Stocks at Risk Model
Our hybrid systematic + fundamental approach allows us to sort through thousands of companies each with hundreds of datapoints and ratios continuously to identify outliers and changes. Outlier statistics are aggregated, weighted and summarized into a Stock at Risk (SAR) Score.
The SAR score is a ranking of stock riskiness. Measured in standard deviations, a lower number indicates a riskier stock. It quantifies risk in Valuation, Financial Condition, Business Trend, Earnings Quality, and ‘Red Flags’ for all non-financial US equities with market capitalizations greater than $750mn that meet minimum share price and trading volumes.
This table provides a sampling of the factors our model is designed to survey.
While the Stock at Risk model adds value by itself, fundamental analysis adds substantially more.Our company reports are typically short oriented. A fully developed discussion is provided in every report. The analysis begins with the Stock at Risk model as a framework. The preliminary thesis is developed and confirmed by comparing the company with its competitors on a variety of metrics and in time series. We read all relevant SEC filings, earnings call transcripts, investor presentations and press releases. We analyze the company’s marketplace and competitive position for insights into drivers of future earnings and value.
Research themes include:
- Slowing growth and/or new competition
- Poor business models or cyclical changes in product supply and demand dynamics
- Inventory or receivables buildup leading to sales declines and/or margin compression
- Improper capitalization of expenses or other deliberate and questionable accounting practices
- Insufficient cash flow or untenable debt maturities
- The competitive need to continue investment or the need to dilute existing shareholders
Our work always seeks to identify catalysts that will cause the stock price to move in the direction of our investment thesis. We also identify the risks that might cause our recommendation to be wrong.
Types of Shorts
We find four general types of opportunities for short selling in the market: overvalued growth stocks, cash flow shorts, balance sheet shorts and quality of earnings/manipulation shorts. The categories are not mutually exclusive; sometimes a company falls into more than one of these categories.
Overvalued Growth Shorts
Growth shorts can be categorized further into pure speculations and fast growing “real businesses” that are overextended.
Pure speculations can often be found among biotechs, emerging technology and other companies such as “patent trolls” or blank check companies. These are dangerous shorts because they have little with which to anchor a valuation. Without a fundamental anchor, investors can conjure up any expectation to justify a value. Investors often overlook risk elements. These stocks are far more prone to headline risk than other types of shorts. Positive news of a new customer or pending FDA approval is sometimes enough to propel the stock skyward.
Speculative shorts require very strong and specific catalysts, such as a finite amount of time before cash burn forces a dilutive offering or the entry of credible new competitors in a market that had been exclusive to the company. Past recommendations in this category include Cheniere Energy (LNG), Intercept Pharma (ICPT), A123 Systems (AONE) and RealD (RLD).
Overvalued “real businesses” can often be found in consumer, technology, industrial and energy industries. These are often darling stocks with large institutional followings due to recent historical growth who are led by IR-savvy, promotional management teams. These stocks can get very expensive before they fall. Since a short investor always needs more than just valuation to justify a position, our models look for evidence of overstated growth (perhaps due to acquired growth), slowing growth, working capital or margin problems and/or earnings quality issues. Recommendations of this type include Restoration Hardware (RH), Deckers Outdoor (DECK) and Clean Energy Fuels (CLNE).
Cash Flow Shorts
Cash flow shorts are companies that generate insufficient or negative cash flows. There could be temporary or permanent large expenses, including R&D or capital expenditures that are required in order to maintain competitiveness. The critical determinations revolve around whether the cash flow problems are indicative of structural deficiencies in the business or are transitory. A visible cash burn situation is often critical in deciding on these names as shorts. The key risk to cash flow shorts involve the risk of refinancing, especially in an easy credit environment. Other risks include that if the cash deficit is not too large, the deficits can persist indefinitely. In fact, severely over-levered companies that escape acute financial crises often produce spikes in stock prices. Successful recommendations of this category include Solar City (SCTY), Ciena (CIEN), Quicksilver Resources (KWK), GrafTech International (GTI) and Chesapeake Energy (CHK).
Balance Sheet Shorts
Often related to cash flow shorts, balance sheet shorts are companies caught in a bind due to very high debt service, impending debt maturities, large contingent obligations (e.g., guarantees or underfunded pensions), covenant breaches threatening debt acceleration and revolvers running out of room. The focus area for analysis needs to be understanding the cash flows available for debt service and the terms of the debt. The key risks involve the credit environment and sudden refinancings, or improvements in the cash flow pictures of the companies. Past recommendations of this sort include Central European Distribution Company (CEDC), Overseas Shipholding (OSG), Quicksilver Resources (KWK), Steel (X) and Orient Express Hotel (OEH)
Earnings Quality Shorts
Companies sometimes manipulate earnings in order to show higher growth or better earnings than otherwise. This type of behavior spans a range from putting a positive spin on a negative event, through aggressive accounting that may comply with GAAP to extremes such as outright earnings manipulation and fraud. To uncover these cases, our models look for Cash Flow from Operations that falls short of Net Income and the causes for such a shortfall. We also look for unusual or new asset accounts, unusual growth in current or deferred asset accounts, misallocation of operating cash flows to the investing or financing sections of the Statement of Cash Flows and a long list of qualitative red flags that use text searches within a company’s financial footnotes. Recommendations of this type have included Iconix Brands (ICON), KB Home (KBH) and Chesapeake Energy (CHK).