Small caps: A good hunting ground for short selling?

Some small companies may one day grow to be large and successful, but others could fall victim to unfavourable market dynamics, poor management decisions, or a combination of both.

While a traditional long-only strategy can be utilised to find future potential market leaders, short selling also provides the ability to make positive absolute returns on individual positions from falling share prices.¹

And it’s within the smaller capitalised end of the market where there’s typically a broader dispersion of both positive and negative returns compared to the large cap index.

As illustrated in the chart below, in any given year there are a number of opportunities in the S&P/ASX Small Ordinaries Index with negative total share price returns.

Source: Factset. Data shown one year total company returns to 31 October 2022 for constituents of S&P/ASX Small Ordinaries Index. Company returns >200% not shown. Illustrative purposes only.

When interest rates are higher, companies with poor operating cash flow and high amounts of debt could struggle more to pay that debt back, presenting opportunities for short sellers.

Indeed, in periods of rising interest rates, interrogating a company’s cashflow against its growth aspirations and net debt position can be telling.

But even in periods of low interest rates, as we have seen over the past few years, businesses will still make poor operating or financing decisions, creating opportunities for short selling small companies.

Analysis of balance sheet and cash flow statement is a good place to find clues to which companies will be successful and which ones are candidates to endure periods of negative returns.

Comparing reported gross operating cash flow with profit and loss statements and inventory levels with receivables on balance sheets are also good places to look.

If a business has a non-transparent business model, or one that’s not easily understood, or a value proposition that’s not clear, these are red flags that a company could be a shorting opportunity.

Similarly, if a business is stripped of assets and has minimal earnings but has a high valuation in the market – these are also red flags to do more work to explore shorting opportunities.

¹ Investors should be aware that the use of short selling creates additional risk compared to a long only strategy

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