Should You Short These Top Hedge Fund Stocks?

It's smart to follow hedge fund managers, right?

Not necessarily.

Simply because top hedge fund managers are snapping up a company's stock doesn't mean you should do the same. In fact, you might be far better off doing the exact opposite.

That's because when the groupthink consensus shifts, or when hedge fund investors panic, these managers will collectively rush to sell widely held stocks. And as this happens, these companies' share prices could tank.

With this in mind, I went through some of the stocks most widely held by top hedge funds, to see whether there might be potential shorting candidates among the group.

I took each stock through a proprietary model called the "EQ-Scan," created by John Del Vecchio, CFA -- a leading forensic accountant and shorting expert -- exclusively for The Motley Fool. It looks for glaring red flags and aggressive accounting tactics that may overstate a company's true financial performance.

Here's what I found.

Company

No. of Hedge Funds That Have Stock in Top 10 Holdings

EQ-Scan Grade

Apple (Nasdaq: AAPL  )

75

D

Pfizer (NYSE: PFE  )

36

C

Microsoft (Nasdaq: MSFT  )

34

B

Google (Nasdaq: GOOG  )

24

D

ExxonMobil (NYSE: XOM  )

23

B

MasterCard (NYSE: MA  )

22

C

Oracle (Nasdaq: ORCL  )

22

D

Data as of September 7, 2010.

Let's dig in deeper
Why did these companies get these scores?

Apple's trailing-12-month (TTM) free cash flow margin declined from 28.8% to 22.3%, even as revenue nearly doubled. Days sales outstanding (DSO) increased from 29 days to 37 days over the last year. And accounts receivable (AR) as a percent of revenue increased from 32.2% to 40.8%. All of these could indicate aggressive revenue recognition, which pulls future sales forward, making current sales appear stronger.

Google's DPO spiked from 10 days to 121 days. Accounts payable (AP) as a percent of revenue spiked from 4% to 47.9%. The high DPO may signal unsustainable cash flow generation, as the company delays paying bills -- which of course can't last forever. The increasing AP may also signal unsustainable cash flow generation. In other words, it appears Google may be delaying bill payment, which makes cash flow artificially higher.

Oracle has a similar story. Its DPO increased from 21 days to 32 days, and AP as a percent of revenue increased from 3.9% to 8.2%. It appears Oracle, too, may be delaying bill payment to artificially boost cash flow.

MasterCard saw accrued and other current liabilities divided by sales drop from 90.4% to 44.2%, even as revenue grew. Accrued liabilities that drop sharply relative to sales could signal an unsustainable short-term boost to earnings.

Interestingly, when I dug into Microsoft, Pfizer, and ExxonMobil, I didn't find any glaring red flags.

Should you short these stocks?
Maybe -- if further digging suggests that red flags are real and meaningful. Delving into a company's financials can yield some interesting insights that can confirm or deny the results of screens, which focus only on bigger-picture metrics.

When we uncover financial red flags, well, that's a sign that we may have found a good shorting opportunity.

To learn more about other red flags that might be lurking on companies' financial statements, as well as to learn more about the red flags our scanner identified, drop you email address in the box below. I'll immediately arrange for a coworker to send you a FREE copy of our latest shorting reports, "5 Red Flags -- How to Find the BIG Short," and "4 Deadly Mistakes Even the Pros Make."

Adam J. Wiederman owns no shares of the companies mentioned above, nor is he short any. Google, Microsoft, and Pfizer are Motley Fool Inside Value choices. Google is a Rule Breakers selection. Apple is a Stock Advisor recommendation. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of ExxonMobil, Google, Microsoft, and Oracle. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Motley Fool has a disclosure policy.


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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 17, 2010, at 6:44 PM, Alexa225 wrote:

    So presumably a "D" grade means the stock is a potential short candidate? (Some clarity on the grades would have been helpful.)

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