In times of market volatility there’s a dash to the safety of good, strong defensive stocks. The flow of funds as investors rotate their portfolios out of weaker stocks can be disastrous for anyone left holding the bag. While short selling is an art that very few practice, understanding the qualities of a good short sale candidate can ensure that you weed them from your portfolio avoiding the fate of so many in the process. These days identifying stocks at risk is much easier than you think.
James Montier, former Soc Gen global equity strategist, wrote a series of papers on short selling strategies at the last market top in 2007 with some astonishing results. In one paper he identified an ‘unholy trinity’ of fundamental characteristics that weak stocks tend to display. Backtesting showed that a portfolio of stocks displaying these characteristics fell on average by 6% per annum over a 20 year period. Our own model of this strategy has fallen by almost 20% in the last 3 months, underperforming the FTSE 100 by 10%. Given results and history such as this eyeballing the list to make sure you minimise your exposure to companies with these qualities would be extremely wise. Review the full list here.
Characteristics of weak stocks
Montier takes a very common sense approach to finding short sale candidates. He focuses on highly rated companies that exhibit weak fundamental trends. The characteristics used are as follows:
Montier blended these three characteristics into his ‘unholy trinity’ stock screen by looking for a Price/Sales > 1, F-Score < 4 and Asset Growth > 10%. Perhaps unsurprisingly given the recent levels of investment in the areas the current list of stocks includes a large overweighting of energy and materials stocks but also a huge number of financials. While of course the underperformance of these characteristics work at the portfoliio level rather than at the company level, some of the more notable current stocks on the list include previously highly regarded names such as Parkmead Group, Quintain Estates & Development, Range Resources and mobile payments group Monitise.
Of course, like any quant screen, this is a basket approach and simply being on the list doesn't mean that a stock will underperform. Some may do very well but, on average these metrics have been shown by Montier to have signal, so it's certainly worth thinking hard if a stock is exhibiting these qualities, especially in troubled times. As Buffett said, "it's only when the tide goes out that you learn who's been swimming naked".
Investors can also use other proxies for high valuation such as the P/E ratio or P/B ratio and other proxies for weak fundamentals such as the Altman Z-Score which highlights bankruptcy risk. Each of these indicators are available on our Stock Reports in a variety of visual ways making them easy to eyeball.
It’s how you cook’em
Of course the lessons of Montier’s short selling screen are that you need to learn how to use these indicators in unison with each other rather than on their own. A high valuation alone doesn’t necessarily signal poor future performance as in even weak markets money can flow into highly valued high quality stocks. One glance at our ‘Buffettesque’ strategies shows the level of outperformance that portfolios of cash generative ‘quality’ names have achieved recently. Many of these stocks are also on premium price to sales ratios to the market. It’s how you use these signals in tandem that will protect your portfolio from the kinds of stocks that can half and seriously damage your long term wealth.