By Ed Bowsher at Moneyweek Videos

Hedge funds get a lot of negative attention in the press, but the best ones are very good at spotting overvalued shares. Once they’ve found these overvalued shares, hedge funds will short them – in other words, they’ll bet that the share price will fall. In this video, I’m going to look at some of the warning signs that hedge funds look for when they’re hunting for shares to short.

Warning Signs That Hedge Funds Look For When Shorting

Video length 00:07:11

Transcript

Hi, in this video. I'm going to look at hedge funds and shorting and I know that they're both things that a lot of people are quite negative about. But during this year I'm going to look at why they can actually be positive things for investors and for markets. So let's just quickly look at what we're talking about here, hedge funds. A hedge fund is basically a high end investment fund. They often have quite high charges for investors and they often pursue quite complex investment strategies and many people argue that hedge funds at least partly caused the stock market crash a few years back; and shorting is very simple, you short a share when you place a bet that the share price is going to fall, where as most investing when you buy a share in the hope the share price will go up, that's going long. Betting the price will fall is going short, or "shorting."

Now you might think oh my goodness hedge funds their bats are doing all these complex strategies charging too much causing financial crises and shorting that's bad too. That's ripping off ordinary investors and driving share prices down so that ordinary people end up losing their money. And if you combine the two together, hedge funds and shorting, wow that sounds really nasty and unpleasant. But sometimes hedge funds  sure can do good. Think back to the whole Enron scandal in the early noughties. It was hedge funds who first spotted the dodgy things were going on at Enron and the hedge funds hadn't been around...  If hedge funds hadn't been around looking for shares to short, Enron could have carried on being fraudulent, sucking more investors into the bubble for longer and more people would have ended up losing money in the end.

We've seen similar examples not as well publicized but similar examples of fraudulent companies more recently. Most recent one is a Spanish company called Gowex. Now Gowex had a business providing Wi-Fi in Spain and its share price was going up and up and up. It was a great stock market success and then a small specialist hedge fund called Gotham City Research. This is a hedge fund that just focuses on fining companies to short Gotham City realized that Gowex was very overvalued. So Gotham City took a short position and Gowex and shorted lots of  shares and then Gotham City publicized its findings to the markets. So the share price would then fall and Gotham City could make money and you might say that's terrible because shareholders in Gowex lost out because share prices fell. But the reality was Gowex was basically fraudulent. The CEO of the company had been claiming revenue that was way way too high. You know it's wasn't doing anything like as well as it made out because Gotham City came along the Gowex fraud collapsed earlier than might otherwise have been the case. So Gotham City did a positive thing. And there's been other examples of hedge funds shorting companies and successfully pointing out not necessarily that a company was fraudulent but that it was just overvalued. And when you have these specialist hedge funds looking for overvalued companies you actually get a more efficient market where share prices correspond more closely to the real underlying value of the company.

So I guess the next question is what do the shorters like Gotham City look for when they're looking for companies to short. Well I think they often focus on the issue of revenue and revenue recognition.  Remember revenue is not the same thing as cash coming into the company's bank account. Profit and cash are both important.