A lot of stock market analysts are getting more serious about their short portfolios as U.S. markets seemed to have topped out here with the Dow at around 18,000. With that in mind, the team from Goldman Sachs Group Inc (NYSE:GS) Portfolio Strategy Research, led by David J. Kostin, suggest three tried and true methods for selecting stocks to short in their April 13th report.
Screen for expensive stocks
The first suggestion from Kostin et al. is to take a “quantitative approach with a long and consistent record of identifying underperformers.”
They note that since 1980, companies with the highest EV/sales multiples have underperformed sector peers over the next 1-, 3-, and 5-year horizons. The GS analysts also note that a basket of the most expensive stocks in each S&P 500 sector (identified with a combination of valuation metrics) has underperformed the S&P 500 index by average of 5% a year, coming in behind the index in 25 of the last 35 years. Intercept Pharmaceuticals, Cheniere Energy and Liberty Broadband Class A are all in the top five most expensive stocks in terms of EV vs sales ratios.
Short stocks underweighted by mutual funds
The analysts point out that the basket of stocks most underweighted by large-cap mutual funds has fallen behind the S&P 500 by 12% since the start of 2013. These stocks have also had more negative returns than a basket of stocks most shorted by Hedge Funds. The mutual fund underweights are continuing to underperform so far in 2015 at 1.0% vs. 1.4% increase, and have done so with slightly lower volatility (13% vs. 14%).A second method for selecting stocks to short is to “Learn from the wisdom of the crowd, by shorting the stocks most commonly underweighted by mutual funds.”
Select stocks to short based on fundamentals
The third method Kostin and colleagues offer for selecting stocks to short is to focus on fundamentals and look for firms with the highest likely return dispersion and who are facing structural or demographic issues. They highlight that: “Our recent work on return dispersion allows us to identify the stocks with the highest micro sensitivity (as opposed to macro sensitivity) and largest probability of firm-specific risk in the near future. Among the universe of stocks that we identify as most likely to move independently from other S&P 500 firms, we highlight the stocks where Goldman Sachs Research expects the largest price declines, both in absolute terms and relative to consensus price targets.”