Thursday, March 5, 2015

The Young Money guide to short selling

The title of this post is an overstatement: this isn't a comprehensive guide to short selling. Instead, it's a description of how I think about shorting and what I look for-- and avoid-- in a short.

My style of short selling is very different from the one most hedge fund managers use, so hopefully this post will provide a useful variant perception, but I don't claim that this is the One True Way to short stocks.

My favorite shorts

There are two dynamics that I look for in a short. The first is an industry-wide expansion that's been financed with debt. To generate the cash they need to service this debt, industry players have to keep producing even when doing so doesn't yield economic returns. This is self-defeating and leads to severe, prolonged gluts.

Iron ore miners, and mining companies more generally, provide a contemporary example of this dynamic.

The housing bubble provides another example: most homebuilders took on a lot of debt to buy land. When the bubble burst, the land market froze up, leaving them with large inventories they couldn't liquidate. The only way they could monetize their land and pay back their debt was to build more houses, which exacerbated the downward pressure on house prices.

A similar dynamic occurs when companies have to sell leveraged assets. The Lehman Brothers bankruptcy examiner's report explains why Lehman's effort to sell its toxic assets was self-defeating:

But if the need to reduce leverage forces the sale of illiquid assets at a loss, it has a double impact; in addition to the loss, the perception can be that there is "air" in the valuation of the other illiquid assets that remain on the balance sheet, exacerbating the risk of a loss of confidence in the firm’s future.

The second dynamic I look for is failed exponential growth.  In Irrational Exuberance, Robert Shiller writes that "naturally occurring Ponzi processes" are a defining feature of asset bubbles. Since Ponzi schemes pay their existing investors with money from new investors, they have to grow exponentially or else they'll collapse. While asset bubbles aren't fraudulent, they follow a similar growth-until-collapse trajectory.

A necessary ingredient of the housing bubble was that mortgage lenders continually relaxed their lending standards, allowing a larger and larger group of people to buy houses. Eventually they ran out of remotely decent borrowers and began lending to people who were so marginal that they defaulted on their loans within a few months. At that point many subprime lenders failed and the rest pulled back, starving the bubble of the exponential growth it needed to sustain itself.

Something similar happened during the dotcom bubble. In early 2000, tech stocks traded at high P/E ratios because they were growing quickly. But by then the marginal buyers of high-tech products were money-losing competitive local exchange carriers and dotcom startups. Many of the CLECs and dotcoms had no real business plan and went out of business within a couple years, ending the dotcom bubble's exponential growth. They were the final, marginal buyers of the dotcom era, like subprime deadbeats were the marginal buyers of the housing era.

Conventional wisdom says that shorting a bubble is too risky. I partially agree-- catching the exact top of a bubble is difficult, and there's a severe penalty for being early and shorting into exponential growth. I never short a bubble unless I'm convinced that its exponential growth trend had failed.

In my experience, though, there are usually great shorting opportunities even after the trend has clearly failed. By September 2000 it was clear that the CLECs and dotcoms were goners, but the NASDAQ 100 was only 15% off its all-time high. By February 2007, the whole subprime sector had already imploded, but leading homebuilders were only 20-30% off their highs and XLF, the financial sector ETF, was less than 10% off its high.

The market offers opportunities like this because few investors understand the extent to which bubbles are like natural Ponzis and will collapse without growth. Most investors are backward-looking and extrapolate recent years' performance forward. Every bubble has periodic shakeouts that give way to further appreciation, and these shakeouts train people to buy the dip. There are also some people who missed the bubble and are anxious for their chance to get in, and when the bubble finally bursts they think their opportunity has arrived.

Less-favorite shorts: frauds

Short sellers often target companies that they think are committing fraud. This is a viable strategy, but it has several under-appreciated risks:

• It's become very crowded. Frauds are arguably the most popular kind of short nowadays.

• Occasionally a company that looks fraudulent turns out to be legitimate and the stock surges. Robert Friedland and Patrick Soon-Shiong were both dogged by controversy during their careers, yet they both managed to create and sell multibillion-dollar companies.

• There's a bigger macro component to fraud-busting than most people assume. Enron didn't collapse until the entire merchant-energy sector experienced a liquidity crisis. (Edit 4/4/15: This statement is incorrect. While Enron went bankrupt during a period of rising bond spreads, the merchant power sector didn't experience a severe crisis until mid-2002, six months after Enron's bankruptcy. Mea culpa.) Allied Capital was able to continue its Pozni-style growth for years until the Global Financial Crisis prevented it from raising new money.

Shorts I don't like and don't do

• Overvaluation
Short sellers sometimes argue that a company will never be able to grow into its valuation. In my experience, companies that trade at exorbitant valuations because they're growing quickly keep trading at exorbitant valuations so long as they keep growing quickly. And occasionally a company does grow enough to justify a steep valuation, e.g. AAPL and HANS/MNST.

Some companies have structural reasons for being overvalued. RGLD invests in gold-mining royalties and has always traded far above NAV. It's sustained a large premium to NAV because it offers yield and good capital allocation in an industry that's notorious for offering neither.

• Aggressive accounting
Companies with liberal accounting innovate more. Investors typically look only 1-2 years into the future, so they often won't support a project that has the potential for strong long-term returns but requires a lot of upfront investment. Creative accounting gives companies a way to invest for the long term while meeting short-term expectations.

