As the Technoking once tweeted:
“SEC: three word acronym. Second word is “Elon’s”
… the SEC didn’t blink.
Short side investing
In the tradition of Harvard Business School case studies, which all begin with an anecdote about the person in question, their role, career progression, goals, ambitions, mental state, the weather, and precise number of coffees they’ve had that morning… actually, this is Crombie GI, we’re all about alpha per hour so we're getting straight to it.
With valuations at all-time highs, market jitters and anything with “green” in the title attracting valuations so rich Bernie Sanders wants them to pay more tax, I thought it’d be a good time to look at short selling: What is it? Why do I do it? How does it help?
If you’re familiar with short selling, you can skip the next two paragraphs. If you’re still here, short selling is the practice of selling shares you don’t own to benefit from declines in share prices. How good is finance? “Selling things you don’t own sounds like a great way to make money, James – perhaps I should sell my neighbour’s house?” I love the enthusiasm, but it’s a little bit more complicated than that. When you sell something short, you give the owner an IOU in exchange. Let’s assume a) I’ve developed a deathwish and b) this manifests itself as a desire to short Tesla. Let’s assume you own 10 Tesla shares, I take those shares and sell them in the market today for $1,000 each (meaning I receive $10,000). In exchange you’ll get an IOU saying I’ll purchase 10 other Tesla shares in the future and give them back to you. I’ll also pay you an interest rate or “borrow cost” (let’s call it 1%) for borrowing the shares, so everyone is happy. And, because you have an IOU, you’ll remain fully exposed to the price movements of Tesla, even after I’ve sold them short.
Let’s assume Elon engages in his favourite pastime: getting high and trolling the SEC on Twitter. The SEC takes umbrage, and Tesla’s share price falls to $800. I buy 10 shares in the market for $8,000 and give them to you, settling the IOU. I also pay you $100 in interest. I pocket the $2,000 difference between the price at which I sold the shares and the price at which I repurchased them and after paying you $100 in interest, I end up with a profit of $1,900. The whole process is facilitated by our respective merchant banks and we both remain anonymous throughout.
To those familiar with short selling, welcome back. Short sellers are often painted as nasty, cave-dwelling misanthropes or opportunistic long-only investors who want to charge hedge-fund fees. Tautology? Perhaps… While both points are sometimes true, I believe short sellers serve an extremely important role in public equity markets. Here’s why: imagine you go through the world with only two possible opinions: positive and neutral. Marry the love of your life: positive. Family member dies: neutral. Loss of employment: neutral. You’d probably end up with an overly optimistic view of the world – you need negative views in order to see things clearly. The same goes for equity securities: if there were no short sellers, there could only be positive views (buy), or no view at all (don’t buy). This optimistic bias would result in securities priced in a way that doesn’t reflect their risks – which is bad for everyone. Short sellers are the necessary negative views on the world.
So, brief introduction out of the way, let’s look at short-selling philosophy, identifying short candidates, and risk management.
Short-selling is not the inverse of long-side investing. On the long-side, you make money by having other bulls buy. On the short-side, you don’t make money when other bears go short (at least not always – they’re usually trading in volumes insufficient to exert significant pressure on the share price). On the short side, you make money when the bulls capitulate. It’s much more important to understand the bull thesis and when it might be proven wrong than it is to understand why this is such a bad and overvalued company.
Furthermore, on the long side, bravery helps you win. Jumping with all the heroism of an amphetamine-fuelled racoon into a what looks like a screaming dumpster fire of a stock can deliver some pretty solid returns – and is also a lot of fun. On the short side, cowardice helps you win. It can be better to show up after the battle and stab the wounded. Time for some examples.
John Hempton, an Australian hedge fund manager and all-round weapon, relayed the story of Bre-X, a gold mining company in the late 90’s, in a podcast last year. The story is portrayed in the 2016 film “Gold”. Essentially, Bre-X discovered the largest gold mine in human history, by a factor of about… 30, in the middle of the Indonesian jungle. It was eventually revealed as a fraud and the stock sank to $0. However, on its way to $0, it went from ~$5 to $286.5 / share, which, if you’d shorted it at $5 is a return of -5,630%. Assuming I shorted $10,000 worth at $5, that’d be a $573,000 loss. Furthermore, your broker would probably stop you out of the position, meaning you’d be forced to close the short and book the loss – taking it from a paper loss to a cash loss. Bravery in short selling can cause you significant pain.
Back to Bre-X: speculation began around the true amount of gold at the Indonesian mine, and the stock started to wobble in early 1997. At this point, the head geologist (who found the “gold”) falls out of a helicopter and – you couldn’t make this up – was eaten by Bengal tigers. It turned out the core samples were fake and there was no gold at the site. The stock falls into a death spiral over the next 6 weeks. But you could have shorted it at $100 on the way down, and $100 to $0 is still a 100% return. When shorting frauds, it’s often best to show up after the battle and stab the wounded.
