The fact that a stock is overvalued is not enough on its own to trigger short selling: for example, the market might be rewarding a business reorganization. The company must be going through a down-performing period.

Let’s examine the necessary characteristics for a company to be an ideal short sale target:
• Deteriorating fundamentals and onset of a catalytic event, namely, an event that may have a negative impact on the company in the short term (for example, announcing lower profits than expected by analysts, accounting problems, adverse regulatory changes, funding problems). In particular, before setting up a short position on a stock, it is necessary to identify a catalytic event, because a stock can go on being overvalued for years. This brings to mind a maxim attributed to John Maynard Keynes, who, speaking about market irrationality, said: “Markets can remain irrational longer than you can remain solvent”.
• Companies belonging to distressed industries negatively affected by external changes.
• Changes in the equity structure.
• Companies with inflated share prices characterized by:
– low cash flow
– high price earning
– strong leverage.
• Companies whose management lies to its investors, for example by adopting aggressive accounting practices, through “accounting tricks” with stock options, “accounting tricks” with pension funds, one-off depreciations, reports with pro-forma data instead of actual data. Warren Buffett maintains that EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) is profit net of bad news, something you would want to take with great caution.
• Companies who are destroying value: i.e., companies with a low return on equity and a high price/earning ratio, who are putting their liquidity in investments whose return is lower than their return on equity, and are therefore bound to erode their profit structure.
• Companies with a high insider selling, i.e., with lots of shares being sold by the company’s managers. (Do not confuse insider selling, which is legal, with insider trading, which is illegal.) Insider selling data are published periodically by the SEC.

A useful exercise to spot short sale target companies is to read public documents, such as the Company Annual Report (10K filing), the Company Quarterly Report (10Q filing) and other reports published by the SEC (SEC filing). Another document is Form 144, which has to be filled out by company executives whenever they place a personal order to sell their company’s shares. Top managers must also fill in Form 4 within ten days of the month end to report on the purchases and sales of their company’s shares. When an investor owns a stake of 5% or more, he must file Form 13-D with the SEC. Every year, during their general

annual meeting, companies must file a proxy statement with the SEC aimed at informing the shareholders on which items they can vote. This document also reports how many shares are held by management, executive remuneration, shareholders with a greater than 5% stake in the company’s equity, pending legal disputes and a lot of other useful information.

It is useful to analyze the executive compensation packages, in particular incentives (stock options, loans extended by the company to top managers, fringe benefits, golden handshakes, insurance policies, private airplanes, apartments), to understand whether the company is managed for the benefit of shareholders or of top managers.

Additional information on a short sale target company can be obtained by interviewing the company management, competitors, suppliers, customers, trade associations, advisors, journalists, independent analysts, etc. This information can then be used to form a personal idea as to the assumptions made in the company’s business plan.

Before getting into a short sale, it is necessary to gain a macro-view: you must identify sector dynamics and deteriorating industries, economic cycles, the state of public finance, capital flows and emerging trends.

Many traders feel it is also necessary to read technical analysis indicators, such as trend indicators, oversold/overbought trends, momentum indicators, Fibonacci’s indicator, money flow indicators. And it is important to monitor the volume of options traded on the company. A further step is the collection of reports issued by brokers to measure analyst consensus of the company and the expectations of the financial community.

Hedge fund managers follow a strict discipline for short selling, fixing target prices that represent a threshold that, once reached, leads to the sale or closing out of the position. Generally, short selling managers do not resort to leverage, in that short selling is an inherently leveraged strategy. One of the greatest risks short selling managers run is that once they have spotted an overvalued company and they have sold it short, a buyer steps in, offering to take the company over and paying a premium to shareholders. Shorting a company with good fundamentals because it is experiencing temporary problems or based on an excessive valuation is risky, because a good management team can rapidly fix problems.

Short sellers try not to be deceived by the apparent story represented by financial statements; they try to scratch the surface and see what lies behind the numbers. To evaluate the health of a company, analysts study the financial reports of the last two years (10Q, 10K and possibly 8K). Great attention must be devoted to footnotes, and in particular it is important to figure out what has not been written in reports that should have been. Analysts look for accounting items whose actual value is lower than their balance-sheet value: securities that have not been marked to the market, real estate with inflated prices, inventory made up of obsolete products, receivables unlikely to be collected, etc.

Most of the recommendations expressed by brokers on shares go from buy to add to hold, and only a few analysts are willing to express a sell, reduce or underperform guidance on a stock. Analysts are constrained by corporate finance relationships or by the need to protect their business relationships with corporate management. This is why brokerage firms tend to be rather biased towards optimism.

To get complete information, you should buy this book!

This review is from: Investment Strategies of Hedge Funds
A great book of explanations on investment strategies. An easy read that explains each strategy a hedge fund might employ. If you want to invest in hedge funds or you are studying to someday run a hedge fund, you need to know what they do. There are so many blogs, articles, news reports out there telling how risky these vehicles are. Make your own mind up. Read this book.