Flags for shortselling

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.

  1. Competition – When a strong threat appears and take away market share
  2. 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
  3. Loss of major customer – This happens when a business has a few key customers and it lost one of these.
  4. FADs – the product is a fad. Technology companies can fall under these such as Atari.
  5. Regulatory actions – When a bill is passed that is unfavorable to the business
  6. Delayed Financials – When a company has to delay their reporting. Shows problems with internal controls and sometimes accounting frauds.
  7. Unexpected loss
  8. Dividend cuts
  9. Reverse split
  10. The end of growth
  11. Failed business model
  12. Declaring war on shorts – Short sellers are often encouraged by these
  13. Resignations of key management
  14. Hype
  15. Aggressive mergers that might up the risks and debts
  16. Family ties – when many different family members are running key management positions
  17. Significant insider selling
  18. Unfavorable Auditor’s Report
  19. Unreasonable management pay
  20. Management not able to achieve stated plans
  21. 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
  • Cyclical
  • Speculative

Flags to look out for in financial statements

  1. 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.
  2. 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.
  3. Inventory
    • 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.
  4. Soft assets
    • Check is there current expenses that are accounted into assets.
  5. Goodwill
    • Large amount of goodwill might indicate aggressive acquisitions that might lead to higher risks
  6. Long Term Assets
    • Reasonable depreciation
    • Change of depreciation method from acceleration to straight line.
    • Did company lengthens the term of depreciation
  7. Liabilities
    • 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.
  8. Company Bond Prices
    • A lower bond price of 90 percent and below might indicate some problems. Below 80, means investors are concerned.
  9. Z-Score
    • 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.
  10. Equity
    • 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.
  11. Common-size financials
    • A frame of reference in analyzing financial statements. Eg. Accounts receivable percentage as of total assets.
  12. 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.
  13. 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

Common Technical Indicators for Short-Selling

  • Head and Shoulders Top
  • Late Stage Failed Base
  • Punchbowl of death
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