And so, I booked my biggest loss in SGX and sold off Triyards.
And what happened? What was my investment thesis and what went wrong?
I entered in early 2016 based on low P/B hoping for a turnaround and based on analysts report. And when it dropped further, I entered twice. My rationale behind it was the shipping industry had shown signs of picking up. There are now more ship owners asking to build new vessels. And the industry looks like it might turn around in late 2017/2018.
And I was wrong.
So what was wrong?
- I failed to analyse their economic moat. In their latest earnings release statement (Jul 17), their margins were hurt. They did not have a competitive advantage and faced with strong competition.
- I had loss aversion bias and averaged down in hope of recovery. That’s a bad strategy when there’s no near term turnaround in sight.
- The low P/B strategy did not work out. There was an impairment charge to the assets and that was one of my primary reasons for selling it out. There’s a possibility that some companies might buy over Triyards but I would not want to place too high hopes for that when the industry is still in consolidating phase and there’s no significant growth of orders in the industry. Another reason that I sold out was a rise in accounts receivables with a reduction in operating cash.
- Watch loss aversion bias!!
- Economic moat matters
- Macroeconomic turnaround takes time
As value investor, it is also important to know the other side and how short sellers select their targets. Several are related to fundamental business analysis as below.
- Competition – When a strong threat appears and take away market share
- Commodity Trap – When the product of the business becomes a commodity with little differentiation other than price. Short sellers often look for premium products to eventually become commodities. When this happens, profit collapses and the stock price
- Loss of major customer – This happens when a business has a few key customers and it lost one of these.
- FADs – the product is a fad. Technology companies can fall under these such as Atari.
- Regulatory actions – When a bill is passed that is unfavorable to the business
- Delayed Financials – When a company has to delay their reporting. Shows problems with internal controls and sometimes accounting frauds.
- Unexpected loss
- Dividend cuts
- Reverse split
- The end of growth
- Failed business model
- Declaring war on shorts – Short sellers are often encouraged by these
- Resignations of key management
- Aggressive mergers that might up the risks and debts
- Family ties – when many different family members are running key management positions
- Significant insider selling
- Unfavorable Auditor’s Report
- Unreasonable management pay
- Management not able to achieve stated plans
- Quarterly deterioration in cash balance
A common idea is to short sell before the 4th quarter as the first 3 can be unaudited.
Typical type of stocks to short
- Blue chips
- Growth stocks
Flags to look out for in financial statements
- Cash Per Share = (Cash + Marketable Securities) / Share Outstanding
- A short seller will calculate the burn rate which is the average quarterly reduction in the cash balance.
- Accounts Receivable
- Check allowance for doubtful amounts. A low ball account will boost receivables as well as profits
- An increasing trend of accounts receivable might be a red flag.
- Another metric is day sales outstanding = (Ending Receivables / Credit Revenue) x Number of Days in the Period. A good gauge is comparing with the industry and competitors.
- Short sellers will also look at the discrepancies between sales growth and accounts receivable. An example is when sales growth is lesser than accounts receivable growth.
- Change in accounting for inventory that might increase the gross profit. Eg. if a company changed its accounting valuation method from FIFO to LIFO. Basically, if inventory costs increases and a company wants to understate this, it can move toward FIFO. This means that the first items purchased will be the first ones included in determining the value of inventory.
- Discounts and write-offs are major red flags especially in retail
- Inventory turnover ratio = Costs of Goods Sold / Average Inventory. Red flag if ratio increases over time.
- Days sales of inventory = Ending Inventory / COGS x Days in the Period. Red flag if there is rising over time and is 20 percent longer than industry peers.
- Growth trends in raw materials that might eat into margins if the finished product price trend is slower than that of raw materials.
- Soft assets
- Check is there current expenses that are accounted into assets.
- Large amount of goodwill might indicate aggressive acquisitions that might lead to higher risks
- Long Term Assets
- Reasonable depreciation
- Change of depreciation method from acceleration to straight line.
- Did company lengthens the term of depreciation
- Liquidity ratios – Current Ratio (Current Assets / Current Liabilities) should have a 2:1 ratio. Quick Ratio (Current Assets – Inventory) / Current Liabilities should not be below 1.
