Evil's guide to short selling

From Evil Knievil from t1ps.com

These recommendations do not constitute advice, please read the risk warnings

Is shorting ethical?

My critics call me greedy, selfish and opinionated, and a destroyer of wealth. They are correct about the compliments and should have added that I am drop-dead gorgeous. But I am not a destroyer of wealth. I should say that I have added almost £1 million to my own wealth over the past six weeks.

I think what the carpers are suggesting is that shorting a company's shares somehow destroys good companies, causes workers to lose their jobs and generally 'talks down Britain'. There is no doubt that if I open up a short in a company, that act in itself can cause the shares to drop. I have been so successful over many years that I have a large army of devoted followers. There is no point in false modesty when I have so little to be modest about. As news of my shorting gets out, my loyal devotees will follow their guru (viz yours truly), and shares of a company in my gaze will fall. But they will only continue to fall if my analysis is correct.

Just occasionally, even my forensic brain gets it wrong or, rather more often, I trade while under the influence of alcohol and make a minor error of judgement. If I am wrong and short a company which is fundamentally undervalued then, no matter how much I huff and puff, the shares will go up and I will lose money. The company will not be destroyed and the only jobs threatened will be with the vintners of Kensington, whose best customer might himself face a few temporary cash-flow issues.

If, however, my analysis is correct (as, invariably, it is) then shares in the company which I am shorting would have collapsed anyway, reflecting the fact that the company was fundamentally overvalued by the market. If I am lucky the company will indeed go bust and its workers will be thrown out on the dole. But the point is that this would have happened anyway. My shorting the shares will not have caused the company to collapse. My activity merely means that the cloud (P45s for the workers, etc.) will at least have a silver lining. For me, anyway.

Shorting is, therefore, not unethical. Indeed, one might argue that the presence of shorters serves a useful function. The job of 95% of those employed in the City is basically to talk up shares. Financiers, brokers, PR bimbos, tipsters, fund managers and traders - they are all in it together. They want shares to carry on rising irrespective of whether they are rising too far. The ordinary investor seeking to make rational long-term investment decisions is, therefore, faced with a barrage of 'analysis' and comment suggesting that shares both collectively and individually should be bought. Who can provide a counter view? Who can ensure that there is a balanced debate helping ordinary blokes to make a balanced judgement? It is only the shorters, my fellow bears, who can provide such balance. As such, I like to think that I am not unethical and that I actually provide a real service to the investment community. At some stage I expect this will be recognised and that I shall receive a knighthood or perhaps even be ennobled for my services to the dis-investment community. I am quite happy to loan the Labour Party some of my spare millions if this could accelerate the process. Does anyone have a telephone number for Lord Levy?

I digress. The point is that shorting is a highly ethical business. It can also be highly profitable. The key is stock selection.

What to short

One can make money from shorting in any market. It helps when shares are collapsing generally. At that stage shorting becomes like shooting fish in a barrel. However, if you select the right target you will win, whatever is happening in the wider world. I am lucky. My infamy and my enormous natural charm mean that I have a wide range of useful contacts and an even wider range of useless ones. And that means that there is a constant flow of information coming into Evil Towers, allowing me to execute trades with that added advantage.

Some might call it insider dealing but such people generally do not know what they are talking about. If a bloke tells me something and does not say where he got it from and does not make me an insider it would be rude of me not to take advantage of that information. I am always discreet, so if there is anyone out there who wishes to pass on advance notice of any profits warnings on the way, feel free to get in touch.

But for those who do not have contacts as superb as mine (let's face it, that means everyone), there are four key screens one can use to identify stocks ripe for shorting.

1. Asset backing

If you think about it, the share price of a company must in some way be linked to the value of its assets. If a company is valued at 100p, but it would cost only 5p to replace all its assets, is it really worth 100p? It might be that investors are prepared to pay a huge premium to assets because they believe that the company will generate so much cash over the coming years that the value of that cash - discounted back - is more than enough to account for the gap between share price and asset value. But that belief is a leap of faith, because there can be no guarantee that the cash will indeed be generated as forecast. In my experience, where a stock has minimal asset backing, investors have rarely braced themselves for the possibility that the cash will not arrive and, thus, when there is a trading disappointment the shares have nothing to support them.

Perhaps this is best illustrated in reverse, with a stock I own, James Cropper. It is a paper-maker which - at a trading level - has served up more disappointments than Tim Henman's brief Wimbledon campaigns. Its latest coup was to halve its dividend. But its shares have not collapsed, precisely because behind a share price of 140p are net assets of 220p per share. Investors know that in a worst case scenario, Cropper could just sell up and return more cash to investors than the current share price. Had Cropper had minimal asset backing I fear that its shares would today be sub-50p.

Incidentally, when looking at assets one should ignore intangible assets completely. Effete marketing men might get turned on by the value of brands but I do not. Goodwill brought onto a balance sheet as a result of acquisitions should, in my view, be written off on day one. It rarely is. The only assets that really count are hard assets which can be sold on, so ignore intangibles completely.

2. Debt and interest cover

Though millions of our fellow citizens are drowning in debt, few seem to realise that at some stage borrowings need to be repaid. That is basically because most of the plebs are a pretty stupid bunch. They will soon be getting a nasty shock because base rates are going to go up. Luckily for me, quite a few PLCs are run by men and women who are equally stupid and the over-borrowed are a prime target.

