Highlights in this issue:

*** How to make money when the market tanks...
*** 2 easy ways to short a share...
*** Tips to pick the share set to plummet... and more...

From the overworked laptop of Julie Brownlee...

Dear Investment Academy Reader,

With September comes fear on the stock markets the world over! Why? Well, historically, September is the worst performing month of the year on the markets. Research has shown that shares tend to lose value over the month. And after the stellar run on the markets since their March lows, maybe September will result in that correction many analysts have been alluding to.

But, if it does happen, don’t stress! Help is at hand! I’ve got a few strategies to make the most of a tanking market...

How to make money in falling markets

Has the stock market rally petered out? Since Friday last week, the JSE All Share Index has shed 3%. And, as I write, the JSE closed flat. With investors realising the global recovery has a long way to go before it’s anywhere near back to health, stocks could fall a lot further. And with the notorious “bad” month upon us, you need to be prepared. That means the time could be nearing for the trader in you to profit by shorting overpriced stocks.

How shorting works

A stock market trader might borrow, say, 10,000 Shoprite shares at 5700c, in return for a fee paid to the lender (often a pension fund). He sells the borrowed shares and waits. Say two days later, Shoprite shares fall to 5350c. He buys back the 10,000 shares, making a profit before trading costs of R35,000 – i.e. (57.00-53.50) x 10,000 – then returns the 10,000 shares to the original lender. That’s if all goes according to plan.

The biggest risk is a “short squeeze”. Imagine our trader had borrowed a relatively illiquid share. But having sold the stock, the price then sharply rises. Our short seller still needs to buy 10,000 shares to return the shares he borrowed. This could prove difficult and very expensive if there are few sellers around.

How you can go short

Going short by borrowing individual stocks isn’t feasible for retail investors, unless you have millions to play with. But there are two ways you can mimic it. For speed and flexibility, spread trading is best. You could open a down trade (“sell the spread”) on Shoprite at R10 a point (where 1 point equals a 1c change in the share price) when the quoted spread is 5690c/5710c. When you close out, if the spread has dropped to 5340c/5360c, you make 330 points – i.e. 5690-5360, or R3,300 at R10 a point. To minimise your losses, in case the share price rises, you should take out a guaranteed stop loss. You do pay a little more for this, but it’s worth it.

Secondly, you have put options. An equity option might give you the right to sell 1,000 Shoprite shares before the end of September at a fixed “strike” of 5700c. You pay a non-refundable premium of R2 a share, or R20,000, to buy ten (R2 x 1,000 x 10). If the Shoprite share price is 5350c when the option expires in September, you stand to make R35,000 (R3.50 x 1,000 shares x ten options), less the R20,000 premium. That’s R15,000 in profits!

How to spot a share to short

So what do you short? James Montier at Société Général suggests you screen firms. Weed out those with the “very unhealthy combination” of high price and “worrying accounting”. High price here means a high price/sales (p/s) ratio – Montier suggests 1.5 or above. As Sir Alan Sugar once commented on The Apprentice, a business selling £10 notes for £9 could generate lots of sales (and by extension a decent p/s ratio), but it’s pretty obvious why it isn’t a good bet.

As for the “worrying accounting”, leaving aside pure fraud, there are several ways a firm can stay within the rules but “ensure it can beat analysts’ quarterly forecasts”. Watch out for a growing gap between operating profits and cash flow from operations. Cash flow is hard to manipulate. A big gap might mean, in arriving at the profits figure, a firm’s used some “highly subjective estimates” to its advantage. For example, understating bad debts and overstating expected pension fund returns.

Also look for debtors (“receivables”) and stocks (“inventory”) rising faster than sales. The former suggests a firm is desperately trying to boost turnover by shifting stock onto customers (“channel stuffing”). The latter can flag slowing sales.

Beware of falling depreciation (the accounting charge against profits made to reflect asset wear and tear) as a percentage of total fixed assets. By lengthening the expected life of an asset to reduce depreciation, a firm can boost profits. The last red flag is fast asset growth. Sometimes to boost short-term revenue and earnings without adding much long-term value, acquisitions are used.

Your chance to short could be just around the corner

“The last time developing countries got this expensive was October 2007,” says Adrian Camino on Bloomberg. The MSCI index trades at 15.4 times reported earnings, compared with 14 for the S&P 500. Meanwhile, current prices put a typical MSCI stock on 1.7 times its net assets – “the highest on record” – and above the MSCI World average of 1.5. In short, says Mathieu Giuliani, a Palatine fund manager, “emerging market stocks are at risk”.

As the Johannesburg Stock Exchange falls into the “emerging” category, your opportunity to take advantage of this could be looming. Keep an eye on the market!

Happy trading!

Julie Brownlee
for The Investment Academy

** This article was adapted from a MoneyWeek feature.