Last week, we looked at James Montier's three-pronged approach to shorting stocks. Following on from that, it's also worth mentioning a useful accounting test that he developed in the context of shorting called the C-Score (C apparently stands for cheating or cooking the books). It's similar in nature to the Beneish M-Score, i.e. it's focused on identifying tell-tale signs / quantitative red flags which accompany bad accounting practice. Even if you don't fancy shorting individual stocks (given the scope for unlimited loss!), the C-Score approach is still a useful tool as a red flag that's worth knowing about - as with the Altman Z-Score, we're considering adding it as part of the Stockopedia PRO Stock Report. How does it work? Montier's C-Score is made up of six red flags or warning signals. The idea is that, like the Piotroski F-Score for financial health, these elements are scored in a simple binary fashion, 1 for yes, 0 for no. These scores are then summed across the elements to give a final C-score ranging from 0 (no evidence of earnings manipulation) to 6 (all the flags are present - yikes!). The areas tested are:
Of course, any of these elements on their own may be perfectly innocent, but it's probably worth knowing the explanation for it before you invest. The idea is that, the more flags that are present, the more likely it is that something may be going on below the surface of the accounts. Having said that, Montier's original list from 2008 contains some fairly respectable names like Amazon - so beware of false positives, as with any statistical measure.Does it work? Montier found that, in the US, stocks with high C-scores underperformed the market by around 8% p.a., generating an absolute return of just 1.8%. In Europe, high C-score stocks underperformed the market by around 5% p.a., although, interestingly, they still generated absolute returns of around 8% p.a... As a shorting tool then, Montier suggests using the C-Score in combination with some measure of over-valuation. This was on the basis that high-flying and generally more expensive stocks that are tempted to alter their earnings in order to maintain their high growth status. He used a threshold price to sales ratio of 2 and found that this drove the absolute return down to -4% in both the US and Europe!The Source Montier's excellent book, quot;Value Investing: Tools and Techniques for Intelligent Investmentquot; is available on Amazon (Chapter 25 discusses this strategy - it is also available online). If you’d like to run quantitative long and short screens like this across the UK market, sign up now for beta access to Stockopedia PRO, our UK stock screener.Further Reading
updated Feb 06, 2012
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