5 Steps to Identify Short Candidates

February 5, 2008
David Brown

Gather a group of portfolio managers and active traders together and you’ll
hear about a broad assortment of diverse strategies, but one point on which
you’ll likely find agreement is that the most difficult task is selecting stocks
for shorting. This might seem easier when the market is falling, but in fact
consistently finding stocks that will underperform the market indexes is
difficult under any conditions. After all, companies are in business to do well
and management is focused on bolstering shareholder wealth — using any and all
available tactics.

Many traders will just play the charts. That is, they will use their favorite
technical indicators to find good short-term or swing trades, such as shorting
stocks, buying puts, or opening options spreads. For them, technicals seem to be
more reliable than fundamentals when playing the short side. And for very
short-term trades, this may be true. However, for longer-term position trading,
long/short strategies, pairs trades, or portfolio hedging, pure technical
trading often loses its effectiveness, and fundamentals gain much more
importance.

For the past 30 years, after applying quantitative models to develop the
lunar landing module for NASA, I have been applying my expertise to the equity
markets to seek small systematic edges in the challenging pursuit of alpha.
Throughout that time, I have been an active investor, trader, analyst,
newsletter author, and the CEO of two publicly traded companies serving the
investment community, and I currently lead an equity research firm that serves
institutional investors, portfolio managers, and self-directed investors.

In my view, these are the five fundamental factors (or “red flags”) that are
most useful in identifying stocks poised to underperform the market:

1. Company Growth Ratio. Stock valuation versus anticipated future
earnings performance is a cornerstone of any short strategy, often through a
trailing or forward PEG ratio. I prefer a slightly different version that I call
Company Growth Ratio (CGR). It is the projected 5-year EPS growth rate divided
by the projected next fiscal year P/E. So, high is good, low is bad (which is
the opposite of PEG). This factor has tested well as an indicator of 3-12 month
performance both on the long and short sides.

Investors rarely confine their interest in a stock to only the current year’s
data since that data is already discounted. So in essence we are asking, “How
much must we pay for the growth that we expect over the next 5 years?” Rather
than use current P/E, we use the Projected P/E, i.e., the P/E that will exist if
at its current price the company earns what is expected during the next fiscal
year. In other words, we assume that most investors are pricing in the next
year’s growth. , as shown in the following chart.

2. Net revisors. This factor is the percentage of Wall Street analysts
who follow the stock who have lowered their current year earnings estimates
during the past 30 days. If a large percentage of analysts have done so, then
lowered expectations for the company’s earnings is relatively new news. Again,
this indicator tests well in its ability to forecast lower prices ahead. Thus,
by combining these first two indicators, we are saying that we want companies
that are relatively overvalued in light of their future growth prospects (factor
#1) and have had the current year earnings forecast lowered by a significant
number of analysts in the past 30 days.

3. Projected next year’s earnings growth. We want to focus on
companies that are expected to show decreased earnings next year versus the
current fiscal year. The greater the percentage decrease identified by analysts,
the more we like them as a short candidate. So not only do we want the company
to be overvalued against next year’s projected earnings (factor #1) but we want
that earnings figure to be lower than what is expected this year.

4. Value and growth ratios. Frequently, companies that have exhibited
poor growth have a relatively low P/E and hence a high perceived value. But here
we want stocks that are forecasted to have poor growth and yet still have poor
value (i.e., a rich price). Surprisingly, this is not hard to find. Poor value
is represented by relatively high price to book, price to cash flow, and price
to sales, as well as low dividend yield. Poor growth is represented by declining
forward year-over-year projected growth rates in earnings, revenues, and cash
flow.

5. Earnings quality. Here we look for factors like poor ratios of cash
flow to reported earnings, slowing receivables and inventory turnover, and
aggressive accounting practices (as identified by a forensic accounting score.)
Overall earnings quality is a factor which has significantly increased in
importance over the past 5-7 years. I suppose we have Enron to thank for that.

As an example, the following chart illustrates the historical performance of
my composite long-term value rank. It shows the cumulative bottom decile return
of the S&P 400 mid-cap universe vs. the overall index return, rebalanced monthly
for a 10-year period.

When making a final selection of short candidates, it’s also good to stick
with the weaker overall sectors with respect to recent price performance.

One important caution is to stay away from individual stocks carrying high
short interest levels. That might seem counterintuitive, but excessive short
interest can easily fuel a powerful short-covering rally — leaving you holding
the bag.

So how has this model performed? Well, let me give you a real world
illustration of how I have used these factors in an integrated manner. In
October 2007, Forbes Magazine invited me to participate in the annual “Love Only
One” stock-picking contest in which a dozen institutional analysts were invited
to submit a long pick and five were asked for a single short pick — all to be
held for a full 12-month period starting with the closing price on October 31,
2007. Each of us would be judged on how the selected stock performed over that
time period. I was asked to select a short.

With the help of my team at Sabrient, we initially identified five short
candidates for entry positions out of a large database of stocks having analyst
consensus estimates to work with. The following table shows how much each had
fallen as of January 22, 2008.

Our top pick was FreightCar America Inc.
(
RAIL |
Quote |
Chart |
News |
PowerRating), and it was
submitted to Forbes as my single short selection. The CGR was in the lowest 7%
of our stock database. Net revisors was in the 50th percentile — not too bad.
Projected earnings growth next year was in the 30th percentile. Its value rank
was in the 35th percentile and the growth rank was quite low, appearing in the
17th percentile. Finally, the earnings quality metric produced a terrible score,
all the way down in the 2nd percentile. All of these combined to create a
composite score in the bottom five of all eligible stocks.

As shown, all five have fallen substantially. In fact, as of 1/22/07 (less
than 3 months), the average drop was an astounding -35.9% while the S&P 500 was
down only -15.4%.

Of course, it’s easier to find these stocks when you have access to a robust
computer model and database like a quant research firm. Also, keep in mind that
a fundamental outlook can change suddenly due to significant events like
mergers, takeovers, strategic partnerships, breakthrough products, etc.

Nevertheless, when you are looking for short plays and have identified a list
of possible candidates through other means (e.g., charts), focusing on stocks
with the weakest fundamentals should help enhance your returns. I have found
that the fundamental red flags include:

1. Low Company Growth Ratio (projected 5-year EPS growth rate divided by the
projected next fiscal year P/E)

2. Reduced current year earnings projections by Wall Street during the past
30 days

3. High percentage decrease in earnings expectations for next year

4. Poor value (high price ratios) coupled with poor growth prospects
(declining projections for earnings, revenues, cash flow)

5. Poor earnings quality, including declining ratio of cash flow to earnings,
slowing receivables, and aggressive accounting practices.

This should encourage you to look beyond the charts and technical factors
when seeking longer-term position trades on the short side, such as for
long/short strategies, pairs trades, or portfolio hedging.

David Brown is the co-founder and Chief Market Strategist for
Sabrient Systems LLC, an independent equity research firm based in Santa
Barbara. Click here to learn more about
David Brown’s quantitative approach to stock-picking, sign up for his monthly
newsletter, or download free special reports.

5 Steps to Identify Short Candidates

BUY THE FEAR, SELL THE GREED

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