- Debt Ratios – D/E should not be more than 70 percent in general except for certain industries. Times interest earned ratio (EBIT/ Interest Expense) which give a sense of a company’s ability to pay off debt is often used by banks in making loans. If the ratio falls below the specified level, the company will be in default and the bank has the right to require the repayment of the loan.
- Watch out for special liabilities such as the corporate pension. A short seller might get concerned if a company increases the average return which will understate the overall pension liability.
- Another note is off-balance sheet liability often in the form of a new venture known as special purpose entity which companies like Enron used to cover their tracks. A special ratio (Balance Sheet Debt + Off-balance Sheet debt)/ Equity. Short sellers will look at the growth of this ratio over time as well as a comparison to industry peers to look out for companies doing aggressive accounting.
- Look out for warranties which can be a potential liability if their product fails.
- Company Bond Prices
- A lower bond price of 90 percent and below might indicate some problems. Below 80, means investors are concerned.
- Z-Score = 1.2a + 1.4b + 3.3c + 0.6d +1.0e, where
- a = Working capital / total assets
- b = retained earnings / total assets
- c = earnings before interest and taxes (EBIT) / total assets
- d = equity market capitialization / total assets
- e = annual sales / total assets
- The higher the Z-score the better it is. If the Z-score hits 1.8 or lower, then the company is in trouble and there may be a short-sale opportunity.
- Large and growing negative retain earnings
- Growth Rates higher than ROE which might suggest that the company has not enough cash flow to finance its growth
- Toxic Private Investment in Public Equity (PIPE). Can refer to 8-K which can dilute shareholders.
- Common-size financials
- A frame of reference in analyzing financial statements. Eg. Accounts receivable percentage as of total assets.
- Income Statement
- Recognized future contracts upfront causing inflated income
- High bill-and-hold policy where company will invoice a customer but retain the goods in the warehouse
- Broker recognizing the whole sales amount as revenue
- Key metrics for retail/restaurants
- Same-store sales or comparable store sales
- Average revenue per store
- Aggressive vendor financing
- Spike in revenue without new product launches or major customer contracts
- Low gross margins compared to competitors.
- Honey-pot accounting
- One-time charges (recurring “restructuring” costs, write-downs)
- PEG > 1.7
- Current PE / Forward PE > 1 = bullish. If it’s too much above 1, it can be too optimistic and a sell-down can occur if the business condition changes.
- Cash flow statement (Net income + Depreciation = Cash Flow)
- Risky large cap-ex
- Decreasing Operating cash flow margin: Operating Cash Flows/Sales
- Factoring (Selling accounts receivables for less than the full amount)
- Consistent negative cash flow after acquisitions
- Unhealthy Day’s Sales of Payables: Accounts Payable / (Cost of Goods sold X Number of days in the period)
- High volatility in operating cash flows
- Low Quality of Earning (QE) ratio (less than 0.5): Operating Cash Flows / Net Income
- Low Cash Flow Efficiency (less than 1): (Current Assets – Cash and Cash Alternatives) / (Current Liabilities – Short-Term Debt)
- High valuation based on high growth for DCF valuation
Suitable Variables to identify candidates for short-selling
- High D/E > 0.5
- Days Sales in Receivable Index (Annual Change in the day’s sales in receivables)
- Gross Margin Index > 1 (ratio of gross margin over the past year)
- Asset Quality Index > 1 (ratio of non-current assets over the past year), company could be deferring costs to inflate earnings
- Sales Growth Index > 1 (ratio of sales over the past year), company may be subject to accounting manipulation
- Depreciation Index <1 (ratio of depreciation over the past year), company many be aggressively changing its depreciation policy and assumptions to improve profits
- M score above -2.22
Just saw a recent report highlighting the underperformers in S&P
Personally, I think some companies are worth researching more ->AAP, AZO, KR, TSCO, LB, APA, MAT, AKAM, SLB
Some reasons why I am interested in these few
AAP – just went through acquisitions that might see margins improving, positive insider transactions
AZO – Best margins among competitors
KR – unusual bullish call options at strike 25
TSCO – Recommended across different analysts and its business model sounds good to fend away Amazon
LB – Strong brand
APA – Some reports indicate possible turnaround in their assets in the later half of the year
AKAM, MAT – positive insider transactions
SLB – Market leader
Which one do you think is the best value?