Finding and taking short positions
A good short has 2 ingredients: it’s a company that’s overvalued relative to its prospects and it has an upcoming event that will prove the bull thesis incorrect (called a catalyst). Catalysts are critical in short cases, even more so than on the long side because stocks tend to drift upwards over time. This means shorts can harm performance for extended periods and may not ever work out, or your returns take so long to materialise they’re no longer impressive on a compounded annual basis (20% returns that take 3 years to materialise work out to ~6.3% p.a. – about as exciting as watching paint dry). I’ll put the next sentence in its own paragraph, just to emphasise its importance:
Never short on valuation alone.
You need valuation and a catalyst to have the best chance when shorting.
So where do we find good short ideas? (This is not investment advice) I think looking for trends is a good place to start. Late last year / earlier this year, we had stimulus cheques and people working from home. Some consumer stocks saw rapid earnings growth as people spent their stimulus cheques. Bed Bath and Beyond (BBBY) was a good example. BBBY’s price demanded more stimulus cheques in the future – which were unlikely to materialise. Overvalued: yes, catalyst: probably a downgrade in one of their next 2 quarterly reports. The stock turned out to be a solid short.
Right now, I’m looking through ESG stocks for potential shorts (again, not investment advice). After COP26, anything with “environmental” in the Bloomberg description attracts a Bernie Sanders valuation (which I’m calling a BS valuation). Don’t get me wrong there’s a lot to be said for ESG investing. However, ESG standards could be a lot better. Greenwashing is rife and many companies have overstated their ESG credentials in an attempt to get a slice of the trillions of dollars that’s flowing into the area. It has become so bad that if you paint something green (thus making it environmentally friendly), its valuation doubles. This can leave some companies valued much more highly than warranted by their expected future cash flows – all you need now is a catalyst and you’ve got a promising short.
This sounds like a tough game, James, your upside is +100% and your downside is theoretically negative infinity. Why would you play? Well, there’re three reasons I think shorting is worth the hassle. Firstly, it acts as a hedge – you know, because hedge funds are meant to be hedged (who knew?). Let’s say you’ve got a long position that’s fundamentally sound. Let’s also say the market has a tantrum a la March 2020 and everything falls 30%. Your long thesis remains intact but you’re also down 30% - ouch. Your investors have formed an angry mob and roam the land with a concerning appetite for medium-rare investment managers.
Losses like this can leave people, to use a poker term, “tilted” i.e. unable to recognise promising odds and take advantage of them. You might panic and sell, or worse, fail to see the opportunities in the chaos of the market selloff.
But if you paired your long position with a short of equal size and March 2020 rolls along, sure you’ll lose 30% on the long, but you’ll also gain 30% on the short leaving your portfolio unchanged – or in other words, you’ve outperformed the market by 30% - which is excellent and slakes the cannibalistic thirst of said angry mob. Furthermore, you can close the short, take your profits and reinvest them in stocks which have been punished too severely in the sell off, setting you up for further gains.
This part will get technical – but there’s a joke at the end, so stick around. By setting your portfolio with 1 long and 1 short position of equal size, you have net exposure of 0%. Net exposure is long exposure minus short exposure. In this situation, you’re 100% long and 100% short, making net exposure 0%. A portfolio with a net exposure of 0% won’t react to broad market moves. If all stocks in the market rise 5%, you’ll gain 5% on the long position, and lose 5% on the short position. The portfolio will remain unchanged, which doesn’t sound great… but if the market falls 5% you’ll also be unchanged, which is better news. The main driver of your portfolio is stock-specific news – also known as alpha.
The second reason I think short selling is useful is shorts provide a source of cheap funding. Going back to our earlier Tesla example, selling 10 shares of Tesla nets me $10,000 today. My broker will keep some as collateral (AKA margin), but I can use the remainder to invest in other securities. Let’s say I post $2,000 as collateral with my broker, I could use the remaining $8,000 to go long other securities. Given that borrow cost for most equity securities is well below 1% p.a. that’s a cheap way of getting even more long in names I think are promising. Think about it this way: I’ve $10,000 to invest, I short $10,000 of Tesla, leaving me with $18,000 after posting collateral with the broker. I can use this $18,000 to invest in say, Visa. So long as Tesla underperforms Visa, I’ll make money.
Finally, you can set the net exposure of your portfolio to reflect your overall view on the market. Right now, just about everything is expensive, it feels like we’re days away from the world-ending Omega variant and the money printer’s toner may run dry - so my net exposure is ~30%. I’m being very cautious, even though shorting in this environment has felt like cursing the gods from the top of a skyscraper in the middle of a thunderstorm.
So, to wrap it up: short selling is a useful way to protect yourself from adverse market moves and to profit from companies whose valuations don’t reflect their prospects (so long as there is a catalyst). Never short on valuation alone, and beware angry mobs. Shorting also helps you get more long in the stocks you like and in expressing your view on the broad market.