Why hedge funds can be good news

Hedge funds get a lot of stick in the press, but the best ones are very good at spotting overvalued shares. Once theyve found these overvalued shares, hedge funds will short them in other words, theyll bet that the share price will fall.

In this video, Im going to look at some of the warning signs that hedge funds look for when theyre hunting for shares to short.

Transcript

Hedge Funds. A hedge fund is basically a high-end investment fund. They often have quite high charges for investors, and they often pursue quite complex investment strategies. Many people argue that hedge funds at least partly caused the stock market crash a few years back.

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Shorting is very simple. You short' a share when you place a bet that the share price is going to fall. In most investing, you buy a share in the hopes that the share price will go up, that's going long'. Betting the price will fall is going short, or shorting.

Now, you might think, oh my goodness, hedge funds, they're bad doing all of these complex strategies, charging too much, causing financial crises. And shorting, they're as bad, too, that's ripping off ordinary investors and driving share prices down so that ordinary people end up losing their money. And if you combine the two together, hedge funds and shorting, wow, that really sounds nasty and unpleasant.

But sometimes, hedge funds that short can do good. Think back to the whole Enron scandal in the early 90s. It was hedge funds who first spotted the dodgy things that were going on at Enron.

And if the hedge funds hadn't been around lurking for shares to short, Enron could have carried on being fraudulent, sucking more investors into the bottom for longer. More people would have ended up losing money in the end. And we've seen similar examples, not as well publicised, but similar examples of fraudulent companies more recently.

The most recent one is a Spanish company call Gowex. Now Gowex had a business providing WI-FI in Spain and its share price was going up and up and up. It was a great stock market success.

And then a small specialist hedge fund, Gotham City Research a hedge fund that just focuses on finding companies to short realised that Gowex was very overvalued. So Gotham City took a short position in Gowex shorted lots of Gowex shares. Then Gotham City publicised its findings to the market, so that the share price would then fall and Gotham City could make money.

Now you might say that's terrible, shareholders in Gowex lost out because share prices fell. But the reality was that Gowex was basically fraudulent. The CEO of the company had been claiming revenue that was way, way too high. Gowex wasn't doing anything like as well as it made out. Because Gotham City came along, the Gowex fraud collapsed earlier than might have otherwise been the case. So Gotham City did a positive thing.

There have been other examples of hedge funds shorting companies and for successfully pointing out, not necessarily that a company was fraudulent, but that it was just overvalued. And when you have these specialist hedge funds looking for overvalued companies, you actually get a more efficient market where share prices correspond more closely to the real underlying value of the company.

So I guess the next question is what do the shorters like Gotham City look for when they're looking for companies to short?

Well, I think they often focus on the issue of revenue and revenue recognition. Remember, revenue is not the same thing as cash coming into a company's bank account. There are all sorts of accounting differences between revenue and cash, and I explained those in a video a few months ago, Why profit and cash are both important'.

The crucial point is that when a company agrees a contract with XYZ for £2m, it could say all that revenue comes into the accounts as soon as the contract is signed. Or it could wait longer until more work is done before the revenue shows up in the company's accounts, before the revenue is recognised. Bsically, it's prudent for companies to recognise revenue later than earlier. So the short hedge funds often look at that issue to see if the company is a bit dodgy and is overvalued as a result.

In particular, Gotham City with Gowex looked at the revenue per employee figure for the company. Basically, it was implausibly high. Each employee was making far too much money. So what was going on was Gowex could quite easily boost its revenue figure, inflate that figure but it couldn't really inflate its head-count, so that was a really important warning sign.

Another thing that Gotham City spotted was that Gowex was using a little-known auditor most people hadn't heard of. So that either means the auditor was in on the fraud or just wasn't savvy or experienced enough to spot there was a problem.

And finally, you always want to look at cash conversion that's looking at cash flow so that's, if you like, cash profits, once you've looked at cash coming in and cash going out. So you need to look at how much of that operating cash flow or free cash flow is then converting through to profit.

You're always going to see a discrepancy between cash flow and profit and indeed from cash coming in, you're going to see a discrepancy from cash coming in and revenue. But if that discrepancy is unusually large, and if it's sustained for a long period, that's a warning sign that something is wrong.

So I hope I've shown that hedge funds that short shares can be a positive thing. They're not always bad news. And hopefully these are issues that you can keep an eye on if you're analysing a company, and you're wondering, gosh, is it really overvalued. Perhaps this company is a bit overvalued because they may be playing a bit fast and loose with some of the accounting rules.

I'll be back with another video soon. Until then, good luck with your investing.