Investors who were basking in the early summer glow of a stock market heat wave would be forgiven for feeling mixed emotions about the recent cooling in equity prices. The FTSE All-Share completed an impressive 1-year gain of 30% when it tipped over 3,600 points in May but it’s now more than 7% off that high, leaving many wondering whether a deeper correction is unfolding. While the recent falls are a tonic for market-watchers concerned about unsustainable rises the current conditions perhaps warrant a closer look at portfolio positions to ensure they aren’t harbouring expensive stocks that now look decidedly risky.
Timing a sell decision
We have written at length about the difficulties of deciding when to sell shares and why investors focused on technical and fundamental indicators often see things differently. As part of that decision making process – and after 12 months of strong gains – now is the time to put your shares through a mid-year financial work-out to figure out whether their original appeal still exists. Finding out which if any of them are beginning to look overly expensive against their fundamentals could be an indicator of those that are needlessly exposed to further stock market falls. One way of doing that is to use some smart money criteria that are more commonly associated with short selling.
Back in May 2008, James Montier, the respected GMO analyst [then at Societe Generale (OTC:SCGLF)] put the case for shorting stocks in a research note called Joining The Dark Side: Pirates, Spies and Short Sellers. At the time the economic backdrop was offering a dearth of equity buying opportunities so he began developing investment strategies that picked out expensive looking, low quality companies – the ones whose share prices were very likely to fall.
“It never ceases to amaze me that whenever a major corporate declines the short sellers are suddenly painted as financial equivalents of psychopaths. This is madness, rather than examining the exceptionally poor (and sometimes criminal) decisions that the corporate itself took, the short sellers are hauled over the coals.” James Montier
Borrowing ideas from the dark side
Montier found that it was profitable to systematically sell stocks looking vulnerable due to a fingerprint of high valuation, low financial strength and management excess. For valuation, Montier picked on a metric with a mixed reputation: the price to sales ratio (P/S). The P/S was all the rage during the dot com bubble because, rightly or wrongly, it allowed the market to value companies that weren’t making a profit. These days it remains popular among some analysts who like the fact that sales figures are difficult to manipulate, which can make the P/S a more accurate indicator than others if used with care. In this case however, looking for high P/S shares (typically above 1) can identify potential ‘story’ stocks in the market where investors (and share prices) have got carried away and valuations may have become detached from reality.
Another key factor in the search for potentially sub-standard quality is to look for companies with relatively poor financial strength. Montier chose the Piotroski F-Score – a rigorous nine-point accounting-based test that lifts the lid on whether a company is improving its financial wellbeing - discussed in more detail here. Anything that scores a four or less on this basis qualifies as troublesome. Piotroski developed the F-Score in 2000 as a means of identifying value stocks with improving quality and the results he got were impressive. At the other end of the spectrum, Montier found that expensive stocks with low F-Scores materially underperformed – on his numbers by -0.7% annually, which was 9% worse than the average growth company.
A final indicator worth watching for concerns companies where executives may be being wasteful with the resources at their disposal. With numerous studies finding that spend-happy management teams can often destroy value with poor investment decisions, Montier regarded high percentage asset growth as a red flag. The key is to avoid stocks where this measure is in double figures.
In combination, this "unholy trinity" of factors produced a portfolio of stocks (rebalanced annually) that between 1985 and 2007 fell in value by over 6% against a European market that was rising by 13% annually. Our own interpretation of the screen has proved it mettle, returning -0.63% over 12 months against a 17.7% return from the FTSE 100.
But while Montier developed this and other tools (such as his "trinity of risk" strategy) in the context of weak market conditions, there is arguably no reason not to test stocks against the same measures in a stronger climate. Rather than using the formula for finding short-selling candidates, the same process can be used to spot warning signs that are proven to be debilitating to share prices.
Companies raising red flags
Of the shares currently raising concerns on the ‘unholy trinity’ screen, the majority have market caps of sub-£50m but some are much larger, including loss-making supermarket delivery company Ocado (OTC:OCDGF), which has long been a favourite among short sellers. Its recent investment in a new distribution centre naturally bumped up its asset growth in 2012 but the F-Score of 2 is less than impressive. News of a tie-up with supermarket chain Morrisons propelled shares in Ocado during April and May, making its P/S of 2.5 look expensive against its sector average of 1.1.
Meanwhile, shares in mobile money processing technology company Monitise (OTCPK:MONIF) reached a 5-year high of 43.5p in May but the company has yet to turn a profit despite processing 2 billion transactions on an annualised basis. With revenue on course to hit £70 million this year Monitise has a high P/S of 13.6 (against a sector median of 2.1) while its F-Score is a modest 3.
Elsewhere, semiconductor manufacturer IQE (OTC:IQEPF) makes the list despite seeing its share price fall by 10p to 25p so far this year. IQE has been a long-term acquirer of other businesses and last year was not exception, with two bolt-on deals that grew its net fixed assets by 35%. With an F-Score of just 2 the company is underwhelming on the financial health measure while its P/S stands at 1.6, which is below the sector median of 2.9 but still over the threshold of 1 needed to raise a red flag.
Quality control in expensive markets
It’s worth remembering that while Montier’s strategies have been effective, he is hardly alone in formulating tools to spot selling candidates. For instance, Professor Messod Beneish – the father of the M-Score – is famous for his 8-point checklist for picking up companies that may have been manipulating earnings, and this is another option for investors that want to check up on their shares. Our interpretation of the Beneish M-Score screen has underperformed the FTSE 100 by a staggering -31.2% over the past year.
With the FTSE All-Share continuing to retrace from its May highs, the case for reassessing stocks with a financial health check is looking strong. In the absence of a systematic sell trigger, scanning your portfolio for those companies hurting against short selling criteria could prove to be the ideal tool in identifying and offloading expensive stocks whose quality is looking increasingly uncertain.