How to Identify Short Candidates (By 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.

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.

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.