The best companies to go after are those who are palpably struggling even to support their current interest payments. A brief look at a company's cash-flow statement will reveal the cash cost of servicing its debts, and you must then unearth its free operational cash flow - that is to say the cash generated by operations which is not earmarked for unavoidable capital works or tax. If the free cash flow covers interest costs only barely, you must ask yourselves how such a company would cope if there was even a modest downturn in its trading. Badly, I would suggest…

A second issue which the youth of today have forgotten en masse is that at some stage debt needs to be repaid. If a company's free cash flow after tax, dividends, capex and acquisitions represents only a tiny fraction of outstanding borrowings you might well ask how those borrowings are to be repaid. With difficulty, I would suggest. Inevitably, repayment will only happen at the expense of shareholders, either via dividends foregone or a bail out cash call.

Eurotunnel provides a case study in why over borrowed companies will - eventually - provide free money for those who follow the Evil path.

3. High rating

A company can only be valued on a high multiple of its earnings if it is set to deliver explosive earnings growth for many years, or, rather, if investors believe that it is set to deliver explosive earnings growth for many years. But this rarely happens and the reason is basic economics. That is to say if a company, or sector, is enjoying superior margins or return on capital or earnings growth, new entrants will inevitably become attracted to that sector. It is really very rare that there is any significant barrier to entry other than upfront capital needs in any industry. And if the rewards are perceived as being great enough, the capital will be found. As new entrants join the game, it is inevitable that margins and rates of earnings growth will be eroded. A case in point: internet gaming, where a sector-wide collapse is only a matter of time.

For a while investors, whipped into a frenzy by brokers, tipsters and PR men, will suspend belief and believe that they have stumbled upon the magic stock which can deliver superior earnings growth forever. Perhaps you remember Rentokil, when its CEO was known as Mr 20% because each year earnings would grow by 20%. Of course, it could not last and when there was even a slight shortfall Rentokil's shares collapsed because a high rating demands superior earnings growth forever. A high rating is an invitation to short. Those loss-making enterprises which trade on an infinite rating because they have, supposedly, made some amazing technological breakthrough provide not an invitation but an obligation to short.

4. Management failure

Should you kick a man when he is down? Too right you should. There is no better time. If a manager has failed to deliver on a promise of earnings growth or some other advance once, the odds are that he will fail again. You suggest that I should be more charitable and give someone a second chance. Charity begins at home and at Evil Towers I take the view that you make money from a failing management by shorting ahead of the next failure. The time to close the short is just before the failed manager is handed his P45, as there is always a danger that his successor will be less incompetent.

A short tip

I should admit that this short is a stock which I have been short of for well over a year and - to date - I have not exactly covered myself in glory. That is not to say that I am wrong, merely that the proof of my genius is yet to emerge. It will. The stock in question is Connaught (CNT) which, at 182.5p, is valued at £184 million.

You will no doubt be referring to the points made above. If you check its balance sheet in the most recently reported results for the six months to 28 February 2006 you will see that net assets were just £31.6 million. But it gets better. Strip out intangible assets and net assets are just £3.4 million. This company has no asset backing. Meanwhile, if one adds together its various forms of debt one sees that it owes £19.5 million - not an insignificant figure for a company with such minimal hard net assets. Now, I admit that interest cover appears reasonable (six times in the first half), but you may also note that last year - as has been its wont - Connaught failed to generate cash. Companies which do not generate cash, and which have minimal asset backing and high debts, are the sort to get stuck into.

There are three bonuses here. The first is that the shares have been inflated by inane broker ramp notes. The role of such notes is to provide rallies into which the astute bear can sell. The second is that Connaught operates in a hot sector - providing property services largely for social housing.  There is a view that anyone exposed to the public sector spendfest must be onto a winner. Maybe for now they are. But at some stage this country will be forced to be fiscally prudent. And finally, the profit margin for Connaught is low - sub-4% in the first half. It will not take much of a dip in sales for profits to slide. That will have clear implications for the balance sheet and yours truly will be in the money once again.

This is an abridged version of the first part of an independent three-part guide to short selling, the art of making money from falling share prices, commissioned by UK-Analyst. To read the remaining two parts, which will appear on Wednesday and Friday of this week (on uk-analyst.com), including two more hot short tips, sign up to www.uk-analyst.com. The author is the personal diarist and trusted confidante of Simon Cawkwell, aka Evil Knievil, the UK's most infamous short seller or bear raider. Cawkwell was dubbed 'the king of the short sellers' by The Daily Mail; a former colleague described him as 'the bigoted behemoth of bear trading'; and a well-known Guardian reader attacked Knievil's views as 'outrageous and offensive' - which was taken as a compliment.

This newsletter was published by t1ps.com Ltd which is regulated by the Financial Services Authority and can be contacted on 020 7033 9389. The articles in it are for general guidance only and we cannot assume legal liability for any errors or omissions they might contain.

T1ps.com assurance - all editors and contributors to the Tips service will declare any personal interests they have with any individual company they are discussing.

The value of investments can go down as well as up and you may not get back the full amount you invested. The past is not necessarily a guide to future performance. The difference between the buy price and the sell price for smaller company shares can be significant. Before investing, readers should seek professional advice from a Financial Services Authority authorised Stockbroker or Financial Adviser. Profits from dealing in shares may be liable to tax - the level of tax and bases of reliefs from tax are subject to change. Changes in the rates of exchange may have an adverse effect on the value or price of an investment in sterling terms if it is denominated in a foreign currency.

Some of the shares recommended on this site will be smaller company shares. By their nature such investments can be relatively illiquid and thus hard to trade. And that makes such investments more of a high risk than larger company shares.

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