows the firm to say that the contract is halfway through, which means it can include halfthe revenue in its calculations).

Short interest

It often pays to go against the herd, as the best opportunities can lie in assets ignored or wrongly dismissed by other investors. Nevertheless, when it comes to shorting, the opposite may be true.

Given the most shorted shares tend to underperform the market, there does appear to be a wisdom-of-crowds effect here. Certainly, "whenever I've shorted shares on my own, I have lost money", Clunie admits.

So how do you find the crowd? There are two main ways to measure short-sellers' interest in a company. The simplest measure is the short interest, the number of shares of a company being borrowed by short-sellers as a percentage of the total shares outstanding (short-sellers have to borrow shares from their owners in order to short them). Another measure is the interest rate that short-sellers have to pay in order to borrow shares. As you might expect, short-sellers have to pay a higher interest rate to borrow shares that are very popular among short-sellers.

The stocks to sell now

The only practical way for investors to sell stocks or markets short is through spread betting, where you use a firm such as IG Index to take a view on share-price movements. Because this involves betting amounts that are greater than the underlying price change (for example, £1 for every 1p movement), you are effectively using leverage. This means that you need to be very careful to make sure that your losses do not spiral out of control. Set a stop-loss that will automatically cover your position if the share rises above a certain amount.

One shorting candidate is Tesla (Nasdaq: TSLA). The electric-car company has struggled to meet ambitious production targets while there have been concerns about quality. It faces growing competition from most of the major carmakers, who are coming up with their own electric-car models. Even if you ignore CEO Elon Musk's dubious behaviour and think that it is going to live up to the hype, Tesla appears to be overpriced on a 2019 price-earnings (p/e) ratio of 89.

The mounting backlash over Russian "fake news" has already forced Twitter (NYSE: TWTR) to close down 70 million accounts. However, this is unlikely to prevent it from suffering from a growing backlash among advertisers against social media, with firms deciding to return to traditional approaches, such as print and television. Even if it manages to retain the confidence of advertisers and users, future revenue growth at Twitter will be around 10%-13%, far lower than that of competitors such as Facebook, and not enough to sustain a 2019 p/e and price-to-sales ratio of 37 and 6.5 respectively.

Shares in Wayfair (NYSE: W), an American e-commerce firm that focuses on home furnishings, have gone up fourfold in the past 18 months on the back of strong revenue growth of around 40% a year. However, this rapid expansion has come at the cost of dismal financial reports with negative cash flow and record losses. These raise questions about its ability to service the large amount of debt on its books. There are also signs that Amazon is making an aggressive play for Wayfair's business by launching a service, Scout, that makes furniture recommendations based on your likes.

Weis Markets (NYSE: WMK) is a supermarket chain operating 205 stores in seven northeastern and mid-atlantic states. Ben Axler of Spruce Point Capital notes that it has experienced several operational problems, including repeated investigations over issues ranging from food contamination to pest control. Despite slow underlying growth, potential competition from online retailers such as Amazon, uncompetitive prices and very low returns on capital, it still trades at a relatively high p/e of 21, compared with around 14 for other regional supermarkets.

Because stocks go up in the very long run, returning around 5% a year after inflation, even the best short-sellers struggle to make money from short positions alone. The Jupiter Absolute Return Fund (0800-561 4000) run by James Clunie uses a mix of long and short positions.

Clunie makes his short selections based on a combination of fundamental research combined with quantitative criteria. The fund has delivered a total return of 9.9% over the past three years, compared with 1.6% for Libor, the fund's benchmark. It currently has an ongoing charge of 0.85%.