Other factors can outweigh the effects of aggressive accounting. If a company overstates its earnings by 10% but grows earnings by 30% a year, which is more important?

Aggressive accounting may be a sign of deeper problems, but by itself it's not a reason to short.

• Promotional management
Management may be promotional as part of a strategy to get their product more visibility or raise money on better terms. Like aggressive accounting, promotional behavior is a red flag, but by itself it's not a reason to short.

• Perception shifts
in 2008, I shorted a basket of companies with negative tangible book value. My rationale was that there would be a recession and financial crisis, which would lead to investors and lenders becoming more conservative, and companies with no net worth would go out of favor. This basket was marginally profitable, but it made me a lot less money than my housing and finance shorts.

The difference was that housing/finance stocks were being dragged down by a macro process that had already begun and that I knew would continue. By contrast, the basket trade was based on my vague anticipation that a recession would change people's perceptions of indebted companies.

I made the same mistake last year, shorting POST and VRX on the assumption that people were overvaluing them because they were "Outsider companies." Like in 2008, these detracted from my macro shorts.

• Small-caps and crowded shorts
In 2009, I shorted a Spanish bank called Banco de Valencia. Regulators eventually seized the bank and its stock went to zero, but I didn't make any money because I got bought in at a 10% loss. I was beside myself watching the stock's subsequent decline.

The risk of a buy-in doesn't automatically make something a bad short, but I'm not able to handle the frustration of being bought in, so I don't do it.

• Acquisition targets
I shorted Rio Tinto the day before BHP Billiton offered to acquire it. I also started looking at Consolidated Thompson as a short a couple weeks before CLF acquired it. Those experiences have made me paranoid about shorting acquisition targets. Like shorting stocks with a high buy-in risk, it's just too stressful for me.

• Increasing competition
Increasing competition won't necessarily hurt a company that has differentiated products. AAPL and LULU have fended off a lot of deep-pocketed competitors.

In a commodity industry, increased competition inevitably kills margins, but it can happen with a years-long lag if speculators hoard the commodity. Since 2009, there have been frequent reports of copper being stockpiled in Chinese port warehouses. I think this has kept copper and mining equities much higher than they otherwise would be.

• Structural handicaps
Short sellers sometimes argue that a company has a fundamental flaw that prevents it from earning decent returns: its competitive position is too marginal, its cost structure is high and impossible to bring down, or its management and corporate culture are terrible.

Shorting companies like this has a couple of drawbacks. First, companies that are doomed to produce poor long-term returns sometimes achieve decent short-term returns. History gives us many examples of companies that temporarily turned around before failing.

Second, structural challenges can take a long time to translate into lower earnings. Tesco fell nearly 50% last year, but it was flat for years before that as problems-- the Fresh and Easy debacle, competition from Aldi's, etc.-- piled up. Someone who shorted TSCO in 2007 has a mediocre annualized return and had a 0% annualized return until last year.

In a 1987 Barron's interview, Julian Robertson recommended shorting Winn-Dixie because it was a high-cost player facing competition from low-cost entrants. Robertson was right about Winn-Dixie's future-- competition eventually bankrupted it-- but its stock rose significantly during 1990s despite its weakening competitive position and didn't peak until 1998. It paid large dividends the whole way up.

• Disruptive innovation
Disruptive innovation is a long-term phenomenon, and cyclical phenomena can overwhelm it in the short term. ETFs are steadily taking share from mutual funds, which are likely to fade away until they're a small niche product, but that hasn't stopped TROW from quadrupling since the stock market's March 2009 low.

FSLR is the only major company that invests in making Cd-Te solar panels more efficient, whereas there are many companies investing in polycrystalline solar. I'm skeptical that Cd-Te has much of a future, but that didn't stop FSLR from surging 1100% in the year after its IPO.

The Internet began disrupting newspapers in the 1990s, but newspaper stocks didn't peak until 2004.

Arguments against shorting

"Shorting is hard."

Many hedge-fund managers say that shorting is difficult and that they've never been able to earn sustained profits for it. There are two reasons for this:

One, they're using a crowded strategy and piling into crowded shorts. Most funds emphasize fads, failures, and frauds in their short book. Most funds short all the time as part of a low-net-exposure strategy, even though opportunities for shorting vary across the market cycle.

Two, they short because that's what hedge funds are supposed to do, not because they have a talent or inclination for it. As Whitney Tilson writes, "Most investors expect hedge funds to have a short book." Instead of striving to satisfy investors' unrealistic expectations, why not invest that psychic energy into looking for better investors?

"The market goes up over time."

There's no guarantee that it will continue going up. The Nikkei is 50% below the all-time high it reached 25 years ago. I expect US markets to be lower five years and ten years from now.

Even if the market goes up, it's likely that a minority of stocks will account for all of the long-term gains, with the rest treading water or going down. As Carlo Cannell says in his Value Investor Insight interview:

If you really track the mortality rates of companies, you’d conclude that the market does not have the upward bias everyone thinks it does. The market is actually a carefully pruned garden.

Many industries and emerging markets have fallen over the past five years as the broad market has surged. The same thing happened during the late-1990s tech bubble. Even in a bull market, there are sometimes good short opportunities.

"Shorting is stressful."

This is definitely true. David Merkel argues that being short is like having a leveraged long position, since they both involve the risk of losing more than 100%. Someone who isn't comfortable using margin debt probably shouldn't short.

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